Adverse Selection Problem Research Articles

Government incentive mechanism of closed-loop supply chain based on information asymmetry

Focusing on the closed-loop supply chain (CLSC) comprising the manufacturer, retailer, and consumers in the waste products market, this study investigates how the government addresses the adverse selection problem on the hidden recovery costs of retailer and how it manages the moral hazard problem on the level of retailer’s hidden efforts. Based on incentive theory, a government incentive regulation aiming at maximizing social welfare is established in this study. In addition, a list of contracts with transfer payments is presented to elucidate the retailer’ collection efficiency and motivate the retailer to make the optimal investment. Besides, the impact of related factors on the recovery cost and social welfare level using numerical simulations is validated. Under government regulation, the retailer could maximize profit only by reporting the true recovery technology-type information to the government. Moreover, the retailer with high-recovery efficiency could obtain both retained profit and additional information rent. Finally, as the retailer made efforts to increase the recovery level, it increased investment cost, which affected the enthusiasm of enhancing the retailer’s recovery efficiency. Thus, the government should not blindly pursue the enhancement of recycling efficiency regardless of the cost, but should focus more on the control of recycling equipment and technology cost. Overall, this study facilitates scientific policy development and provides a reference for promoting CLSC operations.

A model of dynamic information production for initial public offerings

We develop a multi-period information-theoretic model of initial public offering (IPO) in the presence of an adverse selection problem that addresses both underpricing in an IPO and subsequent underperformance in the long run. In this model, information asymmetry exists among the owner of a firm going IPO, underwriter(s), informed analysts and uninformed investors. Information asymmetry between the owner and the investors is reduced through both the initial information production by some investors and the evaluations by informed analysts in the subsequent periods as new information arrives on the market. By incorporating future uncertainty, subsequent information revelation, certain firm-specific constraints and the actions of the agents, the optimal or sub-optimal actions of the agents are identified. The model explains why firms going public are underpriced at the IPO and, on average, underperform in the long run. The results are also compatible with social comparison explanations from a behavioral finance perspective.

The COVID-19 Run on Medical Resources in Wuhan China: Causes, Consequences and Lessons.

The COVID-19 run on medical resources crashed Wuhan’s medical care system, a medical disaster duplicated in many countries facing the COVID-19 pandemic. In a novel approach to understanding the run on Wuhan’s medical resources, we draw from bank run theory to analyze the causes and consequences of the COVID-19 run on Wuhan’s medical resources and recommend policy changes and government actions to attenuate runs on medical resources in the future. Like bank runs, the cause of the COVID-19 medical resource run was rooted in China’s local medical resource context and a sudden realignment of expectations, reflecting shortages and misallocations of hospital resources (inadequate liquidity and portfolio composition); high level hospitals siphoning-off patients from lower level health providers (bank moral hazard and adverse selection problem); patients selecting high-level hospitals over lower-level health care (depositor moral hazard problem); inadequate government oversight and uncontrolled risky hospital behavior (inadequate bank regulatory control); biased medical insurance schemes (inadequate depositor insurance); and failure to provide medical resource reserves (failure as lender of last resort). From Wuhan’s COVID-19 run on medical resources, we recommend that control and reform by government enlarge medical resource supply, improve the capacity of primary medical care, ensure timely virus information, formulate principles for the allocation of medical resources that suit a country’s national conditions, optimize the medical insurance schemes and public health fund allocations and enhance the emergency support of medical resources.

Evolusi Pembiayaan Mudharabah Sebagai Instrumen Halal National Fund

At present, in a competitive Islamic financial system, mudarabah (profit sharing) is seen as an alternative mechanism in Indonesia. Since it was introduced mudarabah (profit sharing) has gone through various evolutions to meet the rapidly growing needs of Islamic finance. However, in the current Islamic financial system, mudarabah (profit sharing) is less desirable by the public. This is due to the asymmetric information that is continuously presented in mudarabah (profit sharing) contracts and creates adverse selection problems. Therefore, mudarabah (profit sharing) has rejected its importance as a financing vehicle. Therefore, the purpose of this paper is to analyze the thinking and evolution of mudarabah financing in Islamic banking from the perspective of classical and contemporary Islamic studies and evaluate the risk prevention of mudarabah financing in Indonesia also the development of halal national funds using this instrument. The writing method used is a literature study that looks for theoretical references that are relevant to the topic raised through the method of collecting library data by reading through journals. Mudarabah is one of the important methods of Islamic financing that is widely used in various fields of Islamic finance and has a strategical position on halal national fund development.

