Answer to Question #300250 in Finance for Mark

Question

 Explain the role of asymmetric information in financial markets. How does the existence of asymmetric information explain the importance of banks in financial markets?

Answer 1

"Asymmetric information" describes a situation in which one party to a transaction has greater knowledge than the other. Sellers can take advantage of buyers in cases when the vendor has more knowledge of the product being sold than the buyer.

For example, when one party in a financial transaction has more information than the other, they have the capacity to make a better decision. Economists believe that in some instances, asymmetric knowledge might lead to market failure.

In this situation, lenders can capture a portion of the rents created by their older customers; as a result, competition encourages banks to lend to new enterprises at interest rates that cause them to incur predicted losses in the first place. A consequence is that the allocation of capital is changed in favor of lower-quality and less experienced businesses.