George Akerlof, "The Market for 'Lemons': Quality, Uncertainty and the Market Mechanism," Quarterly Journal of Economics 84 (1970): 488-500. Two important papers that have applied the lemons problem analysis to financial markets are Stewart Myers and N. S. Majluf, "Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have," Journal of Financial Economics 13 (1984): 187-221, and Bruce Greenwald, Joseph E. Stiglitz, and Andrew Weiss, "Information Imperfections in the Capital Market and Macroeconomic Fluctuations," American Economic Review 74 (1984): 194-199.
in the used-car market, this securities market will not work very well because few firms will sell securities in it to raise capital.
The analysis is similar if Irving considers purchasing a corporate debt instrument in the bond market rather than an equity share. Irving will buy a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms trying to sell the debt. The knowledgeable owners of a good firm realize that they will be paying a higher interest rate than they should, and so they are unlikely to want to borrow in this market. Only the bad firms will be willing to borrow, and because investors like Irving are not eager to buy bonds issued by bad firms, they will probably not buy any bonds at all. Few bonds are likely to sell in this market, and so it will not be a good source of financing.
The analysis we have just conducted explains puzzle 2—why marketable securities are not the primary source of financing for businesses in any country in the world. It also partly explains puzzle 1—why stocks are not the most important source of financing for American businesses. The presence of the lemons problem keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers.
Tools to Help In the absence of asymmetric information, the lemons problem goes away. If buyers
Solve Adverse know as much about the quality of used cars as sellers, so that all involved can tell a
Selection good car from a bad one, buyers will be willing to pay full value for good used cars.
Problems Because the owners of good used cars can now get a fair price, they will be willing to sell them in the market. The market will have many transactions and will do its intended job of channeling good cars to people who want them.
Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their securities in the market. The securities market will then be able to move funds to the good firms that have the most productive investment opportunities.
Private Production and Sale of Information. The solution to the adverse selection problem in financial markets is to eliminate asymmetric information by furnishing people supplying funds with full details about the individuals or firms seeking to finance their investment activities. One way to get this material to saver-lenders is to have private companies collect and produce information that distinguishes good from bad firms and then sell it. In the United States, companies such as Standard and Poor's, Moody's, and Value Line gather information on firms' balance sheet positions and investment activities, publish these data, and sell them to subscribers (individuals, libraries, and financial intermediaries involved in purchasing securities).
The system of private production and sale of information does not completely solve the adverse selection problem in securities markets, however, because of the so-called free-rider problem. The free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for. The free-rider problem suggests that the private sale of information will be only a partial solution to the lemons problem. To see why, suppose that you have just purchased information that tells you which firms are good and which are bad. You believe that this purchase is worthwhile because you can make up the cost of acquiring this information, and then some, by purchasing the securities of good firms that are undervalued. However, when our savvy (free-riding) investor Irving sees you buying certain securities, he buys right along with you, even though he has not paid for any infor-
mation. If many other investors act as Irving does, the increased demand for the undervalued good securities will cause their low price to be bid up immediately to reflect the securities' true value. Because of all these free riders, you can no longer buy the securities for less than their true value. Now because you will not gain any profits from purchasing the information, you realize that you never should have paid for this information in the first place. If other investors come to the same realization, private firms and individuals may not be able to sell enough of this information to make it worth their while to gather and produce it. The weakened ability of private firms to profit from selling information will mean that less information is produced in the marketplace, and so adverse selection (the lemons problem) will still interfere with the efficient functioning of securities markets.
Government Regulation to Increase Information. The free-rider problem prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. Could financial markets benefit from government intervention? The government could, for instance, produce information to help investors distinguish good from bad firms and provide it to the public free of charge. This solution, however, would involve the government in releasing negative information about firms, a practice that might be politically difficult. A second possibility (and one followed by the United States and most governments throughout the world) is for the government to regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are. In the United States, the Securities and Exchange Commission (SEC) is the government agency that requires firms selling their securities in public markets to adhere to standard accounting principles and to disclose information about their sales, assets, and earnings. Similar regulations are found in other countries. However, disclosure requirements do not always work well, as the recent collapse of Enron and accounting scandals at other corporations (WorldCom, etc.) suggest (Box 1).
The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy (puzzle 5). Government regulation to increase information for investors is needed to reduce the adverse selection problem, which interferes with the efficient functioning of securities (stock and bond) markets.
Although government regulation lessens the adverse selection problem, it does not eliminate it. Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors: There is a lot more to knowing the quality of a firm than statistics can provide. Furthermore, bad firms have an incentive to make themselves look like good firms, because this would enable them to fetch a higher price for their securities. Bad firms will slant the information they are required to transmit to the public, thus making it harder for investors to sort out the good firms from the bad.
Financial Intermediation. So far we have seen that private production of information and government regulation to encourage provision of information lessen, but do not eliminate, the adverse selection problem in financial markets. How, then, can the financial structure help promote the flow of funds to people with productive investment opportunities when there is asymmetric information? A clue is provided by the structure of the used-car market.
