Question

This is an exercise on moral hazard in credit markets. Assume that a borrower must borrow 100 for an investment. The borrower can choose between a safe project yielding a return of R_s with 100% probability and a risky project yielding a return of R_r with probability p_r and a return of 0 with probability (1-p_r). Assume that the lender cannot observe or control the type of project chosen by the borrower. What are the conditions for the borrower to choose the risky over the safe project under limited liability? What is the minimal level of collateral that will lead the borrower to choose the safe project instead? Alternatively, assume that the borrower has some money of his or her own to invest in the project that costs 100. Assuming that the bank cannot collateralize the loan, what is the maximum amount of the loan such that the borrower will prefer the safe project over the risky project?

Answer 1

Under the limited liability as the consumer has very little assets to give up in case of loss and due to this there is very less risk even then among the given two option investor (borrower) can choose between higher risk investment or in safe investment. A risk averse investor will invest in investment facing risk in order to earn higher returns. The conditions for the borrower to choose the risky over the safe project under limited liability can be

· Greater return in that investment.

· Good relation with that company in which investment has been made.

· To avail future benefits via investment.

If we Assume that the bank cannot collateralize the loan, the maximum amount of the loan such that the borrower will prefer the safe project over the risky project will depend on borowwer’s credit rating, its nature of investment and future prospects of that particular investment. But lender should keep in mind credibility as well as credit rating of borrower and in addition also check books of accounts for present position of the firm to ensure if the borrower will be able to recover loan or not. So if no collateral is there there should be some signed undertakings signed in case of any default.

But credit markets are now facing various snags due to outbreak of virus, and is almost crashed facing a recession. Moreover lenders who had given credit earlier are not sure of even their principal amount will be recovered or not. In short there is not any surity from both parties of their safe investment.