Adverse selection occurs in amarket if it is difficult to distinguish parties that are good risks from those that are bad risks, and the parties that represent bad risks are particularly attracted to the market. For example, consider a set of borrowers that wish to finance projects that are identical in all respects, including offering identical expected returns, except that the projects vary in their riskiness. It can be shown that borrowers with riskier projects will have higher expected profits than other borrowers, and thus will have stronger incentives to borrow, while the expected rate of return to banks from these borrowers is lower than it is from other borrowers (Stiglitz and Weiss 1981). Thus the borrowers that tend to select themselves into the market cause problems for it.
If itwere obviouswhich partieswere the bad risks, those parties could be offeredmore stringent terms or even avoided altogether. Absent such information, in markets subject to adverse selection, the normal function that prices play in determining who participates in the market can result in a perverse outcome. In credit markets, higher interest rates limit whowillwant to borrow by making borrowingmore burdensome, but those with the least risky projects will be the ones driven out of themarket first, all else being equal. Thosewho are less likely to pay back the loan will be less concerned about paying higher interest. Because the average quality of the loans actually made can then deteriorate, the adverse selection problem can be worsened. A higher interest rate will also exacerbate themoral hazard problemfor a given borrower, because the higher interest rate is burdensome only in the event that the borrower actually repays the loan.
Given these drawbacks of raising interest rates to limit access to credit, banks may choose to ration credit, so that borrowers are not allowed to borrowas much as theywant at a given interest rate (Stiglitz and Weiss 1981). It is also possible that credit rationing may not occur, in which case a small increase in interest rates can lead to collapse of the loan market (Mankiw 1986).
Asymmetric Information and Financial Crises
Problems related to asymmetric information can contribute to, and be exacerbated by, financial crises, such as those experienced by South Korea,Thailand, and Indonesia in 1997 98. Financial crises that lead to bank failures can have real economic costs because of the loss of the customer relationships that these banks had cultivated. In the course of repeated interactions with their loan customers, banks gain a considerable amount of information on the customers’ creditworthiness and other characteristics. This information is lost in a bank failure, which can worsen the moral hazard and adverse selection problems (Mishkin 1999). Thus financial intermediation becomes less effective, and real economic activity can be harmed.
Currency depreciation can exacerbate a banking crisis because it tends to worsen the balance sheets of individuals and corporations within the country that have borrowed inforeign currencies.This reduces the value of the collateral that can be obtained fromthese borrowers in the event of default and thus exacerbates themoral hazard probleminherent in creditmarkets: borrowers with less to lose have weaker incentives to avoid default. Moreover, problems related to asymmetric information also limit how countries can respond to financial crises. For example, the higher interest rates required to combat inflation or stabilize the currency can aggravate adverse selection and moral hazard, as discussed earlier.
Information asymmetries can also exacerbate a tendency toward investor panic manifested by bank runs, capital flight, or asset price downturns, and can contribute to financial contagion between unrelated financial institutions or countries during crises.
Models of these phenomena typically posit that uninformed investors try to infer howasset priceswill move based on the information revealed by these prices. Informed investors directly observe the fundamental determinants of asset prices, but the prices are also influenced by exogenous random factors. Moreover, informed investors are unable to drive asset prices directly to their equilibrium values dictated by the fundamentals because of various impediments to asset trading (such as trading costs, short-sale constraints, or borrowing constraints).
Now consider a negative shock to an asset price. Knowing that informed investors are limited in their ability to make trades, uninformed investors are uncertain whether the fundamental asset value is even lower, and therefore demand an additional risk premiumto hold the risky asset,which forces its price down further. Thus asymmetric information exacerbates asset price movement.
For contagion between markets to occur, the simplest scenario is that the fundamental determinants of asset prices in two markets are correlated. Informed investors observe a shock to the fundamentals in one market, and in response reallocate their portfolios inthemarket thathas experienced the shock and in other markets. The uninformed investor is uncertain whether asset price movements in either market are due to transactions by informed investors or due to random noise; given the greater uncertainties, uninformed investors demand a larger risk premium in both markets, which causes asset prices to move together.
Borrowing constraints can also trigger contagion, as shrinkage of investor assets in one country means that investors may be forced to sell their assets in other countries, as collateral requirements become binding (Yuan 2005). This contagion will also be exacerbated by the actions of uninformed investors. It will be stronger during asset price downturns than upturns and does not require that macroeconomic fundamentals in the countries be correlated. These findings are generally consistent with empirical evidence to date. Thus this model offers one explanation of why asset price shocks spread among East Asia, Latin America, and other parts of the world in 1998.
Lender of Last Resort
Moral hazard becomes a policy issue in credit markets because of the lenderof-last-resort role played by various institutions. For example, central banks and other financial regulators are concerned about the possibility of a run on banks, which in turn could arise in part because it is difficult to distinguish solvent banks from insolvent ones. In order to lessen the risk of a run on banks, the central bank or other governmental institution usually provides implicit or explicit insurance to bank depositors. Bank liabilitiesmay even be fully guaranteed on the grounds that the banks are too big or too politically important to be allowed to fail. The consequential moral hazard can give banks little reason to be cautious in their lending, or depositors little incentive to take the trouble to examine the financial soundness of one bank versus others.These problems can set the stage for a banking crisis.
Whether it is necessary or desirable for an international lender of last resort to assist countries in financial crises is a matter of some controversy. An argument in favor of such an institution is that the central bank of a country in crisismay have a limited capacity to restore the economy to health. For example, the provision of extra liquidity through monetary expansion could lead to currency depreciation and increases in inflationary expectations and interest rates (Mishkin 1999). Thus there may be an argument for an institution such as the International Monetary Fund (IMF) to lend foreign exchange to a country so that it can pay for imported inputs and intervene to support its currency, say, to alleviate the real economic harms that a financial crisis can cause. As critics have observed, however, IMF bailouts of countries in financial distress can also cause moral hazard by relieving the governments of those countries of the painful effects of the inadequacies of their economic policies and by relieving international investors of the adverse consequences of investing in inherently risky environments such as emerging markets.
