Asymmetric Information in the Banking Sector: How adverse selection & moral hazard affect our banking system

Q: Which is one sure way to kill a rat but its hideout can’t be traced? A: Set the whole house on fire ~ my high school math teacher”

The economy of any nation – Our OPEC-Member-in-waiting included – is heavily dependent on the banking sector to provide the needed capital so as to keep its economic activity abuzz. It’s common knowledge that capital can either be raised in equity markets or debt markets. Nevertheless, Kenyans have always had a thing for debt and the little confidence that equity had started accumulating has been largely eroded (partly due our bourse’s terrible performance in recent times). Many of our commercial banks posted super-profits inasmuch as our economy is still recovering from effects of last year’s drought and the downward spiral of the shilling. One might ask, “how did the banks make all that money?” Well, the question is really straightforward – the interest rates on loans were at record high levels last year as a direct result of the intervention of the regulator toward the end of last year to save the ailing shilling. However, there are other factors independent of Central Bank Intervention which might as well affect the interest rates charged on individual’s loans. In this paper, I will discuss how information asymmetry is a key determinant of interest rates and how it lead to adverse selection and moral hazard – two possible occurrences which are clearly not pleasant to bankers.

Information Asymmetry:

Information asymmetry is asymmetric distribution of material information which could be influential in decision making by both parties to the loan agreement. Suppose an entrepreneur comes up with a business idea, and is looking to raise capital for the actualization of his dreams. Ordinarily, he will approach a bank with his business plan in hand but although the bank will try to do due diligence before disbursing the loan, the investor will always have has a better understanding of the prospective returns and risks of the business than the lender. Asymmetric information creates problems in the banking sector both before the transaction is closed (adverse selection) and after the transaction has been closed (moral hazard)

Adverse Selection – Occurs when bad credit risks (firms which have poor investment channels and high inherent risks) become more probable to acquire loans than good credit risks (firms with better investment opportunities and less inherent risks).

Because of information asymmetry, lenders tend to have a hard time differentiating between good credit risks and bad credit risks, and demand a blanket premium over and above the existing rates as compensation for the risk arising out of the inability to determine who indeed should be lent to. This causes the good firms to stop borrowing from such a lender because the high rates have devalued their strong credit history while the bad firms become very eager to borrow from such a lender because they know for sure that judging by the strength of their cash-flows, they should be charged an even higher interest rate. As a result, lenders end up with a loan portfolio comprising almost entirely of bad credit risks.

Moral hazard – Moral hazard occurs after the money has been disbursed to the borrower and it arises out of the fact that the borrower may have an incentive to breach the loan covenants by investing in ‘immoral projects’ which are unacceptable in the eyes of the borrower because inasmuch as they have a high possibility of gain to the borrower, they also have a high possibility of failure which will have the most detrimental effect on the lender. Information asymmetry once again causes moral hazard because of the lender’s lack of knowledge about the borrower’s activities. Moral hazard also occurs as a result of high enforcement costs of the debt covenants. In this instance, the lender simply decides that its not worth the effort to keep on chasing after borrowers and have them invest the money in stipulated projects – giving them a freeway to invest in high risk ventures.

Remedies to Information Asymmetry:

Now that we have seen how information asymmetry has detrimental effects on a nation’s banking sector, let’s look at some ways through which we can reduce this problem in our banking sector.

Credit Referencing – In the developed world, any firm which wishes to sell its debt must ranked by credit referencing firms (the main ones being American firms – Standard & Poor’s, Moody’s, and Fitch ratings) Firms are ranked by the strength of their repayment ability anywhere in a range which varies from the esteemed AAA rating to the lowest rating (high yield/junk rating). Judging by the credit score, a lender is able to approximate the probability of default of any single borrower and charge a rate of interest which is proportionate to the innate risk evident in a borrower’s enterprise. In Kenya, credit referencing is yet to take root and as at writing of this article, I am not aware of any firm which offers this crucial service in Nairobi. I think it’s the high time we embraced credit referencing as a way of reducing information asymmetry.

Data Sharing – Due to the secrecy which has continued to shroud our banking system, at times there are red flags all over about serial defaulters but banks miss them simply because they consider immaterial information about their customers as classified. Thus, a person may become unable to repay a loan on a bad investment idea (which he won’t drop because of his singlemindedness) and get his property auctioned but walk over to a different bank and secure financing for the same bad project, probably using a different product. If our bank’s IT systems could get partially integrated, this is a problem which can be quite easily eliminated.

Government Participation – Due to the vulnerability and corruption in our administration systems, there has been instances of forgery of collateral documents such as title deeds. The land records at Ardhi House are, for example, manual and computerization of land registration in this country is long overdue. There has been instances in which several title deeds have been issued on a single piece of land, and I do not want to imagine what would happen if each and every one of those holders would approach his bank for a loan with his title deed as collateral and default on the same.

Improved Loan Underwriting – In some commercial banks, loan underwriters are basically data entry clerks. They simply key in information from an application form without paying due attention to material facts which could be evident right on the application form. Underwriting is the entry point of risk in any financial services firm and some risks could be avoided if this initial process could be carried out meticulously. There is always an essence of evaluating the proposed project’s cash generation potential, its SWOT analysis and its history before acceptance.