1.

0 Introduction
One of the main postulates in classical economics is the well informed and rational market
participants. In other words, in classical economics, it is assumed that all the market participants
have full market information when they make decisions. However in reality this is far from the
truth. In many markets not all the information is available to all the market participants. In most
of the situations complete information about the consumer behavior or the producer behavior is
not available. This results in an imbalance of information within the markets and therefore the
competitive market hypothesis loses its ground. As a result market failures occur and the markets
do not operate as efficiently as they are expected to in classical economic thought and thus is the
invisible hand at work; therefore the markets fail to iron out the imperfections themselves thus
causing many a concerns. Financial markets are no exceptions to this phenomenon.
In this backdrop the first part of this essay attempts to study the causes and impact of such
information related market failures in the financial markets and how the financial system
counteracts such problems. Two such information related phenomena resulting in market failures
are the adverse selection and the moral hazard. This essay an attempt is made to identify the
causes and remedies of these problems in financial markets.
Another phenomenon that arises mainly due to the information problems is the transaction costs.
This essay further attempt to explain how the financial markets try to lower the transaction costs.
The latter part of the essay is devoted to a study of how the transaction costs are lowered in a
commercial bank in Sri Lanka, namely the Commercial Bank of Ceylon Plc.
1.1 Definitions
Financial system
According to Ross Levine the functions of finance include; savings mobilization, resource
allocation, distribution of risk, providing corporate control and providing the means for the
exchange of goods and services in the economy (Levine, 1997). The financial system performs
these functions with its components. In a broader sense, the financial system is said to have six
components; namely, financial markets, financial institutions, financial instruments, financial
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regulation, money, central bank. However, according to the structural approach these can be
categorized into three main components, as, financial markets, financial institutions and financial
regulators.
Financial markets
When the entire financial sector is considered the financial markets encompass the foreign
exchange markets and the insurance markets in addition to the credit markets. They trade
different financial assets in these financial markets. In this assignment the problem of
asymmetric information in all these three financial markets are considered.

1.2 Problems of Asymmetric Information

Information problems in the realm of economics are twofold. Information asymmetries occur
when one party has more information than the other. This is different from the case where no
information is available to either party a case of uncertainty. Clearly, when the information
asymmetries are present, one party is having a competitive edge over the other party; or in other
words, the party that lags behind in the information front cannot make optimal decisions.
Therefore the asymmetric information problem is an obstacle to the efficient functioning of
markets and thus results in market failure. (That is optimum choices are not made.)
Both adverse selection and moral hazard occur due to information asymmetries between the
buyer and the seller. However, adverse selection occurs before the transaction takes place due to
the lack of sufficient information on the part of the buyer whereas the moral hazard occurs after
the transaction has taken place due to the changed or altered behavior of the buyer which was not
foreseeable to the seller; or in other words, the buyer not being able to act according to the
agreement reached at the time of closing the deal. As can be seen in any other market of goods or
services, these information problems are present in financial markets as well.
The following sections discuss how adverse selection and moral hazard occur in financial
markets and the financial systems response to these problems.

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Adverse Selection
The credit markets are meant for raising capital for the investment purposes. That is, in credit
markets, excess liquidity from surplus economic agents is transferred to the liquidity-deficient
economic agents. The financial institutions which are involved in such liquidity transfers mainly
include the banks and the stock markets. In the banks liquidity transfer takes place in the form of
loans whereas in the stock markets it occurs though share / bond issues.
In the case of banks there are two types of market interactions. They take deposits on the one
side and make loans on the other side. When making loans to the liquidity-deficient economic
agents for investment purposes there is an optimal interest rate at which the expected return to
the bank is maximized (Stiglitz & Weiss, 1981). Beyond this point the expected returns fall as
the riskiness increases and therefore the probability of repayment falls. This happens because the
banks cannot perfectly identify the good customers who would repay the loans clearly a
matter of asymmetric information.
On the other side of the banking industry there is deposit taking from the economic agents with
excess liquidity. Usually when a bank raises its assets using such deposits (borrowings by the
banks) the bank has to back them with some investment plan in order to be able to repay for the
deposits and the interest. In this instance the bank has more information about the repayingability of these deposits than the depositors and that gives rise to the problem of asymmetric
information.
When it comes to the case of stock markets the economic agents who provide liquidity
necessarily know where their funds go into and often have a certain degree of control over the
decision making process in the particular entity. Therefore the problem of asymmetric
information, particularly the adverse selection occurs to a lesser degree than in the banks.
According to Cohen and Siegelman (2010), in the case of insurance markets where the risk is
traded, adverse selection occurs when the buyers of insurance policies have more information
about their risks than the underwriters and thus make use of this information in buying insurance

