Define Asymmetric Information in Banking Flashcards

A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well.

Adverse selection: A situation where sellers have information that buyers don't (or vice versa) about some aspect of product quality. It occurs before the transaction. EX: (In order to fight adverse selection, insurance companies try to reduce exposure to large claims by limiting coverage or raising premiums).

(After the transaction) The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Financial Crisis: Occurs when an increase in asymmetric information from a disruption in the financial system causes severe adverse selection and moral hazard problems that hurt the house hold savers and the financial markets.

How to identify financial crisis coming: Stage one Boom and bust of asset price Spikes in interest rates Increase in uncertainty

Stage one of Financial Crisis: Deterioration in financial institutions/ balance sheets Asset price decline Increase in interest rates Increase in uncertainty Adverse selection/moral hazard problems worsen Stage two: Economic activity declines Banking Crisis Adverse selection/Moral Hazard worsen Economic activity declines Stage three: Unanticipated decline in price level Adverse selection/Moral hazard worsen Economic activity declines

Bank panic/crisis Occurs when multiple banks fail simultaneiously.

The source of the contagion is asymmetric information

The decrease in bank lending decreases the supply funds for borrowors which leads to high interest rates. Bank panics lead to an increase in adverse selection and moral hazard.

Reserves, Cash items in process of collection, deposits at other banks, securities, loans, other assets

Checkable deposits, non-transaction deposits, borrowings, bank capital

Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission of a medical disease. Basically it can be viewed as the spark to the bomb.

Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee. Uses the purchase and assumption method and increases moral hazard incentives for big banks.

Federal Deposit Insurance Corporation and Improvement act of 1991: The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails. Payoff method- allows the bank to failand pays off deposits. Purchase and assumption method- willing merger candidate to assume control

Clear checks, issue new currency, withdraw damaged currency from circulation, administer and make discount loans to banks in their districts, evaluate proposed mergers and applications for banks to expand their activities Act as liasions between the business community and the federal reserve system, Examine bank holding companies and state chartered member banks, collect data on local business conditions, Additional: is the central bank of the US. It was created by congress to provide the nation with a safer, more flexible, and more stable monetary and financial system.