Risk in Financial Markets & Monetary Policy in New Zealand

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Table of contents

1  Risk in Financial Markets  1

1.1  Asymmetric Information  1

1.2  Transaction Costs  4

2  Monetary Policy  5

2.1  The Role of Monetary Policy in an Economy  5

2.2  The Operation of Monetary Policy in New Zealand  6

2.3  The “Best Practice in Monetary Policy  8

2.4  New Zealand’s Approach in Comparison to other Countries.  10

2.5  Concerns and Recommendations  13

3  References  17

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1 Risk in Financial Markets

Risk in financial markets becomes a major issue regarding financial transactions between parties in the market. “Risk in finance relates to the uncertainty of both the amount and timing of the future cash flows of a business or project”. (Anonymous, no year)

It occurs when financial decisions have to be made with an amount of uncertainty about the pay-off of the financial transaction. This is because of insufficient knowledge about the other party involved in the transaction, which is called incomplete or asymmetric information. This lack of information makes it difficult to decide accurately and creates a problem on two fronts, before and after the transaction. (Mishkin, 2001, p. 34-35, 187)

1.1 Asymmetric Information

Adverse Selection is the problem created by asymmetric information that occurs before the transaction is initiated. It means that a potential borrower seeks out a loan but knows for himself that the outcome of his investment is most likely to be undesirable (adverse) for the lender. Due to the fact that these people are the ones who most actively seek out loans the probability is therefore very high that these will be selected. Since this problem leads to loans that may base on bad credit risks the lender is more likely not to make a loan even though if there might be a good credit risk available. (Mishkin, 2001, p. 35)

Countermeasures to avoid the problem of adverse selection exist. An option is to sell information about the businesses to people who want to supply them with their funds in order to minimize the inequality in information. But as soon as information is sold, other people not paying for the information will benefit from it as well and will adjust their actions

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according to it too, eliminating any profit for the original purchaser of the information. This problem is called free-rider problem; as a result only little information is produced due to this problem. (Mishkin, 2001, p. 189)

The government can reduce the problem of adverse selection if it either produces information about the businesses itself or provides incentives for businesses to reveal honest information about themselves, so that investors can distinguish between bad and good firms. But government regulations do not eliminate the problem since businesses will make themselves appear to be a good company even though they might not be one. (Mishkin, 2001, p. 189-190)

In terms of financial intermediaries government allows only particular trustworthy institutes to enter the market in order to guarantee effective financial transactions. These intermediaries become experts in screening out good from bad credit risks, thereby reducing the loss of adverse selection. They then acquire funds (private non-traded loans) from depositors and lend them to good firms. Since the bank lends mostly to good firms, the return of the investments is so high that it is feasible to pay interests to the depositor and continue engaging in information production activity. As a result the financial intermediaries can lower the risk of ineffective financial transactions due to adverse selection and free-riding. (Mishkin, 2001, p. 37, 190-191)

The second front based on asymmetric information that bears a significant risk to financial transaction is the problem called moral hazard. It occurs after a transaction is made and describes the risk (hazard) that the borrower hides information or uses the money for activities that are undesirable from the lender’s point of view because these activities make it less likely to be able to repay the loan. Due to this reason lenders may decide not to make a loan. (Mishkin, 2001, p. 36)

Moral hazard has significant consequences when firms raise funds with equity contracts. This consequence is the principal-agent problem that

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arises because of a lack of information and control what is done with the funds by the different equity-owner parties after the transaction. A small minority party may take advantage of this lack of information and uses the funds according to its self-interests rather than the interests of the whole business. (Mishkin, 2001, p. 192-193)

Countermeasure to defeat the principal-agent problem is the production of information (monitoring), but since it is costly in terms of money and time it makes equity contracts less desirable for financial transactions. Government regulation can help forcing companies to particular standards and thus making profit verification easier. But this is considered to be not that effective since there are still enough loopholes where people can make it hard for the government to find or prove fraud. (Mishkin, 2001, p. 194)

Financial intermediaries again can avoid the principal-agent as well as the moral hazard problem. These institutes verify and watch the firms’ activities they have financial transactions with, having their own people as members in the firms’ managing body. Since they claim non-tradable equity in the firm they provided with funds, they avoid the free-rider problem as well because nobody else can benefit from the firm’s monitoring activities. (Mishkin, 2001, p. 194)

To reduce the risk of moral hazard one can ensure that the borrower has a large financial involvement in the transaction, thus making minimizing the incentive to behave in a way that the lender does not expect or desire. Furthermore one can write provisions in a debt contract to restrict a company’s activities, but again this causes monitoring and enforcement costs and still suffers from the free-rider problem. (Mishkin, 2001, p. 196)

However, financial intermediaries have the ability to avoid both free-rider and moral hazard problems by making private loans with fund provider, which cannot be traded. Thus they can benefit from monitoring and

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enforcement, shrinking these problems in debt contracts. (Mishkin, 2001, p. 198)

Moral hazard and adverse selection are crucial issues since a financial market will not work unless these problems are solved.

1.2 Transaction Costs

But asymmetric information is not the only risk for financial transactions. Again, financial intermediaries play a major role since they are the primary route in linking borrowers to lenders. This is due to the fact that financial intermediaries can reduce transaction costs because they have the expertise to lower them and can achieve economies of scale with bundling funds from many investors. (Mishkin, 2001, p. 34, 185-186)

This bundling allows individual persons to provide multiple small funds to multiple lenders and thus being able to diversify their portfolio and thereby reducing their own risk. In addition the low transaction costs and the expertise of the intermediary make it possible to offer services to the customer in order to make it easier for them to conduct transactions. (Mishkin, 2001, p. 185-186)

All in all asymmetric information and high transaction costs bear significant risks to participants in financial markets. These risks can be overcome by involving financial intermediaries. This process is called indirect finance. (Mishkin, 2001, p. 33-34)