Explain why marketable securities (debt and equity) are not the primary source of financing for businesses and how financial intermediaries and government regulation can partly overcome the problem of asymmetric information (adverse selection).
The presence of adverse selection caused by asymmetric information helps us to understand and explain seven puzzles in the financial markets. The first four puzzles illustrate why securities do not play the greatest role as the provider of funds to corporations. The firth puzzle shows that the financial sector is the most regulated sector, a way used by the government to reduce part of the problems caused by adverse selection. The sixth suggests that only large firms, with a good reputation, do have access to securities markets, and the seventh one stating the use of collateral security as a way of reducing the problems associated with adverse selection. These concepts are further explained below.
The lemon problem concept, borrowed from the used market analysis has been used to explain why indirect financing is greater than direct financing in the financial markets. Lemon problem states that there are good and bad cars in the used car market. The buyer of the used car does not have enough information about the quality of the second-hand cars, while the seller has enough information about the quality of the car. As a result, the buyer will not know whether he/she is buying a good car or a lemon. With this in mind, the buyer will only be willing to buy average quality cars, a car with a quality between a high-value good quality car or low-value lemon car. On the other hand, the seller will know whether the car is a lemon or a peach. With a lemon car, the seller will be willing to sell if the buyer is willing to pay a price between the value of a lemon and a good car. Whilst, if the car is a peach the seller will know that the car is undervalued by the price the buyer is willing to pay, and so the owner may not want to sell the car. Due to this adverse selection, few good cars will be available in the used car market, sales are going to be low since very few people want to buy a bad car. Therefore, the used-car market will then function poorly.
This lemon problem is also present in the securities markets (the bond and equity market). In the equity and bond markets, there are bad and good firms, which makes it difficult for the investors to identify which bad or good firms are. Investor A will therefore be willing to pay the average price for the securities, that is the price value between the price value of securities from bad firms and the value of securities from good firms. The managers of good firms, and with better information, they will know that the average price offered by the buyers resembles the undervaluation of securities and will not be willing to offer their securities for sale. On the other hand, the bad firms will be willing to sell their securities, since this average price will mean a higher price than what they are worth. Investor A will not be willing to purchase shares from these bad firms and as a result, the financial markets will perform poorly.
This analysis is the same in the debt market where the investor will seek to purchase bonds. Only bad firms will be willing to issue their bond, and because the investors are not willing to buy these bonds issued by bad firms, they will end up not buying the bonds at all. As a result, few bonds will be sold in this bond market and the conclusion will be that debt and equity markets are not good sources of financing. This explanation shows why marketable securities are not the primary source of financing for businesses. It also explains why stocks are not the most important source of financing for businesses. Thus the lemon problem reduces the effectiveness of the securities market in channeling funds from savers to borrowers.
In the absence of asymmetric information, buyers of securities will be willing to pay the full price of the securities issued by the firms and good firms will be willing to sell their securities in the market. This statement calls for the provision of information, by private or by the government in order to reduce the problem of adverse selection.
- Private and sale of information – private institutions may engage in the production and selling of information to investors. These private firms will differentiate good firms from bad firms. This is the job of a credit rating agency, like Moody’s. Due to the free-rider problem, the provision of information will not solve the problem of adverse selection completely. The free-rider problem is a situation where people who have not paid for the service still have the ability to benefit from the service.
- Government regulation to increase information – provision of free information by the government could also help the investors in distinguishing bad from good firms. The first step occurs when the government releases negative information about firms, which is a difficult thing in practice. The second step is for the government to regulate the finance market. Through international and local accounting standards, both private and public trading companies are required to publish their financial statements. However, window dressing and manipulation of accounting figures are still a prominent activity, therefore adverse selection will still exist.
- Financial intermediaries – like in the used car market where the lemon problems exist, intermediaries can be used to reduce the lemon problem. Car dealers who have the expertise and resource to check the quality of vehicles before they go to the market will help in improving the efficiency in the car market. On the same note, financial intermediaries may also help in improving efficiency in the finance market. Here the banks will provide private loans, rather than purchase securities directly from the open market. Actually, in SA some financial institutions are not required to own shares, while insurance companies are required to own a certain % in relation to the value of their assets.
- Collateral and net worth – the security that is provided by the borrower, will reduce the consequences of adverse selection since it reduces the lender’s losses in the event of default. In the event of default, the lender will sell the security and use the proceeds to make up for the losses.
