Question

We have discussed the issue of asymmetric information that results in moral hazard and adverse selection problems. Now, consider the following situation. You are uncomfortable lending money to your neighbor. However, when the bank that you have an account with lends funds to him/her, you are more comfortable. Why is that the case? Why would banks have an advantage? Explain your answer using the problems mentioned above.

Answer 1

Moral hazard is the risk that a party has not entered into a contract in good faith.

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa.

Now, in the given scenario

Case 1: I provide loan to my neighbour

Case 2: I deposit money in bank A, bank A provides loan to my neighbour

I am happy in case 2.

Applying above problems to this scenario,

In case 1, moral hazard problem may exist, because I cannot judge my neighbour's intention. In case he defaults I cant do anything about it.

In case 2, by taking a bank in between, this problem is eliminated as bank checks the credibility of the borrower. Also, there are consequences if the borrower defaults.

Similarily, in case 2, adverse selection problem will be eliminated as well. As bank will do background check, banks will have a lot of information about the person the bank lends to, while the information with me is limited.