For potential lenders, investigating borrowers’ trustworthiness is costly. This problem, known as asymmetric information, occurs both before and after a transaction.

a. Before a transaction, the least creditworthy borrowers are the ones most likely to apply for funds. This problem is known as adverse selection.

b. Lenders and investors can reduce adverse selection by:

i. Collecting and disclosing information on borrowers.

ii. Requiring borrowers to post collateral and show sufficient net worth.

c. After a transaction, a borrower may not use the borrowed funds as productively as possible. This problem is known as moral hazard.

i. In equity markets, moral hazard exists when the managers’ interests diverge from the owners’ interests.

ii. Finding solutions to the moral hazard problem in equity financing is difficult.

iii. In debt markets, moral hazard exists because borrowers have limited liability.

They get the benefits when a risky bet pays off, but they don’t suffer a loss when it doesn’t.

iv. The fact that debt financing gives managers/borrowers an incentive to take too many risks gives rise to restrictive covenants, which require borrowers to use funds in specific ways.