Question

Adverse selection and moral hazards are two terms used in financial markets to describe situations where one party is at a disadvantage.

1. Explain the adverse selection problem in financial markets.
2. Discuss the solution to the adverse selection problem.
3. Discuss how to reduce/solve the problems arising from moral hazard.

Answer 1

ADVERSE SELECTION PROBLEM IN FINANCIAL MARKETS.

Adverse selection refers to the exploitation of asymmetrical information / information failure between the buyer and seller prior to transaction  , such that one party is unfairly benefitted. In the markets, it is usually the seller who , being cognizant of some flaws in product that can undermine pricing , does not disclose it to the buyer -  putting the buyer at a disadvantage.

A good example can be when company managers , who have access to internal assessments of the company , increase issuance of shares when stocks are overvalued. The buyers will ultimately be at a loss when stocks fall to real value.

SOLUTIONS TO ADVERSE SELECTION IN FINANCIAL MARKETS :

1. ESTABLISHING TRUST BY INCREASING INFORMATION TRANSPARENCY : Clearing prices for transactions should be made public. The market will then automatically convey all the right prices to all potential buyers who can then make informed decisions.
2. INFORMATION MADE PUBLIC BY PRIVATE COMPANIES : Third party companies like Moody's , Standard and Poor's make public the evaluations of other companies . This greatly helps buyers in making informed decisions based on values that are not baked up by the sellers.
3. GOVERNMENT REGULATIONS : Government agencies like FASB , IASB , SEC and standards like  International Accounting Standards and Generally Accepted Accounting Principles - heavily regulated these sectors.
4. EXPERT INTERMEDIARIES : Intermediaries in the indirect finance markets help to establish a performance guarantee of the investment to the buyers while maintaining a reasonable price for the sellers

REDUCING PROBLEMS ARISING FROM MORAL HAZARD :

MORAL HAZARD refers to the post transaction risk that a party has not entered into a contract in good faith or has exploited asymmetrical information to gain advantage over the other party. In the insurance sector this means running contrary to the ethical principles laid down in the contract to materialise a great risk to gain profit , as the other party has to bear the financial consequence . Usually moral hazard is exposed by a change of behavior in the party after closing of transaction.

Example of Moral Hazard in financial markets

The Great Recession of the late 2000s in the US exposed years of faulty accounting in big corporations like AIG and Chrysler . These corporations were at the brink of failure. The Govt then deemed these corporations " too big to fail " and bailed them out - saying that these companies are vital to the US economy. It became a moral hazard for the corporation managers because they understood that regardless of risky business accountings , the government has their backs. To eliminate this The Dodd-Frank Act of 2010 was passed that denies corporations any future bailouts and asks them to prepare in advance for any such eventuality.

REDUCING PROBLEMS ARISING FROM MORAL HAZARD :

1. THOROUGH AUDITING : In financial markets, moral hazard mainly manifests as a Principal - Agent problem. Because ownership of shares and control fall to two separate entities , the principals and agents respectively , the lack of information symmetry may encourage the agents to perform futile expenditures and even fraud. This would be mitigated if shareholders had more information about manager's actions by means of thorough auditing.

2. EXPERT INTERMEDIARIES : Such as Venture Capital Firms have greater oversigh . They provide equity capital in return for monitoring oversight by means of board members and exclusive equity shares.

3. REGULATING COVENANTS : Debt contracts enforce certain restrictive terms and conditions by means of covenants to discourage undesirable behavior (purchasing new businesses or restricting the use of the loan amount to finance only certain stipulated activities). These covenants also encourage certain desirable behavior such as maintaining minimum capital, holding life insurance that will pay off the loan in case of death of individual. Covenants that maintain collateral value (a small collision/theft insurance in auto loans ) or to provide information that gives the lender the rights to see the audits, also exist.