Question

What effects do 1. adverse selection and 2. moral hazard have on the money loaning process respectively and how can their negative effects be negated?

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Answer 1

Adverse selection

Adverse selection occurs when a particular group that actively selects a product or service performs worse than expected. The ability to engage in adverse selection usually arises when one side to a contract has an information advantage over the other party. It is a risk exposure that exists before the money is lent or invested .Adverse selection examples:

1. lenders face adverse selection issues when offering a menu of mortgage products
2. sometimes lender screening leads to reject higher risk applicants resulting in greater adverse selection.Adverse selection risk alters lender decisions about retaining loans in portfolio versus securitizing them

Moral Hazard

Moral hazard refers to the risk that one side to a contract has incentives to engage in activities that might cause harm or loss to the other party. It is a risk after the financial transactionMoral hazard on the part of the borrower may arise from efforts to circumvent common rules-of-thumb used by lenders that dictate the amount of credit borrowers can obtain.For eg ,sometimes borrowers exaggerate their income in order to reduce the debt-to income ratio in order to qualify for a higher loan amount. This income exaggeration is a form of moral hazard since the lender is exposed to risk from the borrower’s action.

Negating effects of moral hazard and adverse selection

Borrowers repay there debts on time to create a positive impression in credit market so that they can have access to loans in future as well . Thus, the underwriting process by which lenders verify the borrower’s capacity and willingness (reputation) to repay their loans is the cure to the inherent moral hazard present in debt contracts. So people with lower reputation has to bear heavy cost for loans as compared to ones with good reputation. Mortgage lenders normally engage in borrower screening by requiring that borrowers provide proof of reported assets and incomes in order to verify that the borrower is capable of repaying the debt. Full documentation mortgages creates credit rating which is a score provided by credit rating agencies to quantify borrowers reputation. Also to negate the impacts financial intermediaries would be a great help. With their expertise in gathering reliable information at reduced cost, financial intermediaries can extend financing to many firms or individuals who would otherwise not get it. Requiring collateral can also reduce information asymmetry risks. Collateral reduces adverse selection by requiring a specific value of collateral. Collateral also lowers moral hazard risk because the borrowers stand to lose their collateral if they do not make the required payments.Requiring a minimum net worth also reduces adverse selection because only those individuals or businesses with sufficient assets over liabilities will be considered for a loan. Moral hazard is reduced because the borrower can be sued if they fail to make timely payments on their loans.