Financial intermediation, risk aversion and asymmetric information

The structure of information plays a crucial role in the model. The main goal of the paper is to examine the effects of incomplete information on the nature of financial equilibrium and on the capital structure of firms. In addition, the study endeavours to show that the results derived in the literature of credit markets are not robust to changes in model specifications. This attempt aims at contributing to the advance of the economics of credit markets by offering further insights. The structure of the model is established in Section 2. The context is a simple one-period partial equilibrium model with informational asymmetries. In the model, entrepreneurs are considered to behave in a risk-averse manner and each of them is endowed with a project at the beginning of the period. The projects, if undertaken, require outside finance from riskneutral bankers, who offer financial contracts to entrepreneurs. All projects are assumed to have the same expected return and are divided into two types: one with a high probability of securing the successful return and a second with a low probability. The quality of an individual entrepreneur's project, that is, the success probability - not known by the financial institutions is private information. The generalisation of the analysis to continuous categories of entrepreneurs is discussed in the conclusion. Section 3 briefly discusses de Meza and Webb's ( 1990) contribution, where projects are ranked by the first-order stochastic dominance. In this model, capital market failure involves over-investment if pooling equilibrium prevails. Section 4 develops the model previously established. If negative incentive effects are not considered, the financial equilibrium involves pooling equilibrium with both categories of projects being entirely financed through outside equity. With this type of solution there can be no adverse selection and social efficiency is achieved. Indeed, if the capital structure of firms is wholly absorbed by outside equity, all projects will be equally atractive to risk-neutral financiers. A special case is investigated in Section 5. The assumption that equity contract entails no costs seems unreasonable because of moral hazard problems. Incentive effects may justify an optimal small proportion of outside equity in the capital structure of firms. It is therefore assumed that in all projects the share of equity held by outside investors is fixed and relatively small. With this assumption the model exhibits interesting properties.