Question

In: Finance

How does adverse selection hurt banks? Why wouldn’t banks just charge higher interest rates for loans?...

How does adverse selection hurt banks?

Why wouldn’t banks just charge higher interest rates for loans?

How does moral hazard hurt banks?

What are some of the factors used in credit scoring?

Payment history, amounts owed, length of credit history, credit mix in use, new credit.

What does it mean to “perfect” collateral?

Why did credit analysis fail to prevent the subprime mortgage crisis?

What are the Five C’s of Credit?

Explain some of the questions that financial institutions try to answer to assess the Five C’s for a business loan application.

What are some of the problems with using ratio analysis to assess creditworthiness?

Explain each of these strategies for managing credit risk and give an example of each

Loan covenants

Conditions precedent

Monitoring

What are some of the potential problems of using credit scoring models such as Altman’s Z Score to assess creditworthiness?

Solutions

Expert Solution

Ans a)  That is what happen when banks try to make more profit by charging higher interest rate where borrower will more likely to not pay its debt and create a adverse selction problem to banks. This is called adverse selection: the most eager borrowers will be the least desirable, making lenders less willing to lend.

Ans b) Bank can't charge higher interest rate bacause it will create more problem to borrower because business has to get more revenue to fulfil its debt obligations which can't be possible if interest rate will be very high.

Ans c) The other problem that financial systems encounter in processing information is moral hazard. Once a borrower has his loan, he may try to cheat. In investing the money, the most he can lose is the amount of the loan. But he may calculate that the greater the risk he takes with the money, the higher his chances of doing very well. Because his losses are capped, he is encouraged to take a bigger risk with his investment than he otherwise would.

Ans e) Collateral is used for the hedging it is mainly used by the lender to minimize its risk exposure. There is very difficult to find perfect collateral. Perfect collateral is the asset which's value is direcltly realted to the loan value. In that way if borrower default on loan then lender can get the whole money by using perfect collateral.

Ans f) Most of the credit rating agencies were not able to understand the financial insturments formed using securitization and unable to guage the risk associated with it that's why it created the issue during credit analysis. There is also a conflict of interest happens during credit analysis which leads to very lax credit analysis of these financial products. Due to these reasons credit analysis perormed by credit rating agencies failed to prevent the subprime mortgage crisis.

Ans g) Five C's of credit:

1. Character: Credit history

2. Capacity : Borrower's ability ot repay its loan

3. Capital

4. Collateral: borrower secure loans

5. Conditions: such as interest rate, amount of principal


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