A BAYESIAN GAME FOR A PROFIT AND LOSS SHARING CONTRACT

This paper presents a Bayesian Game model for a profit-and-loss sharing (PLS) contract. We develop our model into two parts, namely the model for non-social bank and the model for social bank. We propose the model to reduce adverse selection problem in offering a PLS contract. The Bayesian game starts with an incomplete information. Islamic banks do not know exactly what type of agent is applying for a PLS contract, efficient or non-efficient, the information of the bank is incomplete. In Bayesian game, we assume that the Islamic Bank assigns the agent type with a prior probability. Determination of the profit-sharing ratio of the contract will be discussed. We look for the Bayesian Nash equilibrium of the game in our model which is considered a solution. We show that the bank offers an interesting but risky contract to the agent if the bank assigns that the agent is efficient with a high probability, otherwise the bank offers a less risky contract to the agent if the bank assigns that the agent is a non-efficient agent with high probability. The results can be considered by Islamic banks to reduce the adverse selection problem in PLS contract.

Financial Inclusion in Emerging Economies: The Application of Machine Learning and Artificial Intelligence in Credit Risk Assessment

In banking and finance, credit risk is among the important topics because the process of issuing a loan requires a lot of attention to assessing the possibilities of getting the loaned money back. At the same time in emerging markets, the underbanked individuals cannot access traditional forms of collateral or identification that is required by financial institutions for them to be granted loans. Using the literature review approach through documentary and conceptual analysis to investigate the impact of machine learning and artificial intelligence in credit risk assessment, this study discovered that artificial intelligence and machine learning have a strong impact on credit risk assessments using alternative data sources such as public data to deal with the problems of information asymmetry, adverse selection, and moral hazard. This allows lenders to do serious credit risk analysis, to assess the behaviour of the customer, and subsequently to verify the ability of the clients to repay the loans, permitting less privileged people to access credit. Therefore, this study recommends that financial institutions such as banks and credit lending institutions invest more in artificial intelligence and machine learning to ensure that financially excluded households can obtain credit.

The role of funding portals as signaling offering quality in investment crowdfunding

We examine the effect of the issuer fee paid to portals on the success of investment crowdfunding using 1,694 offerings launched in the US during May 2016 – September 2019. We show that a mixed issuer fee (i.e. fixed gross fee and a share of securities) influences the probability of success, suggesting a positive signaling-effect that mitigates adverse selection problems between retail investors and issuers. Specifically, the use of a mixed issuer fee increases the probability of success by 33.5%. This effect remains after controlling for other information-risk-reducing mechanisms and it is contingent on firm-level characteristics.

Banking Regulation and Collateral Screening in a Model of Information Asymmetry

This paper explores the impact of banking regulation on a competitive credit market with ex-ante asymmetric information and aggregate uncertainty. I construct a model where the government imposes a regulatory constraint that limits the losses banks make in the event of their default. I show that the addition of banking regulation results in three deviations from the standard theory. First, collateral is demanded of both high and low risk firms, even in the absence of asymmetric information. Second, if banking regulation is sufficiently strict, there may not exist an adverse selection problem. Third, a pooling Nash equilibrium can exist.

Diversification of procedural and administrative costs and innovation: Some firm-level evidence

We examine the diversification of administrative and procedural costs on patent stock using a large dataset from the European Patent Office with 15,000 firms for the period between 1995 and 2015. The results reveal that administrative and procedural costs are significant for firm-level patenting activity. However, not all administrative and procedural costs have equal effects. Higher administrative costs often encourage patent application and validation by solving the adverse selection problem and short-run opportunism, as well as other sources of asymmetric information. The effective administration of intellectual property law and low-cost enforcement are found to considerably foster patenting activity. The effects are robust for various mis-specification checks and do not disappear once country-level research and development infrastructure proxies are controlled for. The extreme bounds of administrative and procedural costs are computed across more than 5 billion regressions, and the sizeable impact of administration on patent application and validation outcomes is confirmed.