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policies1. This could happen in all insurance markets ranging from life insurance, vehicle
insurance and health insurance.
Among others, Naranjo and Nimalendran (2000) have found the elements of adverse selection in
the foreign exchange markets where currency trading takes place. In their study, the impact of
occasionally intervening2 governments is found to have created adverse selection problems for
dealers. This is true for unexpected intervention whereas expected intervention has no impact.

Moral Hazard
The credit markets, mainly the banking industry is prone to experience moral hazard. According
to Nier and Baumann (2006) if the deposits in banks are insured or when the depositors do not
see how the bank is managing the risk in its investments and are not demanding higher returns
for their deposits; then the chances of occurrence of moral hazard is high. Similar type of moral
hazard could occur in the stock markets when the creditors perceived investment projects are
altered or abandoned by the borrowing organizations that raise capital with creditors funds.
Moral hazard in insurance markets is quite a common phenomenon. After buying an insurance
policy if the behavior of insured party changes in such a manner that the risk is increased then
that leads to moral hazard in the insurance markets.
The concept of moral hazard has its applications in the foreign exchange markets as well.
Depending on the foreign exchange regime adopted by a country the market participants may not
get the results that they anticipate. This is especially true when countries adopt currency pegging
(Patnaik and Shah, 2010) and managed float policies.
1.3 How financial system overcomes the problems of adverse selection and moral hazard

1 It should be noted that this is different from the problem of moral hazard in
insurance markets.
2 in the foreign exchange market
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In view of addressing the above mentioned information related issues the financial system of a
country makes it mandatory to the market participants to disclose certain information at regular
intervals and to adhere to preset guidelines. This is usually done through the central bank and the
other financial regulators and is applicable to all credit, insurance and foreign exchange markets.
All these steps can be identified as means of making up to date information available to the
relevant market participants and cushioning against uncertainty.
The financial system collects and stores the financial histories of individuals and entities with
bad histories, for example, bad credit records. These information are made available to lending
organizations such as banks if and when a need arise 3. Apart from that even the individual banks
do maintain records of individual credit histories and use this information when making fresh
loans or other commitments.
In order to maintain the liquidity position and the investor / deposit holder confidence the banks
are required to maintain a minimum amount of funds with them and that is called the Statutory
Reserve Requirement (SRR). This functions as a cushion against the sudden and unanticipated
withdrawals of funds and also can change time to time depending on the government policy. Also
the banking regulation systems such as Basel II emphasize the requirements for market discipline
which is partly meant for addressing agency problems.
The financial regulators have made it mandatory to disclose the financial status of the financial
market participants on regular basis. These include the annual reports of the companies as well as
their stock prices. These information are made available to the general public though newspapers
and therefore anyone interested would have access to the information.
The financial system makes room and provides the regulatory framework for hedging so that the
market participants can get into hedging agreements thereby reducing the foreign exchange risk.
This in turn reduces possibilities and the impact of moral hazard in the foreign exchange market.
It should be noted here that, although the financial system itself is not hedging it provides the
necessary legal framework and facilitates hedging.
2.0 Transaction costs
3 In Sri Lanka this is done through CRIB
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An information-related concept that has much relevance to the financial markets is the concept of
transactions cost. It is the neoclassical definition that relates the term transaction costs to the
costs of trading across a market, or in other words, the costs that result from the transfer of
property rights (between the economic agents but not within them) 4. According to the business
dictionary transactions costs are the costs that occur in the process of exchange of goods and / or
services due to the market imperfections such as information asymmetry or unavailability of
information. These include the information costs, communication costs and the legal costs.
Transaction costs may also include the transportation costs and are also called friction costs.
According to Dahlman (1979) the transaction costs are comparable to transportation costs and
they do not differ from transportation cost in any significant manner.
According to Allen (1999) the transaction costs are generated because of the information costs
but not all information costs are transaction costs. Apart from being information costs
themselves, the transaction costs need to have occurred when an exchange of property rights
takes place.
Darskuviene (2010) lists the determinants of transaction costs as follows;
1. Asset specificity possibility of employing an asset in various tasks without incurring
significant costs
2. Uncertainty possibility of predicting the external events
3. Frequency of occurrence how many times a given transaction occurs in the market
Generally the transactions costs are lower when all asset specificity, uncertainty and frequency of
occurrence are low. The financial markets lower the transaction costs by structuring themselves
in such a way that the financial institutions and the financial instruments that exist offer the
lowest transaction costs.
According to Dahlman (1979) in any market the transaction costs can be broadly classified into
three types as given below;
4 The same term, transaction cost is used in the context of property rights to
describe the costs of establishing and enforcing of property rights, which has,
though originated with neoclassical concepts, grown into the subfields of law and
economics and new institutional economics (Allen, 1999) and is not the focus in this
assignment
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1. Search and information costs

