Minimizing information asymmetry: does firm's characteristics matter?

Author:Brent, William H.
Position::Report
 
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INTRODUCTION

Lending exposure constitutes the most material risk concentrations within banks, and granting of credit is a very important decision linking durable goods consumption spending and investment. It enables investors to generate profit-oriented economic activities that directly impact on the level of employment within an economy. Information asymmetry (i.e., information imperfection) in lender-borrower relationship can adversely affect the quality of credit decisions, and may result in high incidence of loan defaults.

This paper is a systematic literature review on information asymmetry in light of two perspectives: (1) A large firm is more efficient at minimizing information asymmetry and (2) A small firm is more efficient at minimizing information asymmetry. In particular, we are interested in the extent to which the size of a firm impacts information imperfection. We define "large firm" as publicly-traded equity firm with publicly available US Securities and Exchange Commission (SEC) filings; and "small firm" as small, private, unrated, growing, entrepreneurial corporations or Small Business Enterprises (SBEs).

The classification of an enterprise as a small business is not uniform across all countries. In the current review, we shall employ the US definition of a small business, which is a business that is "independently owned and operated and which is not dominant [italics added] in its field of operation" (Volpe & Schenck, 2008, p. 19). This definition may closely approximate that of other jurisdictions, given that the very name of "small business" must necessitate the absence of dominance and monopolies, where "only one firm, which is large [emphasis added] in size" (Duffy, 1993, p. 119) provides all of the market's supply. The US Congress developed a quantitative standard for classifying an SBE that is based on the number of employees of the enterprise and the average annual income generated by the firm. Table 1 provides an example of the numerical standards used by the US to classify an SBE within certain industries:

The purpose of this review is to evaluate the relative merit of those two perspectives with regard to minimizing information asymmetry in credit rationing decisions. Our method of review involved a systematic comparison of literature of the different proxy variables used to measure information asymmetry. Those proxy variables include but not limited to access to credit, firm size and information on stock offering, equity market valuation, size of borrower, and the Herfindhal index for measuring market concentrations.

This systematic literature review appears to be strikingly skewed in favor of large firms being more efficient at minimizing information asymmetry. The primary reason may be that stricter regulatory requirements, compliance, and firm-specific benefits compel large firms to make public disclosures of their financial position under the environment of generally accepted accounting principles. The resultant effect is efficiency at minimizing information asymmetry.

This review contributes to academic literature on firm size and correlation with information asymmetry. It is, to our knowledge, the first to document systematic difference between amount of information asymmetry and the size of a firm in light of the two perspectives. This fact is made evidenced by the limited and implicit literature on the subject, particularly with regards to small firms being more efficient at minimizing information asymmetry (perspective 2). This review will help institutional lenders to improve upon their lending policies by minimizing the problem of information asymmetry. But before we begin reviewing the systematic literature on the two perspectives, we briefly discuss information asymmetry and few related concepts.

WHAT IS INFORMATION ASYMMETRY?

The seminal work of Akerloff (1970), suggested that the premise of information asymmetry (i.e., deviation from perfect information) is the concept that at least one party to a contract relationship, such as lender-borrower or buyer-seller, is ignorant of relevant information pertaining to a transaction. This creates the attendant problems of "moral hazard" and "adverse selection." A moral hazard may be a situation where a stakeholder to a contract may have the propensity to exercise less caution in a contract because the responsibility for any adverse effect is also partly borne by the other party or a third party to a contract (Dembe & Boden, 2000). For example, lender, L, may extend credit to borrower, B, in an amount that may far overwhelm B's ability to repay with applicable interest. Given that L may have taken insurance policy coverage against default with insurer I, which information may not be available to either B or I. Under such situation, asymmetric information develops, because L is passing on the risk of default to I, while leaving B also with imprecise information as to B's own capability to repay the loan relative to income. Thus there is compartmentalization of information that works solely to the advantage of L, and which leaves L to grow less responsible in the loan decision making.

Adverse selection develops when B suffers the negative consequences of that information compartmentalization. This negative consequence may manifest as deluge of loan default situations on the part of L's customers. Although, the initial incidence of defaults may be covered by the policy with I, the resultant cumulative effects may ricochet on L in the form of being left with significant pool of noncredit-worthy customers. Additionally, I may also want to scrutinize or challenge, in a court of law, the lending practices of L that may have contributed to such unusually high incidences of default, as a way of shirking responsibility for the loan repayments of a large number of defaults.

LITERATURE REVIEW

Perspective 1: A large firm is more efficient at minimizing information asymmetry

Financial reporting and disclosures are very important avenues whereby firms make available their financial performance to outside investors and all stakeholders, including lenders (Healy & Palepu, 2001). Shen and Reuer (2005) noted that regulation requirements for large firms to disclose financial information in accordance with generally accepted accounting principles directly minimize information asymmetry for public firms.

Although, regulatory requirements...

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