Question

CiliBank knows there are well managed and badly managed firms that it can lend to. It knows that well managed companies enjoy good financial health and are relatively low risk. The appropriate premium over the risk- free rate for lending to these firms is 1.5% Badly managed firms are in poor financial health and are relatively high risk. The appropriate premium over the risk-free rate for lending to these firms is 4%. The problem is that, before the lending contract is signed, CilliBank does not know which type of firm it is dealing with; all that its credit risk department is that 80% of the firms are well managed and 20% of firms are badly managed.

a) what interest rate would CiliBank be willing to lend at if the risk-free rate were 1%

b) why would this bank lending market function poorly?

c) specify the particular type of asymmetric information problem being illustrated and prove a general definition of that problem

d) how could well managed companies get a better deal from the bank

e) name the other key asymmetric information problem that banks face, citing a banking-related example

Answer 1

a)

Interest rate calculation = (Risk free rate of return + Risk premium)

Appropriate Interest rate for well managed companies = ( 1 % + 1.5%) = 2.5%

Appropriate interest rate for badly managed companies = ( 1% + 4%) = 5%

Since Cili bank doesn't know which firm is well managed and which firm is badly managed the interest rate which Cili bank is offered is weighted average interest rate

= (Weight of well managed firms * Interest rate of well managed firms) + ( Weight of badly managed firms * Interest rate of badly managed firms)

= (0.80 * 2.5%) + ( 0.20 * 5%)

= 3%

Hence the interest rate on which Cili bank is wiling to lend money is 3%

b)

Cili bank lending function is not well since well managed firm will not willing to borrow money form Cili bank at the rate of 3% Since their appropriate interest rate is 2.5%. They will not suffer the extra burden of interest.

c) Asymmetric problem defines where one party of economic activity has more substantial knowledge regarding that economic activity as compare to other party of such economic activity.

Poor lending function of Cili bank leads to adverse selection problem. Since with the average interest rate (3%) all the well managed firms will leave the market and only less desirable firms will remain in the market since they are ready to borrow money at 3% instead of 5%. If Cili bank lend money to those firms it will be a wrong selection of firm to lending their money and it will impose credit risk as well. In this situation there is possibility that Cili Bank credit portfolio has only badly managed firm's loan.

d) To get the better deal from the bank all the well managed companies can provide more information to the bank which helps bank to analyse companies financial capabilities and credibility. Well managed companies can also use the services of financial intermediaries. They can vouch for the companies quality on the behalf of the bank. When a company is in the business with any financial intermediary for a while they know all in and out of the company. Hence they can approach bank with a better deal for the companies.

e) Apart from adverse selection program, Moral Hazard is other asymmetric problem. In case of banking sector if the lender does not have the knowledge the borrowing intentions then it will leads to the problem for the lender. If the lender come to know the intentions of borrower after lending him the money then it will create the unwanted situation for the lender and impose credit risk on the lenders portfolio. Borrower can breach the term of loan by investing the money in a project which is unsuitable as per the bank's credit assessment. The risk is very high with the information asymmetric problem.