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1.3 Market failures; information asymmetries and transaction costs

In an ideal world, banks and other providers of financial services would emerge wherever the need arose to provide those services, and those financial services would be so efficient that everyone who needed services would get them when they needed them. People who wanted to save their money would be able to open a savings account, people who wanted to take a loan would be able to take credit, and people who wanted to insure themselves would find an insurance product that would address their particular risk.

Free market theorists believe that in a perfectly functioning free market, where a service is in demand, the supply will arise to meet it. According to this theory, the balance between savings and loans will be maintained through the use of interest rates. The theory goes as follows:

Market failures

In practice, letting banks set their own policies, including setting interest rates, does not always produce desirable results. If the market is left to itself, many people do not get access to the financial services that they could benefit from; most often it is the poor, particularly the rural poor, who have the least access of all. One of the reasons for this is that the connection between interest rates and savings is not as clear as it might seem. Increased interest rates do not always lead to higher savings rates. Savings are not determined simply by the profit that can be earned; they also depend on how much income someone has. Higher interest rates may, in some cases, lead to lower savings rates as people can reach their target savings goal more quickly. Also, with the development of other types of financial intermediaries, particularly insurance companies, people may choose to save less if they know they are protected against future risks (Pagano 1993). We cannot assume, therefore, that financial markets can ‘self-regulate’ to maximum efficiency through adjusting interest rates.

There is another even more important reason why financial markets, left to themselves, will not necessarily result in the most efficient allocation of resources. This is because of what are known as market failures. Market failures refer to situations when the market alone does not produce the most efficient outcome.

Market failures arise for a number of reasons. These include, among others:

The most significant reasons for financial services not being provided to everyone who could make use of them are the interrelated problems of information asymmetries and high transaction costs.

Information asymmetries refer to the fact that, in the real world, information does not flow smoothly. Some people have access to information that others do not. In the case of financial services, this means that those providing the financial service do not always know as much as they would like to know about the person to whom they are providing the service. When lending money it is important to know something about the person borrowing, to make sure that they spend the money in such a way that they will be able to repay the loan, and to keep track of them and make sure they don't run away without repaying. Because of this, they do not provide financial services to everyone that needs them. That is, even though they might have enough funds at their disposal, they choose not to disburse them to potential borrowers whom they don't know enough about, especially when it is too expensive to get the information they need. Thus we have credit rationing, even without any government intervention (Stiglitz and Weiss 1981).

The two most important results of asymmetric information relevant to financial services are known as moral hazard and adverse selection.

Moral hazard can arise when someone's behaviour changes based on their access to financial services. For example, a business person may make a riskier investment after taking a loan with a high interest rate (to try to get a higher rate of profit and so repay the loan more easily). So, in this case, high interest rates can cause risky behaviour. Another example is when a person who has taken out insurance against their car being damaged will drive less carefully because they know they will not have to pay for it in case of an accident. Those providing the financial services have to work out ways to prevent the users of the service acting in this way. They may require other information about the clients that can reassure them that they will not do risky things, they may require certain forms of assurance (for example, collateral for loan takers, or a deductible for someone taking insurance) or they may simply decide not to lend to certain clients about whom they are not confident.

Adverse selection refers to the fact that it is often people whose activities are particularly risky who take high interest loans, or buy insurance. As it is not possible for lenders or providers of insurance to be sure how risky their customers' behaviour is, they have to use various mechanisms to screen potential borrowers. These methods are inevitably imprecise, which means that some potentially sound customers are rejected.

List one example each of moral hazard and adverse selection that you are familiar with. How might banks or insurance providers try to reduce the likelihood of these particular things happening?

Moral hazard: a homeowner does not bother to install smoke detectors because they have insurance in case their house burns down. The insurance provider can offer cheaper premiums to people who can prove they have smoke detectors installed.

Adverse selection: a person who knows that early fatal heart attacks run in their family buys a life insurance policy to ensure that their family will be financially secure in case of their death. An insurance provider can require medical records and make those with illnesses running in the family pay higher premiums.

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In practice, it is often poorer and less-well-connected people who are not given the financial services, as lenders or insurance providers will prefer to lend to or insure those who have more money to start with, and those who can provide collateral. They also prefer to lend to those about whom they can easily collect information. Often this means they lend to people who are 'like them' and so they feel they know better, or those with whom they actually have personal connections. They 'trust' such people more and, in financial service provision, when there are no formal systems in place to verify someone's honesty, then trust becomes central to any transaction.

Another reason why poor people, particularly the rural poor, might not be provided with financial services is because they demand services on such a small scale, be those savings deposits or loans. It is more difficult for those providing the services to make a profit on such small transactions, because each transaction has an administrative cost. The rural poor often live in areas with poor transport and communications infrastructure, where it is particularly expensive for both service providers and the poor themselves to reach each other, and is also particularly difficult and expensive for financial service providers to get the information they need about potential clients to provide them with services. These are what are known as high transaction costs.

Given information asymmetries and high transaction costs, the best allocation of resources may only come about through some type of government or other external intervention. Governments are responsible for putting infrastructure in place that will reduce the transaction costs associated with providing services in rural areas. Governments can also take risks that private lenders may not to ensure that everyone who can make good use of financial services gets access to those services, or they can put regulations in place that make sure the services are made available to those who need them.

Any type of government intervention is of course only as good as the government making that intervention; while the private sector has its limitations, the track record of governments in providing the appropriate interventions has not always been very good. The challenge in providing all those who need them with financial services is to work out what type of intervention will help, rather than hinder, in the goal of providing services both efficiently and equitably.

There are also important ways in which private financial service providers can adapt the way they provide services and so reduce the problems of information asymmetries and high transaction costs. Increasingly, innovative financial services providers are learning from, and building on, the traditional systems of financial intermediation that exist in poor communities. This allows them to reduce information asymmetries, so as to provide financial services to people previously not reached by formal providers.