Financial Intermediaries and Information Costs
Information costs make direct finance expensive and thus difficult to obtain. This generates the role of indirect financing and financial intermediation. Much of the information collected by intermediaries is used to reduce information costs and the effects of adverse selection and moral hazard. To reduce adverse selection, potential
borrowers are typically carefully screened. To minimum moral hazard, all borrowers are carefully monitored and the penalties are imposed on borrowers who violate their financial obligation. Banks reduce information costs in the following ways:
Screening and Certifying to Reduce Adverse Selection
Before getting any type of loan, a potential borrower must fill out an application. Typically this application will require information, like a social security number, which can be used to gather your credit history and credit score. This credit score tells a lender how likely you are to repay a loan. The higher the score the more likely you are to pay back the loan. Once this information is verified, a borrower with a higher credit score will have access to larger and/or lower interest rates. Banks also use other types of information beyond your loan application. Many banks look at patterns in your checking or debit card accounts. They can learn a gr eat deal about your habits and gauge certain types of risks for the bank. Banks gathered tons of information, have specialist who can interpret this information, and can effectively minimize adverse selection problems.
Monitoring to Reduce Moral Hazard
To minimize moral hazard problems, banks also use specialists to monitor individuals who take out loans and firms who issue stocks and/or bonds. Many times the bank will actually take part in the same investment strategy of the borrowing firm, (or use a venture capital firm to do the same thing). In this way the bank can more closely
monitor the activities of the firm and monitor where it is that they use their borrowed funds. Finally it should be noted that the market system itself can help to limit moral hazard problems. If a firm is mismanaged and the stock price falls, a new company can take-over and remove the managers. Because of this, it is generally in the interest of the
managers to satisfy the desires of the stockholders of their company.