INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION

INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION I ntroduction and S ummary N umerous markets are characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess “inside” information about their own projects for which they seek financing. Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible. Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION

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Publisher
Wiley
Copyright
1977 The American Finance Association
ISSN
0022-1082
eISSN
1540-6261
D.O.I.
10.1111/j.1540-6261.1977.tb03277.x
Publisher site
See Article on Publisher Site

Abstract

I ntroduction and S ummary N umerous markets are characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess “inside” information about their own projects for which they seek financing. Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible. Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this

Journal

The Journal of FinanceWiley

Published: May 1, 1977

References

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