Following the IMF decision not to bail out Russia in 1998, the amount bywhich interest rates on bonds in developing countries exceeded those in industrial countries increased, particularly for countries with weaker economic fundamentals, indicating that investorswere increasingly taking into account the risks of lending to developing countries (Dell’Ariccia et al. 2002). It cannot be concluded, however, that this change was for the better, even if it indicated that moral hazard was reduced: IMF lending that reduces risks could be a good thing on balance, and its positive effects would also be reflected in interest differentials across countries. For example, an IMF intervention in a developing country could alleviate market failures such as coordination problems among creditors to the country, by acting as a catalyst that restores confidence and induces creditors to resume lending rather than waiting for other creditors to take the first step.
Measures to Limit Moral Hazard
At all the levels at which moral hazard exists in financial markets, measures can be taken to lessen its impact. Individual loan contracts can include provisions that make it harder for the borrower to take excessive risks or to shirk repayment of the loan. For example, loans can be disbursed in increments, conditional on performance to date. One reason for the existence of financial intermediaries like banks is that they can perform these disciplining functions at lower cost than can individuals, such as by threatening to withdraw future business from recalcitrant borrowers.
At the level of the banking system, the dilemma for policymakers is how to containmoral hazard and yet prevent or at least mitigate financial crises.Most governments provide some form of implicit or explicit insurance for bank deposits.NewZealand does not, on the grounds that it eliminates depositors’ incentives tomonitor the riskiness of their banks, and because providing the deposit insurance at the same price to all banks implicitly subsidizes banks with riskier loan portfolios at the expense of those with more responsible ones. New Zealand instead tries to ensure that the public has complete and accurate information on banks’ financial conditions. Some countries that provide deposit insurance, such as the United States, seek to lessenmoral hazard by limiting deposit insurance to relativelysmall deposits, in order to provide larger depositors or other bank creditors with stronger incentives to monitor and price the risks embodied in banks’ loan portfolios. In principle, the moral hazard from deposit guarantees can also be reduced through appropriate ongoing bank supervision and regulation. In practice, in many developing countries in particular, bank regulation remains problematic.
One approach to lessening the economic damage in the event of a crisis is for a lender of last resort to inject capital into financial markets. There may be merit in providing liquidity to the market in general rather thantoparticulardistressedinstitutions, sothat market forces can ultimately determine which institutions survive. If individual financial institutions are to be provided credit by the lender of last resort, Bagehot (1873) suggested that the terms should not be too attractive: the rate of interest should be higher than during normal times. Limiting moral hazard in this way is not without its own costs. Imposing a higher penalty rate can weaken the condition of the bank, signal to themarket that the bank is in trouble, or induce bank managers to pursue a riskier strategy.However,Bagehot allowedthat credit should be provided on collateral that would be marketable in normal times, so that a crisis-induced collapse of asset prices that caused collateral to shrink would not in itself limit the amount that could be lent.
If the crisis is due to a coordination failure, such as a panic-induced run on a bank, a lender of last resort may be able to suspend the obligations of the bank temporarily, in a way that the bank could not do on its own due to credibility problems. This approach would not diminish the risk towhich creditors of the bank are exposed, and thus could limitmoral hazard. The lender of last resort could also coordinate a private bailout of the bank, in an effort to limitmoral hazard. If the coordination of private institutions is at all coercive, however, it will in effect provide a subsidy to the distressed institution, in which casemoral hazard reappears in an alternative form. Indeed, the bailout of the Long-Term Capital Management (LTCM) hedge fund in 1998 raised questions about whether private investors were coerced by the central bank. The LTCM bailout under the guidance of the Federal Reserve has been criticized for causingmoral hazard.
Parallel issues have arisen for the IMF as an international lender of last resort that has bailed out countries in financial crisis. For example, IMF loans of foreign exchange to countries in crisis are disbursed over time, and the institution monitors whether the recipient country is complying with the performance and policy conditionsnegotiated as part of the loan agreement.
To avoid the moral hazard that IMF bailouts can cause, an alternative approach is to rely more on private-sector solutions. Along these lines, Mexico, Brazil, and other countries have introduced collective action clauses into their sovereign bond contracts since 2003. Such clauses are intended to facilitate debt restructuring in the event of a crisis, primarily by making it harder for a small minority of bondholders to block debt restructurings endorsed by a large majority. Inclusion of these clauses appears to have lowered borrowing costs for these countries, despite concerns that the clauses might make it easier for some countries, particularly those that are less creditworthy, to avoid repaying their debts.
A degree of deliberate ambiguity in the actions of the lender of last resort may also limit moral hazard. If it remains unclear whether the lender of last resort will provide a bailout in all situations, the parties who might or might not be bailed out will have incentives to actmore responsibly.The decision by the IMF not to bail out Russia in 1998, on the heels of its bailouts of South Korea, Thailand, and Indonesia in 1997 98, could be seen as creating such ambiguity.
A final restraint on moral hazard is for managers and owners of failed institutions to be punished: managers should lose their jobs and shareholders their capital. The argument may be applicable to national economies in crisis as well: a change of government tends to have a salutary effect in the recovery from a financial crisis, particular if mismanagement by the government was partly responsible for the crisis. See also bail-ins; bailouts; balance sheet approach/ effects; banking crisis; contagion; currency crisis; deposit insurance; financial crisis; International Monetary Fund (IMF); International Monetary Fund conditionality; International Monetary Fund surveillance; lender of last resort; spillovers