Question

Many countries (including the United States and European countries) are forecast to have a severe drop in production this year.

a. In this context, do you think that in the coming months there will be an increase or decrease in adverse selection problems in commercial loans? Explain what are adverse selection problems and justify your answer.

b. How can an economic crisis affect a bank balance sheet? Will your bank capital increase or decrease? Explain your answers.

c. Could a lending crash in a country collapse during an economic recession? How? Explain your answer.

c2. What could the government of that country do to avoid it?

Answer 1

1. many countries know that in the future they are going to face a severe drop in production. this forecasting leads to some changes in the financial operation in the country. As the production is going to be decreased so the turn over as well as return from business also going to decrease. so commercial banks are always careful about their lending money. in this situation, if they lend money then it will be difficult for them to get it recovered. Adverse selection occurs when there is unequal information spread between buyers and sellers, which leads to distorts the market and leads to market failure.

Adverse selection leads to a situation where the risky companies are not aware of their degree of riskiness so with that illusion they select a risky investment.

In reverse those companies who are overprotective they will prefer to take more protective investment which may not be necessarily applicable to them.

Now the investment or the bank if it will provide a middle decision means an average level of a plan then in this case bank may face trouble/loss.

2. In the economic crisis, the bank balance sheet is affected two ways.  First, during the crisis, central banks supply liquidity to disturbed financial systems. Second, post-crisis, several central banks began pursuing unprecedented quantitative easing (QE) policies by purchasing large quantities of certain types of assets from the private sector to boost their struggling economies. this leads to an increase in reserve and later on it will again create a problem if the banks are not able to adjust/dispose of these reserves in time. the central bank has to sell some treasury or government bonds to acquire extra reserves.

3. A lending crash /credit crisis is a failure of a financial system caused by a sudden and severe disruption of the normal process of cash movement in any economy. A shortage of cash in the bank for lending is just one of the examples of the lending crash. at the time of recession, the lending crash is a very common and predictable situation available to the bank.

4. so to avoid such situation government can purchase government bonds or treasury so that the bank will sufficient with money which will slowly restore the condition of a country.