Information Asymmetry in Banking Sector

The main result of the information asymmetry in the banking sector is just one thing that is
Non-Performing Assets. The very existence of banks is often interpreted in terms of its superior
ability to overcomes three basic problems of information asymmetry, namely ex-ante, interim
and ex-post information asymmetry, over an individual lender. It may be seen that in the Indian
context, a bank often fails to overcome these problems due to various non-random factors as
discussed below.

Non-random aspect of default

1. Ex-ante information asymmetry

Irrespective of the size of the project, almost 70-75 percent of the investment is financed
by banks and financial institutions and 25-30 percent comes from the promoters as their
contribution in the form of capital. In other words, major part of the investment in all the
projects is financed by banks and financial institutions. It is the job of the banker to properly
scrutinise the projects and stay away from unviable and un-bankable projects. The bank’s role
is to screen potential projects to determine expected return and risk from the not very objective
data presented by the demanders of funds. Clearly, the bank’s credit department takes the centre
stage, because it is through its evaluation of potential investment opportunities the bank
productively invests idle deposits mobilised from the household sector in the public interest.
Term project proposals require detailed scrutiny as compared to working capital proposals,
particularly keeping in view the future growth prospects of the project and that of the industry.
The decision of the term loan is irreversible and any wrong decision could result in bad
investment. There may exist situations where many borrowers hide information while
borrowing and once the loans are granted they default. When banks fail to detect them adverse
selection problems result. Adverse selection of the projects without properly scrutinising their
viability has led to substantial accumulation of NPA in the banks. The following situations lead
to failure to overcome ex-ante information asymmetry and thereby cause adverse selection of
borrowers.

a) Lack of organisational learning in the bank - repeated lending to same person or group
of persons with similar dubious characteristics

Organizational learning on the part of the bank is very important in controlling the growth
of NPA. It is obvious that with the experience of repeated lending over a period of time to
varieties of borrowers, a bank can identify a particular type of borrower who is more likely to
default. But in practice it fails to learn from the past. Due to several constraints, whether
internal or external, like political interference, it cannot bar these potential defaulters. For
instance, loans have been extended to
i) industries in the negative list circulated by IDBI, department of industries and RBI.
ii) Existing accounts which have gone irregular, i.e. ever-greening of accounts.
iii) A party which is irregular on existing accounts in a different branch of the same bank.
iv) Several projects with promoters or directors with doubtful integrity.

b) Lack of vision of bank in sanctioning, reviewing and enhancing credit limits

While examining long term viability, both foresight as well as proper scrutiny is lacking on
the part of the bank. Inefficient decisions have resulted in many newly born projects turning
sick or closing down. There are instances in which instalments and interest have become due
before the commencement of commercial production. Such accounts are considered as NPA,
which reflects improper scrutiny and failure in considering moratorium period on a realistic
basis.

c) Political interference

Political leaders/organisations wield enormous power over the banks in granting loans to
particular borrowers. It pays the political leaders to encourage default by the borrowers, in the
absence of an efficient legal system. For instance, rural panchayats are responsible for
recommending loans, but once the loan is disbursed, these rural political bodies take no
initiative to ensure that the loan is serviced and repaid. There are many instances where big
companies received a large volume of loans under political influence and were able to escape
punishment after default. Examples include UB Engineering promoted by Vijay Mallya, an
MP in the Rajya Sabha and Mukand Steel promoted by Viren Shah, current governor of West
Bengal. Earlier, loan melas and debt write off under political pressure have also contributed to
NPA problem of which further discussion will be made in the next section.

2. Interim information asymmetry

There are asymmetries of information that develop subsequent to signing of a contract.

