Asymmetric information is a condition that arises when one party has insufficient information about the additional party involved in the transaction. The difference between the information available to both parties makes it impossible for the first party to make precise decisions during the transaction.
For example, a manager at columbia bank Edison does not have complete information about the individual who has come for a loan to the bank. The bank can be misleading on the financial potential of the party to return the loan. The presence of asymmetric information leads to a situation of market failure.
Two types of asymmetric information exist in the market – adverse selection and moral hazard.
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It is a problem that occurs before the transaction has taken place. The circumstances in which either the party has information that the other does not have can affect the terms of the transaction. There is a high risk of those people who’ll be failing to pay back the loans, be the one seeking out most actively.
Leading to such a situation, the chances of a bad loan increase, which might cause lenders to defer from lending any loans at all. Thus, the odd of good credit risks also fail here.
This problem can be solved by furnishing cheaper information, hiring private companies, government regulation for credible information, or financial intermediation involvement.
This type of asymmetric information exists after the transaction occurs. Usually, the lender is burdened with a high risk of bad credit if the borrower engages in activities undesirable to the transaction.
For instance, the individual taking up a loan uses the money in gambling that runs a high potential of default and not repaying later. The lender would rather decide not to make loans.
To solve this problem, the bank can use regular monitoring of their activities, laws imposed by the government from doing fraudulent acts, or issuing a debt contract.
Asymmetric information is a basic feature of our financial system, which can lead to a situation of market failure. But it can be solved by the right kind of incentives and policies adopted.