Likewise, banks are more effective at monitoring the behaviour of borrowers after funds have been allocated. They can thereby reduce the costs associated with moral hazard – a situation in which asymmetric information can lead borrowers to take action that erodes the value of the loan. Stock markets can also perform this duty.
Influential research literature claims that liquid stock markets help foster corporate governance and hence reduce moral hazard. 5 The basic intuition is straightforward. If managerial compensation is directly linked to stock market performance, either through contracts or stock ownership, managers have an incentive to select and implement actions that increase shareholder wealth.