Voluntary disclosure when private information and disclosure costs are jointly determined

Classical models of voluntary disclosure feature two economic forces: the existence of an adverse selection problem (e.g., a manager possesses some private information) and the cost of ameliorating the problem (e.g., costs associated with disclosure). Traditionally these forces are modelled independently. In this paper, we use a simple model to motivate empirical predictions in a setting where these forces are jointly determined––where greater adverse selection entails greater costs of disclosure. We show that joint determination of these forces generates a pronounced non-linearity in the probability of voluntary disclosure. We find that this non-linearity is empirically descriptive of multiple measures of voluntary disclosure in two distinct empirical settings that are commonly thought to feature both private information and proprietary costs: capital investments and sales to major customers.

The ECB Guide to Internal Liquidity Adequacy: A Principles-Based Approach

The global financial crisis exposed the need for coherence and transparency in bank liquidity management. The problem of asymmetry of information associated with liquidity was particularly acute during the crisis, leading to both adverse selection and moral hazard problems. The inability to refinance in the market eventually required central banks and states to intervene to purchase assets or provide guarantees at the market level and supply public funds, or nationalize individual banks, to correct the market. The European Central Bank Guide to Internal Liquidity Adequacy places significant focus on management’s oversight and responsibilities in addressing these issues before they materialize, or the existence of contingency plans to manage materialized risks. This guide is simply one component of a complex web of supervisory instruments and tools for banks’ liquidity management. This chapter argues that the crisis prevention narrative is delegated to banks to discharge their obligations in bank supervision so as to minimize the asymmetry of information problems created by their business and improve the way they manage adverse scenarios and the risks to depositors, markets, and supervisory authorities. The first part explains the rationale for a principles-based approach; the second part explores the premise of the principles for liquidity management, namely the responsibility of the bank per se to discharge adequate liquidity management as a form of self-regulation; the third part explains some of the key features of the principles; and the fourth part looks at the features of the principles with specific reference to the crisis prevention measures to improve banks’ responses to liquidity risks. This ‘nuts and bolts’ approach surprisingly lacks reference to bank corporate culture as an important all-encompassing matter when it comes to banks and risk-taking. The final section reflects on these preventive elements and highlights the importance of the ECB combining a risk-based and forward-looking ‘judgement’ based approach to supervision.

Interest Subvention for Crop Loans in India: Win-Win or Win-Lose

Problem Definition: Interest subventions (subsidies) on crop loans are a common feature of rural credit markets in developing countries. This study evaluates the impact of an interest subsidy program for the Kisan Credit Card (KCC) scheme - India’s flagship program to provide short-term agricultural credit. The objective behind giving interest subsidies is two-fold – increasing access to credit and improving loan repayment rates (by offering affordable credit), and is therefore regarded as a win-win for the lender and the borrower. However, the effectiveness of this policy has been debated. Moreover, academic research which causally evaluates the impact of such interest subsidy programs is limited. Methodology/Results: We use a unique transaction-level dataset from a large public sector bank to study a natural experiment in which the state of Odisha introduced a new subsidy program for its farmers in 2013-14. We use a combination of matching and difference-in-differences techniques, utilizing the nuances in the policy implementation. Further, we capture the heterogeneous impact of the policy on new and experienced borrowers. With regard to access to credit, not only do we observe a substantial increase (35%) in new loans but also a 20% decrease in the overall loan amount, indicating increased breadth and depth of access. As against the standard economic theories which posit that interest rate reduction leads to a higher repayment rate on loans (by addressing adverse selection and moral hazard problems), we observe a reduction in odds of repayment to 0.36-0.75 times its original value. Managerial Implications: Our impact assessment reveals unintended consequences of the interest subsidy and will let policymakers evaluate if the access-repayment trade-off is acceptable in their context. Further, the counter-intuitive findings shed light on the importance of various operational and behavioral aspects of the agricultural lending ecosystem, which need to be considered to craft effective, i.e., win-win credit policies.

