Munich Personal RePEc Archive
Asymmetric information: the multiplier effect of financial instability
Skardziukas, Domantas
1 March 2010
Online at https://mpra.ub.uni-muenchen.de/23013/
MPRA Paper No. 23013, posted 06 Jun 2010 02:31 UTC
Asymmet r ic infor mat ion: t he mult iplier effect of financial inst abilit y
Dom ant as Skardziukas, Erasm us Universit y Rot t erdam ABSTRACT
Financial market s and financial intermediation are essent ial t o w ell-functioning economy. They perform the role of channeling funds t o parties that have value creat ing invest ment opport unities. How ever, asymmet ric
informat ion can seriously impair the process w hen part ies t o t he financial cont ract are not fully aw are of the risks involved and, as a result , can limit their exposure to financial agreements t o prevent t hemselves from possible
losses. Increasing asymmet ric information as w e explain in t he art icle has a t endency t o bring a ripple effect in t he financial system. This negative money multiplier t hen set s t he st age unt il it severely hampers money supply, product ive invest ment opport unities and finally aggregat e economic act ivit y. The art icle int roduces t he reader w it h t he framew ork of asymmet ric informat ion developed by several aut hors in t he last few decades and builds on t he recent financial developments t hat pose new challenges.
The t heory of asym m et ric inform at ion is one of t he m ost pow erful fram ew ork t heories t hat can explain dat a pat t erns in t he different fact ors during t he periods of econom ic crises.
The academ ics have analyzed t he asym m et ric inform ation and it s consequences t hat arise due t o dissimilarit ies of inform at ion t hat is available t o part ies t hat ent er financial agreem ent s. Oft en t he m ain problem is t hat borrow ers are m ore alert of pit falls of f inancial cont ract since t hey are bet t er aw are of t he risks involved in a project for w hich financing is request ed. These inform at ional differences are t he very underlying cause of adverse select ion or w hat is already know n as t he lem ons problem w hich w as int roduced by Akerlof in 1970. A lem ons problem occurs in debt m arket s because lenders have t rouble det erm ining w het her borrow er’s invest m ent opport unit ies are at t ract ive enough com pared t o t he level of risk involved (i.e. he is a “ good risk” or “ bad risk” ). When t hat happens, lenders provide loans at an average int erest rat e t hat balances off expect ed ret urn for a loan port folio t hat const it ut es bot h high qualit y and low qualit y credit s. Presum ably, one can see t his as a fact t hat risks and t he associat ed required ret urn for high qualit y borrow ers is overst at ed, w hereas t hat of low qualit y borrow ers is underst at ed. Lenders t end t o average out t hese differences; as a result , high qualit y borrow ers end up paying m ore, w hereas low qualit y borrow ers less t han t hey should. If t hat happens, high qualit y borrow ers w ill not seek financing and forego profit able invest m ent opport unit ies.
Furt herm ore, as dem onst rat ed by St iglit z and Weiss (1981), borrow ers w it h t he riskiest invest m ent project s w ill now be t he ones m ost likely t o t ake out t he loans at high int erest rat es, since t hey w ill reap t he benefit s and leave t he loses for lenders should t hey occur. These risky undert akings on behalf of borrow ers w ill result in lenders cut t ing dow n on t he num ber of loans t hat t hey m ake, t his w ay causing t he supply of loans decrease w it h higher int erest rat es m ore t han it w ould at equilibrium . M ankiw (1986) has show n t hat a m arginal increase in t he risk-free rat e can significant ly decrease or even cause a collapse in lending t hrough t he ripple effect described above.
The m echanism suggest s t hat a m ajor sign of financial crisis w ould be a significant increase in int erest rat e of loans available for t hose borrow ers w hose risk charact erist ics are hard t o ident ify. Higher and low er grade bond yields essent ially reflect t he percept ion about t he risk relat ed t o t he undert akings of higher and low er qualit y borrow ers. This percept ion m ight arise eit her because t he lenders are w ell aw are of t he risks relat ed t o bot h high and low qualit y borrow ers, or m ore likely, because inform at ion about t he low qualit y borrow ers is not available. As a result , t he large spread bet w een high and low grade bonds should signal w hen t he adverse select ion problem in t he debt m arket s is far st ret ching.
To reduce t he adverse select ion problem in debt m arket s lenders secure t heir loans w it h collat erals or w it h t he borrow ers’ net w ort h. How ever, value of collat eral or net w ort h can decrease because of low er fut ure incom e st ream s (ex. m arket crash, see Greenw ald and St iglit z, 1988, Bernanke and Gert ler, 1989) or increased int erest rat es at w hich one discount s t hese incom e st ream s. As a result , should a borrow er default in any of t hese cases, t he lender w ill bear higher losses not covered by t he value of collat eral.
