Asymmetric Information

Information is asymmetric when material information is not generally shared with all participants in a market. This means that, in the credit market, for example, borrowers may have valuable information that lenders do not have but that might be critical to make informed decisions. Borrowers typically like to present themselves in the most favorable light to secure a loan and might therefore conceal or distort unfavorable information. By so doing, they put lenders at a disadvantage. Technological innovation has, however, made it possible to minimize disparities in access to quality information.

Asymmetric information can lead to adverse selection and moral hazard. Adverse selection occurs when poor-quality participants or goods in a market are treated much more favorably because of skewed or unbalanced information. The sale of “lemon” (poor quality) cars at market prices is an example of adverse selection that is the result of uneven distribution of information.

A moral hazard occurs when risks are undertaken with the foreknowledge that the costs associated with the risks will be paid by someone else and not the risk taker. This problem is evident in the relationship between depository institutions (banks) and insurance companies.

[Page 32]Banks that invest or give loans without prudence because they know that they will not be responsible for the cost of their losses engage in the furtherance of a moral hazard. Of course, information is imperfect in such situations because the insurance companies are unaware of the motivations for risk taking by the depository institutions. The east Asian financial crisis of the late 1990s has been partly attributed to moral hazard. Concern over moral hazard has also affected the financial crisis in the United States in 2008.