The New EU Remuneration Policy as Good but Not Desired Corporate Governance Mechanism and the Role of CSR Disclosing

The recent global financial crisis (GFC) has put under scrutiny the sound remuneration policy and consequently the incentives design that influences risk-taking by managers in the banking industry to be a politically charged variable. In particular, this paper analyzes the new EU remuneration regulation of bank executive compensation and the role of corporate social responsibility (CSR) on this. Though all the EU efforts put into remuneration practices suggest commitment in aligning risk, performance, and compensation and aim at easing bank managers’ risk appetite for variable payments, the new regulation might drive unintended consequences, creating adverse selection problems in EU banks and hidden compensation habits that lower transparency, thus threatening financial system’s sustainability. Focusing on European Banking Authority (EBA) reports spanning from 2010 to 2017, the data reveals increasing values on the fixed component, less involvement in bank discipline by economic agents, and a potential for accounting-based incentives compensation that might reinforce attitudes towards building countercyclical buffers and smoothing earnings. As well, the new regulation might reduce the number of best-performing bank managers in the Eurozone, since “bad risks” are accepted to the detriment of “good risks,” which might stimulate their migration. In contrast, CSR investment is supposed to offset such practices and incentives that harm EU financial stability. As a result, policymakers, banks, and regulators should promote the transparency of CSR disclosure.

The effect of TARP on lending: Evidence from the lead bank’s share in syndicated loans

We investigate the effect of the Troubled Asset Relief Program (TARP) on the shares of lead banks in syndicated loans by using quarterly data for the period from 2008 to 2011. We find that TARP capital injections to lead banks have a significantly positive effect on their shares of syndicated loans. Specifically, we estimate that the effect of TARP on the lending of lead banks increases their shares by 6.1% that is equivalent to an additional $50.37 million for an average syndicated loan of $840 million. The significantly positive effect is stronger for a lead bank that is larger, has a greater appetite for risk, and is not under supervisory stress. Overall, our results show that TARP was an effective mechanism for promoting the lending of lead banks. The larger fractional share of lead banks in syndicated loan packages signals both the loan quality and their commitment to mitigating the adverse selection and moral hazard problems. This study sheds new light on the mixed evidence of TARP on lending and contributes to the research and policy debates on the role of stringent supervisory scrutiny in lending.

A necessary optimality condition in two-dimensional screening

This paper studies adverse selection problems with a one-dimensional principal instrument and a two-dimensional agent type. We provide an optimality condition that characterizes the bunching of continuum types. The approach is based on a reparameterization of the type space in terms of the endogenous optimal allocation level curves. The condition obtained is related with the optimality of two pooling types in the one-dimensional screening without the single-crossing. We illustrate the method by analyzing one example from the literature as well as a new example far from the linear-quadratic case

A directed search model of crowding out

I show that the labor-market crowding out of less-educated workers can be understood as the labor-market response to an adverse-selection problem. When high-skilled workers apply for less skill-intensive jobs, adverse selection arises when employment contracts cannot systematically discriminate against education level, even though overqualified workers are more likely to quit. In order to separate workers, the equilibrium distorts the labor-market outcomes of less-educated workers with an inefficiently high unemployment rate. Furthermore, the distortion creates a market value of post-secondary vocational education, because it acts as an entry barrier and protects less-educated workers from the competition of overqualified college graduates.

Government Incentive Contracts for Microgrid Users

Tariff subsidies are beneficial to the further development of the microgrid market. In response to the reduction of the power generation costs of microgrids, the energy storage subsidy for microgrids has become a key factor affecting their further development. Therefore, it is essential to explore and establish a government subsidy mechanism for the energy storage price of microgrids. In this paper, we consider the incentive compatibility constraints and participation constraints of both the government and the microgrid energy storage subsidy. The cases of hidden information and no hidden information are investigated. A microgrid energy storage subsidy model of the incentive compatibility constraint was established to analyze the efficiency of the government subsidy and the microgrid energy storage in the “self-generation + energy storage” mode. The results show that there is an adverse selection problem between the government and energy storage subsidies for microgrid users. In the case of no hidden information, the government can sign different contracts with microgrid users according to their different energy storage efficiency levels. In the case of hidden information, it is better for the government to design a menu of different incentive contracts for microgrid users with different energy storage efficiencies. This approach can ensure that microgrid users with low energy storage efficiency continue to participate in the microgrid construction. Microgrid users with high energy storage efficiency can, thus, better control their costs related to the self-generation, self-use, and surplus electricity transmitted to the grid as well as better select high-regulation carbon dioxide emission reductions and their capacity generation.

