Financing, both through debt and equity, is faced with the problem of asymmetric information. The problem of asymmetric information arises because one party has information that the other party does not know. The recipient of financing has information that the fund owner does not know, or the information owned by the fund owner is not as complete as that of the recipient of financing. The fund owner does not know the private information, both because of the nature of the information and for technical reasons (e.g. it costs a lot to get the information). There are two kinds of asymmetric information problems, namely adverse selection and moral hazard.
Adverse Selection
Adverse selection is a problem that arises when the fund owner chooses households and firms that will be provided with financing. Adverse selection occurs ex ante, which is before the financing is disbursed. This problem arises because the fund owner does not know exactly the type/characteristics of the households and firms. Households and firms have private information about themselves, including their type/characteristics. The type/characteristics show a few differentiating things the household and firm are from other households and firms. In the case of households, the type/characteristics are related to, among others, their ability to generate income, their preference for consumption and leisure time, and the extent of disutility from working. Meanwhile, in the case of firms, the type/characteristics are related to, among others, their productivity in generating profit and their efficiency. With the unknown type/characteristics, it could be the fund owner provides financing to the wrong party.
Moral Hazard
Moral hazard is a problem that arises when households and firms use the financing they receive not in accordance with the agreement. The problem of moral hazard is related to private information on efforts made by households and firms as recipients of financing, which is beyond the observation of the fund owner. As Holmström (1979) mentioned, the source of the moral hazard is an asymmetry of information that results because individual actions cannot be observed. To overcome it, monitoring of actions needs to be done. Generally, however, full observation of actions is either impossible or prohibitively costly. With limited observation, the recipient of financing can use financing for other things or use it not in the best way, including reporting business outcomes not truthfully.