Asymmetric information and financial instability We can better understand how financial instability can arise if we recognize the problem of asymmetric information – when one party to a financial contract has much less information than the other party.
For example, the borrower is usually much better informed than the lender concerning the potential risks and returns associated with the investment projects to be financed by a loan. Asymmetric information leads to two basic problems: adverse selection and moral hazard. Generally speaking, adverse selection arises when investments that are most likely to produce an adverse outcome are the most likely to be selected.