Question

As a result of the global Covid-19 pandemic and lockdown, central banks around the world have stepped in to provide massive liquidity to the capital markets. Among the key policies are to keep interest rates low or sub-zero (zero interest rate policy or ZIRP). Discuss the implication of such policies to credit risk management from the perspective of adverse selection and moral hazard.

Answer 1

Central Bank all across the world has cut the interest rate in order to control the adverse impact of the covid19 on the different economies and they have tried to adopt cutting of the interested because they want to control the damage and stimulate the demand in the economy.

Implication of law interest rate policy or zero rate policy on the credit risk management are as follows-

A. Adverse selection situations when sellers will be having more information than the buyers the economy but in this case we can see that due to lower interest rate and negative interest rate, there is a very low scope of manipulation because the interest rate cannot be fixed on the higher side due to presence of lower interest rate in the entire economy and there is a lower amount of asymmetric information to capitalise upon.

B. Moral hazard will mean that there will be change in the behaviour of parties to contract when agreement has been reached and risk has been transferred to another party.

The regime of of zero interest rate policy will increase level of moral hazard & It'll will be higher and it will be increased because there will be incentives which will be available with various people to default because they are trying to take advantage of the adverse economic situation and many will be trying to declare themselves bankrupt because they will be trying to take the benefit of the flexibility in the economic process and they will be trying to the fault on their debt because of adverse economic scenario even though they are having an adequate creditworthiness, these intended defaults will be increasing and it will be leading to increase in the overall moral hazards.