Just as before, w e expect t hat t he adverse select ion problem st em ming from t he sit uat ion w ill again w iden t he spread of int erest rat es on loans bet w een low -qualit y and high-qualit y borrow ers due t o differences in inform at ion available on t he t w o groups of borrow ers.
Asymm et ric inform at ion also leads t o m oral hazard problem bet w een t he part ies t o t he cont ract t hat again im pairs financial efficiency. M oral hazard refers t o borrow er’s behavior t hat occurs aft er t he financing has been obt ained. Because lenders are not f ully able t o ascert ain t he qualit y of invest m ent or m onit or t he use of t he funds, t he borrow er has incent ive t o engage in personally beneficial act ivit ies (ex.
excessive risk t aking, m isallocat ion of funds) t hat increases t he probabilit y of default and det eriorat es t he qualit y of loan. The borrow er w ill reap t he benefit s should it t urn for t he best , w hile lender w ill bear t he losses if borrow er default s.
This agency problem bet w een t he cont ract part ies w ill result in subopt im al levels of financing as lenders cut dow n on num ber of loans t rying t o lim it t hem selves from t he losses.
The agency problem w ill furt her am plify t he ripple effect on t he aggregat e econom y should t here occur an unant icipat ed deflat ion. Under deflat ion, real value of debt grow s w hile t he real value of asset s does not and w ealt h is redist ribut ed t o lenders at t he expense of borrow ers.
Shrinking net w ort h of borrow ers w ould prevent t hem from new undert akings w hich w ould event ually lead t o decline in
invest m ent and econom ic act ivit y.
The presence of inform at ion asym m et ries in debt m arket s explains t he vit al role t hat
banks play in reducing adverse select ion and m oral hazard in credit m arket s t hrough financial int erm ediat ion.
The expert ise t hat t hey have in screening and dist inguishing bad borrow ers from good ones allow s t hem t o reduce inform at ion asym m et ries at low cost (St iglit z and Weiss, 1983).
1.1 2008 Financial Turmoil and the “Lemon Brothers”
The failure of financial int erm ediation and t he resulting increase in asymm etric inform ation is a probably t he sim plest best w ay t o explain t he recent financial turm oil t hat has led t o global downt urn.
Slow ing econom y coupled w it h insolvency of m ortgage borrowers and t he housing m arket crash caused the value of collaterals t o drop sharply. Huge losses relat ed t o m ort gage related debt inst rum ent s pushed a m ajor financial inst it ut ion – Lehm an Brot hers - int o bankruptcy and caused increased risk- aversion in t he m arket s. Because m any financial and non- financial instit ut ions had exposure t o t hese collat eralized debt obligat ions, banks st opped t he lending since t hey could not dist inguish bet w een t hose w ho had loss bearing posit ions in CDOs and could default and t hose w ho w ere not . This has lead t o an im mediat e spike in int erest rat es and dry-up of liquidity in debt m arket s. As a result , even largest and m ost prominent US bluechips could not access debt m arket s t o fund their operat ions and invest m ent act ivit ies. This caused a severe drop in product ion out put and a cont ract ion in aggregate econom ic activit y.
They are m ore efficient t han individuals in m onit oring t he cont ract s and enforcing rest rict ive covenant s t hat reduce m oral hazard problem t hat is likely t o arise (Diam ond, 1984).
The exist ence of asym m et ric inform at ion in debt m arket s gives us an im port ant underlying rat ionale about t he significance of banks in channeling funds from savers t o borrow ers w ho have t he m ost at t ract ive invest m ent opport unit ies. Bernanke (1983) also argued t hat t urm oil in financial m arket s oft en harm s int erm ediation perform ed by banks and brings dow n financing of valuable invest m ent
opport unit ies w hich in t he end leads t o econom ic dow nt urn.
Bank panics are one m ajor exam ple of t he failure of banks t o fully perform t heir int erm ediat ion role. In a panic, deposit ors, fearing t he safet y of t heir deposit s, w it hdraw t hem from t he banking syst em and cause a m ajor w ipe out of funds and significant reduct ion in lending act ivit ies of banks. Undoubt edly t he asym m et ric inform at ion is one of t he m ain ingredient s of financial panic. As deposit ors are not able t o dist inguish bet w een solvent and insolvent banks t hey rush t o w it hdraw funds from all of t he banks t hat could possibly fail t o m eet t heir obligat ions or ret urn t he deposit s in t im e. The result ing capit al deposit out flow bank capit al t o level w here t hey eit her cannot m eet t heir obligat ions, provide new loans or bot h. Cost of financial int erm ediat ion rises, new profit able invest ment opport unit ies are not financed and as t here is no value creat ed in t he econom y, it slips int o recession.