Even when information asymmetries do not exist at the time of contracting, the parties to a
contract often anticipate that asymmetries will develop sometime after a contract is signed.
Because lenders have trouble ascertaining the quality of investment projects that borrowers
wish to undertake, the borrowers have incentives to engage in activities that may be personally
beneficial but increase the probability of default and thus harm the lender. For example, the
borrower has incentives to cheat by misallocating funds for his own personal use, either through
embezzlement or by spending on perquisites, which do not lead to increased profits. Moreover,
the borrower has incentives to undertake investment in unprofitable projects that increase his
power or to invest in projects with higher risk, in which the borrower does well if the project
succeeds but the lender bears most of the loss if the project fails. When there are some actions
which the borrower can take and which affect the likelihood of not being able to repay the debt,
then there exists a kind of moral hazard problem. RBI (1999) report on NPA investigated
around 800 top NPA accounts in 17 banks. It reveals that while loans were taken mostly for
expansion, diversification, modernisation, taking up new projects and for helping /promoting
associated concerns, the single most prominent reason for units becoming sick and accounts
turning sick is the diversion of funds by promoters. Further, no transparent accounting policy
and poor auditing practices often mislead the banks who otherwise could have taken
appropriate measures to minimize loss due to default.

3. Ex-post information asymmetry - need for monitoring

Once lending decisions are made, ongoing monitoring needs to be done with a view to
prevent moral hazard or otherwise in order to assure the maximum possibility of repayment.
The Indian PSBs are not in a position to monitor perfectly the actions of those to whom it lends
money. RBI (1999) report on NPA provided a number of instances where banks have financed
projects of a company whose registered office is far away from the concerned branch of the
bank, thus making it very difficult to monitor the accounts. Disbursement of loan in another
area created problems for the bankers who often failed to keep track and check on end-use of
the fund disbursed. Over-invoicing in cost of construction and machinery; disbursements
against machines-materials-asset not relevant to the project, frequent cash withdrawals of huge
amount, inter-firm transactions, payments for buying property of the partner or director by
withdrawing from cash credit account, and operating cash credit accounts for public issues are
some prominent examples which point to the fact that bankers have not been vigilant in
controlling the end-use of funds. During periodic inspection, appropriate enquiries are ignored
even when certain irregularities are observed by the bankers.
Three decades of government ownership have rendered banks organisationally weak.
Faulty appraisals, absence of effective post-sanction monitoring have resulted in NPAs.
Defective credit appraisal system, absence of risk rating and deficiencies in post-credit
supervision and follow-up are important reasons that led to accumulation of NPAs. Further, it
may be seen how conflict between government policy and bank’s interest generates NPA in
the priority sector. In the case of priority sector lending, a certain proportion of the total
advances would be provided to a particular type of borrower, irrespective of requirement, usage
of the money, credibility or ability to repay. While devising such programmes the government
has not devised any method of recovering loans in case of default. Thus, pre-approved nature
of loans sanctioned under sponsored programmes (leading to adverse selection), lack of
effective follow up due to large number of accounts (and lack of monitoring) lead to formation
of NPA in priority sectors for Indian PSBs.

DIVIDEND SIGNALING THEORY

1.0 SIGNALING DIVIDEND THEORY.

This theory was brought forward by Stephen Ross and Solomon Ezra in 1977.They observed
that from empirical studies, firms that increase significantly dividend payment had a
corresponding increase in share prices whereas those firms that omitted or reduced significantly
dividend payment had a corresponding decline in share prices. This in his opinion suggested
that investors prefer dividend to capital gains.

This is a theory which asserts that announcement of increased dividend payments by a company
gives strong signals about the bright future prospects of the company. An announcement of an
increase in dividend pay out is taken very positively in the market and helps in building a very
positive image of the company regarding the growth prospects and stability in the future.
Companies use dividends to share profits with stockholders and when doing so, they can decide
to issue a dividend when plowing profits back into the company for development and growth
is not the best option, is not necessary or not practical. At the time officials make the decision
to offer a dividend, they usually make an announcement, providing information about the
amount and date so shareholders know what to expect.

These announcements are closely anticipated and followed because investors believe they can
provide information about the company’s financial health. Generally, dividend signalling is
done by the company when it changes the amount of dividend to be paid to shareholders.

