A-43
chapter
1 2 3 4 5
6 7 8 9 10
11 12 13 14 15
16 17 18
Asymmetric Information
in the Financial System
1. Would each of the following events increase or decrease the volume of bank loans?
Explain.
a. New regulations make it easier for shareholders to replace company directors.
ANSWER: With new regulations that make it easier to replace company directors,
captive boards who are not properly supervising company managers are easier to re-
place. This ensures that boards of directors are more likely to protect shareholder in-
terests and to supervise management, which reduces the moral hazard problem.
Stocks become more attractive to savers. Fewer companies need to rely on bank
loans for financings. The volume of bank loans decreases.
b. A new law makes it a felony to default on a bank loan.
ANSWER: If it becomes a felony to default on a bank loan, the cost of bank loans in-
creases for potential borrowers. Fewer companies will take out bank loans to finance
investment projects when they are uncertain about the outcome of their projects. In-
stead, companies will try to obtain financing through the bond market. The volume of
bank loans decreases. On the other hand, banks are more likely to give loans when
more severe consequences are attached to defaulting. Making it a felony to default
will solve some of the adverse selection and moral hazard problems. Only the better
credit risks will still be interested in taking out a loan. Banks can therefore be more
confident about loan applicants’ credit. This has the potential to increase the volume
of bank loans. The net impact on bank loans from the new law is unclear.
c. All the economy’s small firms are bought by large firms.
ANSWER: Large firms are more likely to have a bond rating provided by rating agen-
cies. These ratings decrease adverse selection and make it more likely that firms will
obtain financing through the bond market rather than bank loans. The volume of bank
loans will decrease.
A-44 CHAPTER 7 Asymmetric Information in the Financial System
d. Mutual funds reduce their minimum balances for shareholders.
ANSWER: Reducing the minimum balance for shareholders in mutual funds en-
courages more small savers to purchase shares in mutual funds rather than deposit
funds in banks. Banks will have fewer funds available to loan out. The volume of bank
loans decreases.
2. a. Suppose you are hiring a worker for your firm. You advertise a position for
$50,000, but an applicant offers to work for $40,000. Should you jump at this offer?
ANSWER: Paying a salary of $40,000 is only a good deal for the firm if the applicant
is as productive (in relation to the salary paid) as another worker who gets paid the
advertised salary of $50,000. If the firm is hiring the worker for a job that is hard to
monitor, then the worker who gets paid the lower-than-advertised salary is more prone
to goofing off. The moral hazard problem is more pronounced at the lower salary.
Also, the fact that the worker volunteered to take a lower salary may indicate that this
worker does not plan to work very hard in the first place. The willingness to accept a
lower salary matches the worker’s knowledge of his or her productivity and indicates
an adverse selection problem. In either case, the firm needs to consider both moral
hazard and adverse selection problems before jumping at the offer of paying a lower