Given t he absence of int ervent ion of policy m akers, bank panic decreases liquidit y w hich leads t o higher int erest rat es. The ripple effect cont inues since higher int erest rat es as m ent ioned previously (adverse select ion) decreases firm value. Therefore, bank run is anot her channel t hrough w hich asym m et ric inform at ion bot h ent ers t he financial m arket s as w ell as is furt her reinforced. Again, as a result , t here should be a pat t ern of w idening spreads bet w een low er and higher grade invest ment s in t he daw n of bank panics.
All in all, asymm et ric inform at ion is a very pow erful fram ew ork t hat present s t he dynam ics and result ing dow nt urn t hat happen once t here is a decrease in m oney supply. How ever, decline in m oney supply is not t he only area of financial discrepancies t hat asym m et ric inform at ion can explain. Inst ead, one should t ake a m uch broader pict ure t o see inform at ional asym met ries t hat exist in financial m arket s (see box 1.2) t hat can induce a financial m elt dow n.
1.2 Asymmet ric Information and Financial Derivatives
It appears t hat w it h t he evolut ion of financial syst em and financial product s, t here not only has been a significant im provem ent in t he reduction of inform at ion asymm etries in t he financial m arket s t hrough m ajor advances in t echnology and regulat ion, but also hand in hand increase in inform at ion asymm etries t hrough off-balance sheet trading act ivit ies in highly complex st ruct ured derivat ive product s and OTC (over-t he-count er) m arket developm ent. Not t o m ent ion t hat , even simple derivative product s such as forw ards t hat exhibit st eeper pay-off schemes t han t hat of t he underlying asset already am plify t he consequences of asymm et ric inform at ion t hrough im plicit leverage if a part y t o the cont ract fails t o follow agreement . This can m ake even sim ple and sound linear derivative cont ract s very risky. M eanw hile, OTC m arket s allow for less t ransparency on such agreement s. To continue wit h t he exam ple, OTC forw ard agreement s unlike t heir peer contract s t raded on an exchange, i.e. fut ures, allow parties t o engage int o cont ract and set t le it only on t he m at urit y; t his w ay part y losing m oney in t he cont ract avoids daily m argin calls t o cover m arginal losses should t he m arket t urn out unfavorable. Again asymm etric inform ation and specifically m oral hazard is at it s height since party t o t he contract is not aw are if t he count erpart y w ill be able t o m eet t he obligations on m at urit y. The loses by the end of the cont ract might be so huge t hat t he part y losing m oney m ight not be able to follow t he agreem ent. Finally, even m ore com plex derivat ive cont ract s such as CDOs enable debt t o be repackaged and resold t o m ult iple buyers w hile st aying off t he bank’s balance sheet s; t he debt loses its origins – risk charact erist ics are m odified and inform ation relat ed t o the original debt or is lost . Inst ead, risk characteristics are assigned by part ies t hat are interm ediat ing the cont ract (i.e. investm ent banks) as w ell as t hose that are t rust ed t o m onit or t hem (i.e. rat ing agencies). Such st ruct ure of funneling funds t hrough essent ially m ult iple st ages increases significant ly asym met ric inform at ion bet w een t he init ial borrow er and t he final lender, w hereas the responsibilit y of reducing t hese asymm etries is t hen concent rat ed in t he hands of several inst it utions w hich - as recent event s show – happen t o fail in t heir roles.
Having said t hat , it seem s that wit h t he developm ent of financial w orld, asymm etric inform ation, at least in cert ain m arket s, has been only increasing. No w onder t hat one of t he w orld’s m ost renow ned invest ors Warren Buffet t has called derivat ives t he financial w eapons of m ass dest ruct ion.
Hist orically, financial crises have begun w it h st ock m arket crash, rise in int erest rat es and result ing credit spread rat her t han w it h a failure of a financial inst it ut ion, w it h t he lat t er m ore likely being a
consequence t han a cause. The failure of a m ajor financial int erm ediary how ever significant ly increases t he uncert aint y in t he m arket (see t he box 1.1). Cet eris paribus, asym m et ric inform at ion int roduces a m ult iplier effect t hrough w hich rise in int erest rat es raises lem ons problem in t he credit m arket s, agency problem and value dest ruct ion in st ock m arket s. Failing banking inst it ut ions m ake t he int erest rat es rocket , cause t he final st ock m arket crash bot h of w hich are reflect ed in t he w idening credit spreads bet w een high grade and low er grade bonds. The event s am plify asym m et ric inform ation t o t he degree w here econom ic grow t h is halt ed.
