Financial Institutions: Conduct of Monetary Policy, Tools, Goals, and Targets, Banking Regulation PDF

Section I | Part I Financial institutions: Conduct of monetary policy, tools, goals and targets, Banking regulation | Section I | Part I Learning objectives After studying this chapter, you should be able to: Discuss the effects of...

Section I | Part I Financial institutions: Conduct of monetary policy, tools, goals and targets, Banking regulation | Section I | Part I Learning objectives After studying this chapter, you should be able to: Discuss the effects of information asymmetry Explain the intermediary role of various financial institutions. The regulatory system | Section I | Part I In business if everybody knows the same thing then both investors and managers have the same information. This is called symmetric information. It assumes that investors and insiders have the same information. However, this may not be the case. Insiders (managers) will often have better information to that which outsiders (investors) have. This is called asymmetric information. Asymmetric information has important implications for the capital structure of the firm – the proportion of debt and equity in the capital structure. | Section I | Part I Information asymmetry Information asymmetry occurs when one or more investors possess private information about the firm’s value. Asymmetry creates an adverse selection problem in the market as informed investors trade on the basis of their private information. As the prices falls, sellers of high-quality assets withdraw from the market, leaving only low-quality assets (lemons) for sale. |  Section I | Part I As a result, trading in the asset may diminish or halt altogether because buyers fear that if they transact, they will be left with an overpriced asset (lemon). Moreover, such assets lose their ability to serve as collateral for other transactions, which contributes to the credit crunch. Adverse selection played an important role in the financial crisis of 2007-09 and in earlier crisis episodes. With asymmetric information, low quality goods drive high quality goods out of the market. The market fails to produce mutually beneficial trade. | Section I | Part I Also, in most modern corporations, owners delegate the corporate operations to managers, taking advantage of managers’ special skills and expertise. In this situation of separation of ownership and management, there is likely to be hidden information due to information asymmetries between the owner and the manager. It is often assumed that a portion of corporate value is privately observed by the manager (agent), while it is not observed by the owner (principal). This information asymmetry leads to what is called principal-agent conflict. | Section I | Part I The principal-agent setting leads to a decomposition of the underlying option into two components: a “manager’s options” and “ owner’s option”. Importantly, there is a conflict between the interests of the owner and those of the manager, i.e., there is a conflict between a manager’s option and an owner’s option value. In such principal- agent conflicts, the manager attempts to increase his option value by using private information. This action of the manager, at the same time decreases the owner’s option value due to principal-agent conflicts. The contract must be drafted to provide incentive for managers to faithfully reveal private information and preserve the value of the owner’s option. | Section I | Part I Asymmetric information is common in many of the transactions and contracts that banks and other financial institutions deal with. For example, a firm or an individual wanting to borrow from a bank to finance a new project may have more information about the project’s financial prospects and its level of risk than the bank has. In situations where such information asymmetry is large and there are no adequate mechanisms to address it or compensating the bank, lending will not take place. | Section I | Part I If the problem is widespread as in many developing countries, the growth of financial systems will be adversely affected and funds available for investment will be adversely affected. A lot of modern finance is based on the idea that there are incentives to develop regulations and corporate governance arrangements to minimise the challenges that stem from asymmetric information. | Section I | Part I The key problems stemming from asymmetric information are moral hazard and adverse selection. If these problems are severe, they may deter lenders and borrowers thereby adversely affecting the problem of financial intermediation. Moral hazard is the principle that individuals who are allowed to avoid the consequences of the risks they take are more likely to behave recklessly in the future. This problem occurs because it is difficult for one party to a transaction to monitor the second party. | Section I | Part I Moral hazard is especially common in insurance because the firm cannot completely monitor the activities or conditions of the insured and the behaviour of the insured may affect the probability of payout. For example, drivers who have insurance on their car may drive more carelessly or be less concerned about theft. In finance moral hazard arises when transactions take place between two parties with asymmetric information, for example, a bank lending to an individual without knowing fully the risks associated with the uses to which the individual will put the loan. Moral hazard generally occurs after an individual has made a commitment. | Section I | Part I Adverse selection on the other hand occurs beforehand. Prior to transaction’s occurrences, one party may know more about the value of a good being offered than the other. |