Question

b. How do the concepts of adverse selection and moral hazard explain the credit riskmanagement principles that banks adopt?   [10 Marks]

Answer 1

Concepts of adverse selection and moral hazard help in understanding the credit risk management principle which will be adopted by various banks because-

A) The economy concepts of adverse selection and moral hazards helps in providing with the framework for understanding the principles that will be adopted by financial institution to reduce the credit risk and help in lending successful loans.

B) Adverse selection in loan markets occurs because bad credit risks are the one who are usually lineup for loans and those who are likely to produce most adverse outcome for the company, are most likely to be selected.So, a company should be doing proper screening and monitoring in order to filter out those people according to their creditworthiness

C) Moral hazard exist in the loan market because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view so lender will be subjected to risk of default hence, there should be proper loan commitments and collateral and compensating balance requirement so that it will help in managing with moral hazards.

D) There should be proper credit rationing in order to avoid defaults on the basis of both moral hazards and adverse selection.

E) There should be establishment of long-term customer relationship to avoid such practices which would lead to adverse selection or moral hazards