2. Bargaining costs
3. Policing and enforcement costs
In view of financial markets the above three types of costs can be elaborated as given below:
Search and information costs include the costs incurred in finding the right financial product that
suits the needs of the buyer. In financial markets the products traded are the interest bearing
assets and therefore the search and information costs would encompass the costs associated with
the fact finding with regard to the risks and returns of those assets. Once the right financial
products are identified steps need to be taken in negotiating the deal / transaction and getting into
a legal contract. This process entails the bargaining costs. Policing and enforcement costs are
incurred in getting the other party to abide by the contract and in case if they do not, to take
enforcement action.
Apart from the price of a good or service, the transaction costs are also important as they become
deciding factors in buying or selling of a product. In financial markets the transactions costs that
arise mainly due to the information problems are of significant importance as other types of
transaction costs such as transportation costs do not matter much in these markets. Financial
markets deal with financial products which are mainly legal contracts and fund transfers that
could be done almost instantaneously all over the world without even having to carry the
contracts or funds between places due to the advancements of communication technology and its
applications in the field of finance. Therefore, when discussing the transaction costs in financial
markets the main focus has to be made on the informational aspects of transactions.
The transaction costs cause externalities which can be positive or negative. In order to eliminate
or counter the effects of negative externalities the transaction costs need to be reduced or
ultimately eliminated. Dahlman (1979) argues that when the wealth-maximizing economic
agents become incapable of internalizing all the effects of their transactions 5 the negative
externalities are produced. Therefore it is clear that the externalities are caused by the transaction
costs and thus they need to be minimized, if not possibly eliminated.
2.1 Lowering transaction costs in financial markets
5 If they attempt to do so it would be unprofitable
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As discussed in the preceding sections the ways and means of lowering the transactions costs can
be explored considering the types and determinants of them. As the resultant reaction to these
forces the financial institutions and financial instruments exist such that the transaction costs as
lowered to the minimum possible level in the particular market (segment). As Mishkin and
Eakings (2012) point out, there are two main methods by which the transaction costs are
lowered:
1. Economies of Scale
The financial intermediaries transact with a large number of individuals and organizations
and therefore the volume of transactions is quite high. This high volume helps in reducing the
cost per transaction as compared with an individual making few transactions and incurring
the same costs. For example, suppose a legal contract is to be prepared for lending some
money. If an individual gets it done for one or a few transactions the cost per transaction
would be much higher than when a bank incurs the same costs and divides this overhead
among thousands or even millions of transactions. Therefore the economies of scale are an
important means of lowering the transaction costs in financial markets.
2. Expertise
Another means of lowering the transaction costs in the financial markets is the expertise of
the financial intermediaries that they develop by being in the business over a long period of
time and specialization that they can afford to have again due to high volume of business
transactions. For example a bank can afford to have a computerized customer information
system whereas an individual money lender may not be able to offer such services. This is
partly due to high volume and also partly due to the expertise. Also on the other hand, an
organization such as a bank can provide the services of investment experts or counselors to
its customers in order find better suited investment plans for then. Such expertise and
technological innovation cannot be expected from the individuals.
Another method of lowering the transaction costs is by cutting down the number of middle men
in the transaction process. This is especially true in securities markets.
2.2 How Commercial Bank of Ceylon Plc lowers the transaction cost
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The Commercial Bank of Ceylon Plc has offered its customers access to banking facilities
through a countrywide branch network including 234 customer service points and 585 ATMs.
Saturday and Sunday banking has been made available at strategically located branches. Apart
from that a 24 hour automated banking centre is established in Colombo to provide banking
facilities round the clock to the customers. Therefore any customer who is in need of banking
facilities would have the accessibility to the bank easily. This reduces the transaction costs of
searching and reaching the bank for its customers.
Further, utilizing the advances of information and communication technologies the bank has
provided internet and mobile banking facilities to its customers. This has greatly reduced the
need to physically visit a branch or a service point thereby eliminating the traveling and waiting
times and related costs. Any person using these technologies could have a variety of banking
services and facilities at their fingertips. These advancements have reduced the transaction costs
for customers as well as the bank.
The transaction costs are further reduced by the transition to a common ATM platform. Also the
customers gained more security for their transactions with the line encryption technology, thus
made available.
The operational risk management is done with a view of causing least inconvenience to the
customers while reducing the transaction costs on one hand and on the other, to safeguard against
the possible losses. This is achieved by adopting the concept of optimizing risk vs service vs
cost. For this purpose operational cost has been minimized rather than being reduced to a zero
level6 and accordingly the threshold levels for alert and maximum have been set up.
All financial instruments and measured initially at their fair value plus transaction costs thus
ensuring the financial viability.