Asymmetric solutions to asymmetric information problems

This paper studies markets plagued with asymmetric information on the quality of traded goods. In Akerlof's setting, sellers are better informed than buyers. In contrast, we examine cases where buyers are better informed than sellers. This creates an inverse adverse selection problem: the market tends to disappear from the bottom rather than from the top. In contrast to the traditional model, it is the high-value goods (gems) that are traded on the market, rather than the low-value goods (lemons). We refer to this asymmetric information scenario as the “market for gems.” We investigate the consequences of this undisclosed knowledge of hidden qualities — which we refer to as inverse adverse selection — and the reasons why legal theorists have given this form of asymmetric information substantially less consideration. Conventional legal and contractual solutions to the lemons problem are often ineffective in the gems case: the uninformed buyer in a traditional market for lemons experiences the quality of the good he purchased; in a market for gems, instead, the uninformed seller may never know the quality of the good that he sold. We study three alternative solutions to the gems problem — auctions, suppression of information, and inverse warranties — and identify the condition under which each of them is feasible. We then show how the theory sheds light on real-life gems problems arising in the multi-million dollar transactions involving soccer players, artworks, M&As, Hollywood movies, and diamonds.

Split-Award Auctions and Supply Disruptions

Problem Definition: We consider a buyer that needs to source a fixed quantity. She faces several potential suppliers that might fail to deliver. The buyer conducts a procurement auction to determine contract suppliers and can choose between single-sourcing and multi-sourcing. If contract suppliers fail to deliver, the buyer tries to source from non-contract suppliers but has little bargaining power due to time pressure. Academic/Practical Relevance: The mitigation of supply risks plays an important role in procurement practice but attracted little attention in the academic analysis of procurement auctions. Academic research on multi-sourcing procurement auction typically analyzes these auctions as stand-alone events. In contrast, we investigate the influence of the auction design on the post-auction market structure and identify an effect favoring multi-sourcing. The insights provide procurement managers guidance for their sourcing decisions. Methodology: We apply game-theoretical methods to analyze a stylized model in which a cost-minimizing buyer needs to source from profit-maximizing suppliers who might fail to deliver. The buyer conducts a procurement auction to determine contract suppliers and can choose between single-sourcing and multi-sourcing. If contract suppliers fail to deliver, the buyer tries to source from a non-contract supplier. We assume that in this situation, the non-contract supplier has almost all the bargaining power. Results: First, we show that in such a setting multi-sourcing does not only reduce the supply risk but might also yield lower prices than single-sourcing. The sourcing decision affects the post-auction market structure such that being a non-contract supplier becomes less attractive in case of multi-sourcing. Second, if suppliers are heterogeneous regarding their disruption probabilities, less reliable suppliers will bid more aggressively than their more reliable competitors causing an adverse selection problem. Furthermore, we show that attracting an additional supplier can be risky as it can increase the auction price and the buyer’s total expenses. Managerial Implications: Our analysis reveals a pro-competitive effect of multi-sourcing. This effect is especially important if the buyer’s value for the item is substantially larger than suppliers’ production costs and for intermediate disruption probabilities.

INFLUENCE OF MANAGEMENT ON DEBT CORPORATE POLICY

The author considers features of influence of finance solutions of management of the Russian public companies on debt policy. In a research are included indicators of internal growth and dividend payments by means of which it is possible to estimate corporate financial policy. Internal growth is the indicator of regulation of debt strategy, the including mechanism of precautionary motive. The dependence of the share price on the market value of assets defines installation of communication between the economic interests of shareholders and finance solutions of management. The indicator of dividend payments allows to estimate influence of external negative effects (shocks) on behavior of investors at profit assessment. Increase in dividend payments is connected with their financing from an external source. Management works in logic of precautionary motive, keeping a part of profit for further debt repayment before creditors. The management of the Russian companies not only influences the share price, but also regulates the level of a debt load. The company can use dividend payments on reinvestment of assets (as an investment resource). The author shows as the Russian public companies, solve a problem of adverse selection, switching to cheaper financing sources. The value of a debt is connected with the level of investment into the company. Pledge (property providing) is a guarantee for creditors. As, getting access to debt financing, the company provides to the creditor the complete information about property, thereby, reducing the risks connected with attraction of a debt. The Russian public companies react to changes of debt increase in value of size of assets that will be approved with recapitalization of the company (change of the capital structure due to debt increase and its use for dividend payouts to shareholders).