There w ould be sort ing of solvent from insolvent banks t hrough public aut horit ies and clearing-house associat ions (M ishkin, 1990). Furt herm ore, governm ent as w e have seen recent ly m ight induce m oney supply by providing liquidit y. Uncert aint y w ould slowly fade out , m arket s m ight recover, int erest rat es fall back and if deflat ionary processes w ould not pert ain, one m ight see credit spreads shrinking and econom y recovering as seen t hrough 2009.
This course of event s m ight be ham pered if a subst ant ial deflat ion set s in, leading t o a debt -deflat ion process t hat t ransfers w ealt h from debt ors t o credit ors as described by Fisher Irving (1933) and
det eriorat es t he value of t he com panies. Should t hat happen, given already lower dem and for product s balance sheet s of com panies w ould w orsen leaving t hem w it h excessive liabilit ies, liquidit y problem s and pot ent ial bankrupt cy as seen in m ajor corporat ions in Japan in 1990’s. Invest m ent spending and aggregat e econom y w ould t hen rem ain depressed for a longer period of t im e.
Figure 1.1
As you can see from t he figure 1.1, t heory is rat her consist ent w it h t he em pirical dat a. Credit spreads seem t o balloon in t he daw n of a crisis and during recessions. In addit ion, an int erest ing finding is t hat of t he recent crisis. Apparent ly seeing signs of slow ing econom y on August 2007 Federal Reserve of t he Unit ed St at es cut int erest rat es t o induce m onet ary supply. Despit e t hat , lat er next m ont h t he yield 0
1 2 3 4 5 6 7
Percentae Points
US Credit Spreads and Business Cycle
NBER Recessions Baa-Aaa
Baa-10 Year Treasuries
Source: Aut hors calculat ions based on NBER, Federal Reserve & M oody's dat a
spread bet w een Baa graded bonds and 10-Year t reasuries had already been at 20 year hist orical height s w ell above 2 percent age point s. FED cont inued cut t ing int erest rat es in t he f ollow ing m ont hs, how ever, t hat did not st im ulat e econom y sufficient ly and on Decem ber 2007 t he Unit ed St at es had slipped int o recession w hich t urned out t o be com parable in scale t o t he Great Depression.
M ore t han t hat , it is surprising t o see how M ishkin (2000) has present ed t he vicious cycle t o t he Cent ral Bank of Iceland in his lat er w ork just t o see t he m elt dow n of t he count y’s financial syst em t en years aft er.
To t est t he predict ive pow er of credit spreads and st ock m arket w e ran m ult iple least squares regressions bet w een credit s spreads, st ock m arket and US indust rial out put using different t im e lags.
Sam ple period dat ing back t o 1920’s has been used. We have found t hat over t he period from 1920’s unt il 2010 st ock m arket has had t he m ost explanat ory pow er in predict ing negat ive indust rial out put 4 m ont hs before it has occurred, w hereas w ide credit spreads 1 m ont h before t he crisis. A sam ple regression in figure 1.2 below show s t hat despit e t he f act t hat t he credit spreads bet w een high and low qualit y borrow ers have m arginal explanat ory pow er for fully predict ing econom ic act ivit y, i.e. low R^ 2, it show s t hat it is significant t o t he variat ion of US indust rial out put , i.e. high t -value. This is how ever consist ent w it h t he fact t hat t im ely and w ell measured m onet ary easing and liquidit y inject ions from cent ral bank not account ed for in t he regression oft en induce lending act ivit ies by banks, reduce high risk-aversion and inform at ion asym m et ries in t he m arket t hat are t hen reflect ed in t he back drop of credit spreads, t he result of all w hich is a prevent ion financial and econom ic paralysis.
All in all, alt hough t here has been em pirical evidence t hat t he degree of asym m et ric inform at ion has dim inished over t he course of financial developm ent1, new cent ury and financial derivat es for w hich asym m et ric inform at ion seem s t o be second nat ure pose new challenges t hat w e should t ake very seriously.
Figure 1.2
Dependent Variable: IND (US Indust rial out put ) M et hod: Least Squares
Sam ple (adjust ed): 2 637
Included observat ions: 636 aft er adjust m ent s
New ey-West HAC St andard Errors & Covariance (lag t runcat ion=6) IND=C(1)+C(2)* SPREAD(-1)
Coefficient St d. Error t -St at ist ic Prob.
C(1) 0.236733 0.050135 4.721907 0.0000
C(2) -1.708171 0.418094 -4.085619 0.0000
R-squared 0.046140 M ean dependent var 0.224848 Adjust ed R-squared 0.044636 S.D. dependent var 0.874328 S.E. of regression 0.854592 Akaike info crit erion 2.526754 Sum squared resid 463.0272 Schw arz crit erion 2.540764 Log likelihood -801.5076 Durbin-Wat son st at 1.304958
1 See Ant zoulat os, Tsoum as, Kyriazis (2008), Financial Developm ent and Asymm etric Inform ation
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