Question

Universal Savings & Loan has $1,000 to lend. They can offer one of two types of loans. If they offer a risk-free loan, they will be paid back in full next year with 4% interest. If they offer a risky loan, there is a 20% chance that the borrower will default (pay back nothing) and an 80% chance the borrower will pay back in full with 30% interest?

a. What are the expected profits for each type of loan? Which type of loan will they prefer to offer?

b.Now suppose that the lending institution knows that the government will “bail out” Universal if there is a default. (The government will pay back the original $1,000.) What type of loan will the lending institution choose to make? What is the expected cost to the government?

c. What type of asymmetric information problem is the government creating in this market?

Answer 1

a.

Expected profits for each type of loan:

Risk free loan: $1000*4% = $40.

Risk Loan= $1000*0.8*30%+ $1000*0.2*0%

= $240.

US&L would prefer to offer risk Loan. As there is much more profit in it ($240).

B. As Government will bailout in case of default US&L will definitely offer risk Loan.

The Expected cost to Government is $1000*.2= $200.

C. Asymmetric information, also known as information failure, this occurs when one party to an economic transaction possesses greater material knowledge than the other party.

Here the lender posses greater knowledge than Borrower. He knows that government will bail him out and he virtually has No risk (expect losing interest).

This should make interest rates fall if overall market has information about it.

But there is a interest price irregularities due to it.

If government comes bailing out each time than,

There is higher chance of default in Loan repayment which creates imbalance in society and hence fall in Financial markets.

Thank you. Hope you find it helpful.