Asymmetric Information: Why Intermediaries Exist
Borrowers know more about their own risk than lenders do. This asymmetric information creates two problems, adverse selection before the deal, where the riskiest borrowers are the keenest, and moral hazard after it, where borrowers may misuse the funds. Financial intermediaries exist largely to manage both.
Why it matters
A lender facing a pool of unknown borrowers fears the worst ones are the most eager, so it may not lend at all. Banks specialise in screening before a loan and monitoring after it, which is a big reason indirect finance dominates direct finance.
Worked examples
Distinguish adverse selection from moral hazard for a bank loan.
Adverse selection comes before the loan, when the applicants most likely to default are often the most eager to borrow. Moral hazard comes after the loan, when the borrower may take bigger risks with the bank’s money than with their own.
Common mistakes
- ✗Adverse selection and moral hazard are the same thing. Adverse selection is a pre-contract hidden-type problem, while moral hazard is a post-contract hidden-action problem.
- ✗Markets always allocate credit efficiently by themselves. Asymmetric information can shrink or freeze lending, which is exactly why intermediaries, collateral, and covenants exist.
Revision bullets
- •Borrowers know more than lenders: asymmetric information
- •Adverse selection (before) vs moral hazard (after)
- •Intermediaries screen and monitor to manage both
Quick check
The “lemons problem,” where bad borrowers crowd out good ones before a deal is struck, is an example of
Connected topics
Sources
- Mishkin (2018), Ch. 8Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.An economic analysis of financial structure: adverse selection, moral hazard, and why financial intermediaries exist.