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Economic Analysis of Financial Structure - The lemons problem: how adverse selection influences financial structure

4 important questions on Economic Analysis of Financial Structure - The lemons problem: how adverse selection influences financial structure

How does adverse selection influence financial structure (lemons problems)?

A potential buyer of securities (stocks or bonds) can't differentiate between goods firms (high expected profits, low risk) and bad firms (low expected profits, high risk). In this situation the investor is only willing to pay the price that reflects the average quality of firms issuing securities (in between the price of good and bad firms). Managers of good firms, knowing their securities are worth more won't sell, so only managers of bad firms are willing to sell. Investors know this to and won't buy securities.

What did the Enron collapse illustrate (2001)?

That government regulation can lessen asymmetric information problems, but cannot eliminate them. Managers have tremendous incentives to hide their companies problems, making it hard for investors to know the true value of the firm. Enronn was engaged in a complex set of transactions by which it was keeping substantial amounts of debt and financial contracts off its balance sheets.

What is the most important thing in reducing the asymmetric information in financial markets?

The banks role as an intermediary that holds mostly non-traded loans (private loans)

Why are banks of a greater importance in financial systems of developing countries?

Information about private firms is harder to collect in developing countries, the small are role played by securities markets leaves a greater role for financial intermediaries such as banks.