3.1 References:
6 That would cause more problems to the customers and hence increase the
transaction costs. Therefore zero tolerance for operational risk is not practical
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Allen, D. W., 1999. Transaction Costs. In: s.l.:Department of Economics - Simon Farser
University , pp. 893-926.
Cohen, A. & Siegelman, P., 2010. Testing for Adverse Selection in Insurance Markets. The
Journal of Risk and Insurance, 77(1), pp. 39-84.
Dahlman, C. J., 1979. The Problem of Externality. Journal of Law and Economics, 22(1), pp.
141-162.
DARKUVIEN, V., 2010. Financial Markets. s.l.:Leonardo da Vinci programme project.
Levine, R., 1997. Financial development and economic growth: views and agenda. Journal of
economic literature, 35(2), pp. 688-726.
Mishkin, F. S. & Eakins, S. G., 2012. Financial Markets and Institutions. 7 ed. USA: Prentice
Hall.
Naranjo, A. & Nimalendran, M., Summer 2000. Government Intervention and Adverse Selection
Costs in Foreign Exchange Markets. The Review of Financial Studies , 13(2), pp. 453-477.
Nier, E. & Baumann, U., 2006. Market discipline, disclosure and moral hazard in banking.
Journal of Financial Intermediation, Volume 15, pp. 332-361.
Patnaik, I. & Shah, A., 2010. Does the currency regine shape unhedged currency exposure?.
Journal of International Money and Finance, Volume 29, pp. 760-769.
Stiglitz, J. E. & Weiss, A., 1981. Credit Rationing in Markets with Imperfect Information. The
American Economic Review, 71(3), pp. 393-410.
Commercial Bank of Ceylon Plc - Annual Report - 2013

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