Microeconomics For Dummies

Chapter 15

Understanding the Dangers of Asymmetric Information

In This Chapter

Identifying asymmetric information in action

Encouraging people to behave “badly”

During the banking crisis of 2008–9, one of the key financial markets — the interbank lending market — screeched to a halt. The problem was that any bank needing to borrow had become a signal to a lender that the bank was in a poor financial state. A bank trying to engage in the routine behavior of borrowing from another bank was telling the potential lender that it needed credit, and so inadvertently identified itself as a risk. As a result, until more normal trading conditions returned to the market, no one would risk lending to anyone else.

The only lenders left in the game at that point were the central banks. Amid cries for bailouts, the central bankers had to ponder a difficult question: If you establish the principle that a central bank will bail out a bank in distress, aren’t you saying to those banks that they can always count on you? And doesn’t that mean that banks will have less incentive to keep themselves honest and healthy, financially speaking? After all, if they don’t, they can always come to the central bank for a bailout.

These two cases — signaling that you’re risky by your need to borrow and giving ...