Consequences of Incomplete information for Financial Systems



Abstract

One of the most significant elements of an efficient financial system is the 'complete and sound information' gathering, distribution, and utilization. Financial systems that incorporate information asymmetry experience several issues such as lack of confidence from investors, increase in fraudulent activities, reduction in investment that leads to decline economic growth, higher interest rates that also results in less economic growth, misinterpretations that can lead to inefficient market plays, and many others. Thus, this essay discusses the issue of incomplete information for the financial system and the response of market participants as well as market regulators. Consequences of Incomplete information for Financial Systems

Introduction

Financial system is established to channel the funds from agents with surpluses to agents with deficits. In order to efficiently fulfill its purpose, the financial systems have to acquire and use information while allocating resources effectively (Allen & Gale, 2001). So, information acquisition and use is one of the key functions of a financial system. In market based financial systems, wide range of publicly listed companies in line with extensive reporting requirements release a great deal of amount regarding company's activities. Besides this publicly available information, there are several market analysts who work for pension funds, mutual funds, and other intermediaries that collect financial information. Thus, it is very much apparent that an efficient market is the one which accommodates sound and complete information. This report focus on the issue of incomplete information for the financial system and its consequences while discussing the response of market participants as well as market regulators.

Discussion

In modern economy, financial systems play a crucial role to allocate resources, while channeling household savings to the corporate sector and allocating investment funds between various companies. One of the critical issue associated with the financial system' operations is the manner in which information is gathered, distributed, and utilized by the market participants as well as the market regulators. Different companies incorporate financial systems with different style of information management, where, the manner in which information is gathered and utilized for allocating resources has received significant attention in the context of financial markets. Research indicates that economies involving liquid stock markets and several publicly quoted firms would be more efficient at allocating resources as compared to the economies involve few large intermediaries and a small figure of publicly quoted firms. This trend is mainly because publicly traded firms have to give more information regarding their activities as compared to private firms, and the prices of those firms are themselves informative (Allen, 1999).

The assumption of perfect information is not realistic because borrowers tend to be better informed regarding their investments projects as compared to potential outside investors (lenders). However, this information asymmetry as well as the incapability of lenders for monitoring borrowers without cost results in agency costs, which increases the external financing cost. Due to incomplete information, capital is only accessible at a higher rate of interest, where, the higher capital cost results in lower investment and lead to ...