Question

A colleague tells you that he can get a business loan from the bank, but the rates seem very high for what your colleague considers a low risk loan.

• Give an adverse selection explanation for this, and offer advice to your friend on how to solve the problem.

•Give a moral hazard explanation for this, and offer advice to your friend on how to solve the problem.

Answer 1

Adverse Selection:

There can be a problem of adverse selection if Person A choose to take a loan from a bank that is charging lower interest rates.

Person A may get attracted by the bank which is charging lower interest rates but such banks are characterized by the bad credit risks and A may end up paying a higher interest rates

I would tell the person A to seek the private information from all the banks as much as possible. Diffusion of such information will help A to identify the right bank to opt for loan.

Moral Hazard:

There can be a problem of Moral Hazard if the Bank that gives loan to A indulges in risky activities. Person A cannot see such activities and therefore the issue of Moral Hazard may arise from the Bank side. The bank may start charging higher interest rates to person A in such cases.

I would tell the person A to closely monitor the day-to-day activities by reading newspaper or the data that the bank publishes to the general public. In this way, Person A would be able to identify whether the bank is engaged in doing Moral Hazard.