Miller and Modigliani (1961) work sustains that, in a perfect capital market, a firm value is
independent of the dividend policy. However, some years later, Bhattacharya (1979), John and
Williams (1985) and Miller and Rock (1985) developed the signalling theory classic models,
showing that, in a world of asymmetric information, better informed insiders use the dividend
policy as a costly signal to convey their firm’s future prospect to less informed outsiders. So, a
dividend increase signals an improvement on a firm’s performance, while a decrease suggests
a worsening of its future profitability. Consequently, a dividend increase (decrease) should be
followed by an improvement (reduction) in a firm’s profitability, earnings and growth.
Moreover, there should be appositive relationship between dividend changes and subsequent
share price reaction.
2.1 Assumptions
One of the most important assumptions of the signalling theory is that dividend change
announcements are positively correlated with share price reactions and future changes in
earnings. According to Brigham and Houston (2013), signalling theory is also banked by the
assumption that information is not equally available to all parties at the same time, and that
information asymmetry is the rule. Information asymmetries can result in very low valuations
or a sub-optimum investment policy. Signalling theory states that corporate financial decisions
are signals sent by the company's managers to investors in order to shake up these asymmetries.
These signals are the cornerstone of financial communications policy. In this case, managers
know more than investors, so investors will find "signals" in the managers' actions to get clues
about the firm. So the theory simply suggests that firm’s announcements of an increase in
dividend pay-outs act as an indicator of the firm possessing strong future prospects.

2.2 The rational and provisions of the theory

Dividend decisions are frequently seen by investors as revealing information about a firm's
prospects therefore firms are cautious with these decisions. An information asymmetry exists
if firm managers know more about the firm and its future prospects than the investors.
When investors have incomplete information about the firm (perhaps due to opaque accounting
practices) they will look for other information in actions like the firm's dividend policy.

Signalling is the idea that one agent conveys some information about itself to another party
through an action hence relying on signalling theory is justified. For instance, when managers
lack confidence in the firm's ability to generate cash flows in the future they may
keep dividends constant, or possibly even reduce the amount of dividends paid out.
Conversely, managers that have access to information that indicates very good future prospects
for the firm (e.g. high demand for its goods) are more likely to increase dividends. Another
argument is that a manager who has good investment opportunities is more likely to "signal"
than one who doesn't because it is in his or her best interest to do so.

Investors can use this knowledge about managers' behavior to inform their decision to buy or
sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling
it down when dividends do not meet expectations. This in turn, may influence the dividend
decision as managers know that stock holders closely watch dividend announcements looking
for good or bad news. As managers tend to avoid sending a negative signal to the market about
the future prospects of their firm, this also tends to lead to a dividend policy of a steady,
gradually increasing payment. Investors will notice this and choose to sell their shares at good
prices or retain them for good dividends. Firms are aware of this signaling effect, so they will
try not to send a negative signal that sends their stock prices down. In practice changes in a
firm’s dividend policy can be observed to have an effect on share prices. That is to say an
increase in dividend causes share prices to go up whereas decreases in dividend would pull the
share prices down. This pattern forced Stephen Ross to conclude contrary the MM model that
shareholders do in deed prefer dividend to future capital gains.

2.3 Application of signalling theory

2.3.1 Dividend Announcements and share price reactions
There have been a significant number of empirical tests showing that dividend change
announcements are positively associated with share returns in the days surrounding the
dividend change announcement. Pettit (1972, 1976) found strong support that dividend change
announcements convey information to the market. .
Although there are empirical evidence supporting the positive relationship between dividend
change announcements and the subsequent share price reactions, some studies have not
supported this idea. According to the dividend signaling theory, dividend change
announcements trigger share returns because they convey information about management’s
assessment on firms’ future prospects.

2.3.2 Importance of signaling theory

A dividend decision may have information signaling effect that firms will consider in
formulating their policy. The decision is an important one for the firm as it may influence its
capital structure and stock price. In addition, the decision may determine the amount of taxation
that stockholders pay. The theory will also be used by companies that have future investment
opportunities to attract capital from existing and potential investors.

