INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION

Abstract

Numerous markets are characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess "inside" information about their own projects for which they seek financing. Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible. Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this argues that the average quality is likely to be low, with the consequence that even projects which are known (by the entrepreneur) to merit financing cannot be undertaken because of the high cost of capital resulting from low average project quality. Thus, where substantial information asymmetries exist and where the supply of poor projects is large relative to the supply of good projects, venture capital markets may fail to exist. For projects of good quality to be financed, information transfer must occur. We have argued that moral hazard prevents direct information transfer. Nonetheless, information on project quality may be transferred if the actions of entrepreneurs ("which speak louder than words") can be observed. One such action, observable because of disclosure rules, is the willingness of the person(s) with inside information to invest in the project or firm. This willingness to invest may serve as a signal to the lending market of the true quality of the project; lenders will place a value on the project that reflects the information transferred by the signal. As shown by the seminal work of Akerlof [1970] and Spence [1973], and by the subsequent contributions of Rothschild and Stiglitz [1975] and Riley [1975], [1976], equilibrium in markets with asymmetric information and signalling may have quite different properties from equilibrium either with no information transfer, or with direct and costless information transfer. Signalling equilibria may not exist, may not be sustainable, and may not be economically efficient. In subsequent sections, we develop a simple model of capital structure and financial equilibrium in which entrepreneurs seek financing of projects whose true qualities are known only to them. We show that the entrepreneur's willingness to invest in his own project can serve as a signal of project quality. The resulting equilibrium differs importantly from models which ignore informational asymmetries. The value of the firm increases with the share of the firm held by the entrepreneur. In contrast with Modigliani and Miller [1958], the financial structure of the firm typically will be related to project or firm value even when there are no taxes.1 And firms with riskier returns will have lower debt levels even when there are no bankruptcy costs. Signaling incurs welfare costs by inducing entrepreneurs to take larger equity positions in their own firms than they would if information could be directly transferred; we show, however, that the set of investment projects which are undertaken will coincide with the set which would be undertaken if direct information transfer were possible. Finally, we suggest that financial intermediation, which is difficult to explain in traditional models of financial equilibrium, can be viewed as a natural response to asymmetric information. Consider an investment project which involves a capital outlay K and a future return μ + x ˜ , where µ is the expected end-of-period value of the project and x ˜ is a random variable with zero mean and variance σ 2 . We shall consider an entrepreneur who wants to undertake this investment project and plans to hold a fraction α of the firm's equity, raising the remainder of the equity from other lenders. Throughout our analysis, the firm and the entrepreneur (on personal account) are both assumed to be able to issue debt at the riskless rate.2 The entrepreneur has information that leads him to assign a specific value to µ, but he has no credible way to convey this information directly to other potential shareholders, who have a subjective probabilit