Question

We have a line of credit with a local bank that our company uses for purchasing inventory. Suppose I use this credit source to buy a new motorcycle for my personal use without the bank's knowledge. Which of the following problems describes this situation?

	A.	Securities fraud
	B.	Tax evasion
	C.	Adverse selection
	D.	Moral hazard

Answer 1

The correct answer is D.

Moral hazard.

Moral hazard is a problem where the party entered in to contact with other party does not work in good faith or do something with out the knowledge of other party which can provide risk or loss to the other party.It occurs when one party gets involves in risky events at the cost of other party because he knows that he is protected and other party will bear the cost in case of loss.

Here in the given case, using the credit source a new motorcycle for personal use is bought without the bank's knowledge, it is case of moral hazard.

The other options are incorrect because-

A) Securities fraud is incorrect as there is no securities involved.

B) Tax evasion is also incorrect as there is no tax benefit for the borrower.

C) Adverse selection occurs when two parties does not have equal information that will provide benefit to the party who has the asymmetric information and provide gain to other before entering in to the contact. The major difference between adverse selection and moral hazard is in former the asymmetric information is there before entering in the contract while in later it is used after the parties have came in the contract.

Here, the new motorcycle for my personal use without the bank's knowledge while they were in existing contract. Hence it is not adverse selection problem incurred by bank.

Hope it clarifies!