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1

asymmetric information -> debt markets

Asymmetric information occurs when one party to a transaction has more information than the other party. In debt markets borrowers will generally have more information than lenders. This can cause adverse selection and moral hazard problems for the lender. Each of these needs to be explained along with why they cause problems.

Adverse selection – borrowers with a greater risk of default are the ones who are most likely to seek out lenders. Better answers will explain the insights from Akerlof’s 1970 paper ‘The market for lemons’ – although the discussion should be in the context of lending/borrowing rather than used cars. Knowledge of this problem is likely to cause lenders to reduce lending or not engage in lending thus reducing credit and hence funds for investment by companies.

Moral hazard – borrowers may behave more recklessly than promised/expected after the funds are lent. Hence lenders need to monitor borrowers after loan is made. This increases costs of lending leading to potentially less lending taking place.

2

solutions to reduce adverse selection in debt markets

Lenders having more information about the circumstances of borrowers can help reduce adverse selection. This information can be produced by:

i. private production

ii. government regulation

iii. financial intermediaries.

Better answers would look at the effectiveness of each solution and explain why financial intermediaries provide the most effective solution; that is, they do not face the free rider problem therefore they have more incentive to commit sufficient funds to produce enough information to
overcome the adverse selection problem.

3

Explain how financial intermediation exposes banks to risk and explain what those risks are

Financial intermediation involves asset transformation – the main transformations are:

i. maturity/liquidity

ii. size

iii. risk.

These transformations give rise to liquidity risk and credit risk – each of these need explaining. Discussion of other risks (e.g. market risk and operation risk) are not relevant here as they are not caused by engagement in intermediation). However, Examiners would accept interest rate risk if this is explained as a consequence of mismatching of maturities.

4

main solutions a bank can adopt to manage credit risk

The main techniques for managing credit risk include:

i. screening

ii. credit rationing

iii. monitoring

iv. collateral/endorsement

v. pooling and diversification.

Each of these techniques needs explaining. Better answers would look at how each technique impacts on the different causes of credit risk e.g.screening helps reduce adverse selection whereas monitoring helps reduce moral hazard.