Question

Briefly describe the role of credit ratings and monitoring as methods of asset management for a bank. Are these methods aimed at solving the adverse selection or moral hazard problem? Explain briefly.

Answer 1

Role of the credit rating and monitoring as methods are to help bank create the right kind of assets that will not be defaulted. So, credit rating helps banks know the rating as well as its inherent meaning associated with a particular borrower. In contrast to it, monitoring helps banks to regularly assess the data via documents as well as monitoring of the physical locations so that borrowers are always kept under the vigilance. It will reduce the case of default or bank's asset truing bad.So, these methods help banks in their asset management.

These methods are primarily aimed to resolve the problem of adverse selection, because there is an information asymmetry between the borrowers and the bank. Here, bank does not know much about the borrowers and these methods help bank know more about the borrowers.

Besides, these methods can control the tendency of moral hazard, because the bank cannot make excuses of making a bad decision if the bank had credit ratings of the borrowers.