3.0 CONCLUSION
Investors view dividend changes as signals of management’s view of the future. Managers
hate to cut down dividends, so they also avoid raising dividends unless they think this is
sustainable. Therefore, a stock price increase at time of a dividend increase could reflect higher
expectations for future Earnings per Share (EPS), not a desire for dividends. The signalling
dividend theory concludes that dividend decisions are relevant and the higher the dividend
paid by the company, the higher its value. However, a firm should always make decisions that
will favour its long term objectives because the decision of investors and shareholders should
not be the leading force. In an uncertain world in which verbal statements may be miss-
interpreted or ignored a dividend action does provide a clear cut means of making a statement
that speaks louder than many words.

Information Asymmetry and Sub Prime Crisis

From long experience, we knew that home buyers shouldn’t take on mortgages whose
payments they couldn’t afford, and that they should put enough money down so that they
can sustain a moderate drop in home prices and still have positive equity. Low Interest rates
should have changed the mortgage payments associated with a given amount of borrowing,
but not much else. What actually happened, was however a complete abandonment of
traditional principles. To some extend this was driven by the irrational exuberance of
individual families who saw house prices rising ever higher and decided that they should
jump into the market, and not worry about how to make payments. But it was driven to a
greater extend by a change in lending practices. Buyers were given loans requiring little or
no down payment, and with monthly bills that were well beyond their ability to afford – or at
least would be unaffordable once the initial low, teaser interest rate reset…
Why did lenders relax their standards? First, they came to believe in ever-rising home prices.
As long as home prices only go up, it doesn’t matter much from the lender’s point of view
whether a borrower can make his or her payment: if the payment are too high, well, the
buyer can either take out a home equity loan to get more cash or, if worst comes to worst,
just sell the home and pay the mortgage. Second, the lender didn’t concern themselves with
the quality of their loans because they didn’t hold on to them. Instead, they sold them to
investors, who didn’t understand what they were buying.
“Securitization” of home mortgages – assembling large pools of mortgages, then selling
investors shares in the payment received from borrowers – isn’t a new practice. In fact, it
was pioneered by Fannie Mae, the government-sponsored lending agency, which dates back
to the 1930s. Until the great housing bubble, however, securitization was more or less
completely limited to “prime” mortgages: loans to borrowers who could make a substantial
down payment and had enough income to meet the mortgage payments… The financial
innovation that made securitization of subprime mortgages possible was the collateralized
debt obligations, or CDO. A CDO offered shares in the payments from a mortgage pool –
but not all shares were created equal. Instead, some shares were “senior”, receiving first
claim on the payments from mortgagees. Only once these claims were satisfied was money
send to less senior shares. In principle, this was supposed to make the senior shares a very
safe investment: even if some mortgages defaulted, how likely was it that enough would
default to pose problems for the cash flow to these senior shares? (Quite likely, it turned out
– but that wasn’t understood at the time.) And so the rating agencies were willing to classify
senior shares in CDOs as AAA, even if the underlying mortgages were highly dubious. This
opened up large- scale financing of subprime lending, because there are many institutional
investors, such as pension funds, that won’t buy anything except AAA securities but were
quite willing to buy AAA- rated assets that yielded significant higher returns than ordinary
bonds.
As long as housing prices kept rising, everything looked fine and the
Ponzi scheme kept rolling.

This explanation has identified moral hazard, in that the executives of financial institutions
responsible for originating loans (mortgages) to borrowers (homeowners) may have been
motivated to relax their standards in conceding these loans. Traditionally, the mortgage
model required a financial institution as the originating source for a loan to the borrower
(homeowner), and this institution retained the credit (default) risk. With the advent of
securitization, the traditional model gave way to the originate to distribute model, in which
financial institutions essentially sell the mortgages and distribute credit risk to investors
through mortgage-backed securities. Securitization meant that those issuing mortgages were
no longer required to hold them to maturity. By selling the mortgages to investors, the
originating financial institutions (that is, the institutions that issued the mortgages)
recuperated their funds, enabling them to issue more mortgages and in doing so generate
further transaction fees.
This may have produced moral hazard, as the executives of financial institutions that issue
mortgages and the mortgage brokers were increasingly motivated to focus on processing
mortgage transactions for fees rather than on ensuring credit quality. If the homeowner
(borrower) could not pay the mortgage, and was this was foreclosed, there was little impact
for the issuer.