The Enron Implosion and the Arthur Andersen Conviction
Until 2001, Enron Corporation, a firm that specialized in trading in the energy market, appeared to be spectacularly successful. It had a quarter of the energy-trading market and was valued as high as $77 billion in August 2000 (just a little over a year before its collapse), making it the seventh-largest corporation in the United States at that time. However, toward the end of 2001, Enron came crashing down. In October 2001, Enron announced a third-quarter loss of $618 million and disclosed accounting "mistakes." The SEC then engaged in a formal investigation of Enron's financial dealings with partnerships led by its former finance chief. It became clear that Enron was engaged in a complex set of transactions by which it was keeping substantial amounts of debt and financial contracts off of its balance sheet. These transactions enabled Enron to hide its financial difficulties. Despite securing as much as $1.5 billion of new financing from J. P Morgan Chase and Citigroup, the company was forced to declare bankruptcy in December 2001, the largest bankruptcy in U.S. history up to then.
Arthur Andersen, Enron's accounting firm, and one of the so-called Big Five accounting firms, was then indicted and finally convicted in June 2002 for obstruction of justice for impeding the SEC's investigation of the Enron collapse. This conviction—the first ever against a major accounting firm—meant that
Andersen could no longer conduct audits of publicly traded firms, a development leading to its demise.
Enron's incredibly rapid collapse, combined with revelations of faulty accounting information from other publicly traded firms (e.g., WorldCom, which overstated its earnings by nearly $4 billion in 2001 and 2002), has raised concerns that disclosure and accounting regulations may be inadequate for firms that are involved in complicated financial transactions, and that accounting firms may not have the proper incentives to make sure that the accounting numbers are accurate. The scandals at Enron, Arthur Andersen, and other corporations resulted in the passage of legislation that is intended to make future Enrons less likely. The law established an independent oversight board for the accounting profession, prohibited auditors from offering certain consulting services to their clients, increased criminal penalties for corporate fraud, and required corporate chief executive officers and chief financial officers to certify financial reports.
The Enron collapse illustrates that government regulation can lessen asymmetric information problems, but cannot eliminate them. Managers have tremendous incentives to hide their companies' problems, making it hard for investors to know the true value of the firm.
An important feature of the used-car market is that most used cars are not sold directly by one individual to another. An individual considering buying a used car might pay for privately produced information by subscribing to a magazine like Consumer Reports to find out if a particular make of car has a good repair record. Nevertheless, reading Consumer Reports does not solve the adverse selection problem, because even if a particular make of car has a good reputation, the specific car someone is trying to sell could be a lemon. The prospective buyer might also bring the used car to a mechanic for a once-over. But what if the prospective buyer doesn't know a mechanic who can be trusted or if the mechanic would charge a high fee to evaluate the car?
Because these roadblocks make it hard for individuals to acquire enough information about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealers guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free-riding on the information they produced.
Just as used-car dealers help solve adverse selection problems in the automobile market, financial intermediaries play a similar role in financial markets. A financial intermediary, such as a bank, becomes an expert in the production of information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns allows it to engage in this information production activity.
An important element in the ability of the bank to profit from the information it produces is that it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and bid up the loan's price to the point that the bank receives no compensation for the information it has produced. The bank's role as an intermediary that holds mostly nontraded loans is the key to its success in reducing asymmetric information in financial markets.
Our analysis of adverse selection indicates that financial intermediaries in general— and banks in particular, because they hold a large fraction of nontraded loans—should play a greater role in moving funds to corporations than securities markets do. Our analysis thus explains puzzles 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses.
Another important fact that is explained by the analysis here is the greater importance of banks in the financial systems of developing countries. As we have seen, when the quality of information about firms is better, asymmetric information problems will be less severe, and it will be easier for firms to issue securities. Information about private firms is harder to collect in developing countries than in industrialized countries; therefore, the smaller role played by securities markets leaves a greater role for financial intermediaries such as banks. A corollary of this analysis is that as information about firms becomes easier to acquire, the role of banks should decline. A major development in the past 20 years in the United States has been huge improvements in information technology. Thus the analysis here suggests that the lending role of financial institutions such as banks in the United States should have declined, and this is exactly what has occurred (see Chapter 10).
Our analysis of adverse selection also explains puzzle 6, which questions why large firms are more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route. The better known a corporation is, the more information about its activities is available in the marketplace. Thus it is easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one. Because investors have fewer worries about adverse selection with well-known corporations, they will be willing to invest directly in their securities. Our adverse selection analysis thus suggests that there should be a pecking order for firms that can issue securities. The larger and more established a corporation is, the more likely it will be to issue securities to raise funds, a view that is known as the pecking order hypothesis. This hypothesis is supported in the data, and is described in puzzle 6.
Collateral and Net Worth. Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults. Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lenders losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you fail to make your mortgage payments, the lender can take title to your house, auction it off, and use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely they will get the loan in the first place and perhaps at a better loan rate. The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts (puzzle 7).
Net worth (also called equity capital), the difference between a firm's assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to collateral. If a firm has a high net worth, then even if it engages in investments that cause it to have negative profits and so defaults on its debt payments, the lender can take title to the firm's net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence when firms seeking credit have high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans. This analysis lies behind the often-heard lament, "Only the people who don't need money can borrow it!"
Summary. So far we have used the concept of adverse selection to explain seven of the eight puzzles about financial structure introduced earlier: The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; the fifth, that financial markets are among the most heavily regulated sectors of the economy; the sixth, that only large, well-established corporations have access to securities markets; and the seventh, that collateral is an important feature of debt contracts. In the next section, we will see that the other asymmetric information concept of moral hazard provides additional reasons for the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations, the prevalence of government regulation, and the importance of collateral in debt contracts. In addition, the concept of moral hazard can be used to explain our final puzzle (puzzle 8) of why debt contracts are complicated legal documents that place substantial restrictions on the behavior of the borrower.
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