Banks face challenges when making loans. These include asymmetric information, define asymmetric information, provide an example,...

Banks face challenges when making loans.

These include asymmetric information, define asymmetric information, provide an example, and then discuss impacts of adverse selection.

An additional risk is moral hazard, how does moral hazard have an impact?

Expert Solution

Asymmetric information refer to the situation when one party has more material knowledge about a good in comparison to the other party it happen because of the excessive knowledge. For example the best example for this is the market for used cars. The sell owned the car so he got full knowledge about the car but buyer has no idea. We assume their are 2 type of cars in market firstone is good care and other are lemon cars. A person buys a car without knowing the fact about cars. We know their lies a significant difference in the price of two cars but if their sold an actual prices the condition of car can easily be identified so so as a result both cars are sold on average price where incentive towards selling a bad car is much higher selling a good car. This demotivates the seller of good cars . As a result good cars will start moving out andonly lemon cars are left with.

The same happens in the case of banking there are two type of borrowers a good borrower and bad borrower. A good bro has all the intentions of paying back bank money so expects a low rate of interest but the bad borrower has no intention of pain back so he is not concerned with the interest. Due to this interest good borrowers I will stop taking that as a result the poor borrowers quantity will rise due to which interest rate will rise again and more good borrowers will exit the market at last only e bad borrowers are left in the markets the hence increasing loss of banks.

On other hand moral hazard situation, are onep where entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions.
Moral hazard frequently occurs in the lending and insurance industries.

Rahul Sunny answered 6 months ago

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