Asymmetric information: the multiplier
effect of financial instability
Erasmus University Rotterdam
Financial markets and financial intermediation are
essential to well-functioning economy. They perform the
role of channeling funds to parties that have value creating
investment opportunities. However, asymmetric
information can seriously impair the process when parties
to the financial contract are not fully aware of the risks
involved and, as a result, can limit their exposure to
financial agreements to prevent themselves from possible
losses. Increasing asymmetric information as we explain in
the article has a tendency to bring a ripple effect in the
financial system. This negative money multiplier then sets
the stage until it severely hampers money supply,
productive investment opportunities and finally aggregate
economic activity. The article introduces the reader with
the framework of asymmetric information developed by
several authors in the last few decades and builds on the
recent financial developments that pose new challenges.
The theory of asymmetric information is one of the most powerful framework theories that can explain
data patterns in the different factors during the periods of economic crises.
The academics have analyzed the asymmetric information and its consequences that arise due to
dissimilarities of information that is available to parties that enter financial agreements. Often the main
problem is that borrowers are more alert of pitfalls of financial contract since they are better aware of
the risks involved in a project for which financing is requested. These informational differences are the
very underlying cause of adverse selection or what is already known as the lemons problem which was
introduced by Akerlof in 1970. A lemons problem occurs in debt markets because lenders have trouble
determining whether borrower’s investment opportunities are attractive enough compared to the level
of risk involved (i.e. he is a “good risk” or “bad risk”). When that happens, lenders provide loans at an
average interest rate that balances off expected return for a loan portfolio that constitutes both high
quality and low quality credits. Presumably, one can see this as a fact that risks and the associated
required return for high quality borrowers is overstated, whereas that of low quality borrowers is
understated. Lenders tend to average out these differences; as a result, high quality borrowers end up
paying more, whereas low quality borrowers less than they should. If that happens, high quality
borrowers will not seek financing and forego profitable investment opportunities.
Furthermore, as demonstrated by Stiglitz and Weiss (1981), borrowers with the riskiest investment
projects will now be the ones most likely to take out the loans at high interest rates, since they will reap
the benefits and leave the loses for lenders should they occur. These risky undertakings on behalf of
borrowers will result in lenders cutting down on the number of loans that they make, this way causing
the supply of loans decrease with higher interest rates more than it would at equilibrium. Mankiw
(1986) has shown that a marginal increase in the risk-free rate can significantly decrease or even cause a
collapse in lending through the ripple effect described above.
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