TITLE: "As a Risk Manager you have been asked to suggest measures that may reduce the problem of adverse selection and moral hazard in your commercial bank. "Table of contentsIntroduction: -2Causes and solutions for Informational asymmetry in banks: -5Conclusion: -13References: -14Introduction: -A situation in which one party in a transaction has more or superior information compared to another is known as Information asymmetry. In banks this situation arises when the borrower knows more about the prospect of the business (its riskiness) than the bank. This information asymmetry leads to two main problems: -Adverse selection which occurs before the transaction takes place and can be defined as a process where bad choices are made instead of good ones due to information asymmetry for example bank selecting the borrower who has a higher probability of default that is it is more risky a similar example has been discussed in context of second hand car market by Akerlof in his paper “market for lemons. ” Akerlof in his paper showed that adverse selection can generate a vicious cycle that could even lead to closing down of the entire market for that product. Moral hazard occurs after the transaction is complete and can be defined as the chance of the party with more information in the transaction behaving in a way that can cause damage to the other party.
E. g. a bank in order to get higher returns may give loans to risky borrowers, hoping that in case risks turn negative, the Central Banker would bail out the bank. Mark V. Pauly in his paper The Truth about Moral Hazard and Adverse Selection(2007) talks about moral hazard and adverse selection in the context of health insurance and how information asymmetry in the insurance sector results in these problems these problems are very similar to what we find in the banking sector we can connect the adverse selection of risky borrowers in banks to risky policy buyer in insurance and moral hazard problem of using these policies excessively in the insurance sector with banks giving excessive loans on collateral as discussed by JP. Niinimäki in his recent paper “The Truth about Moral Hazard and Adverse Selection? ”Now let us see the this problem in the current context where the information asymmetry increased between the borrower and the lender and this was due to the downturn that started in the housing market this downturn led to an increase in the default rate in mortgage backed securities (As the value of the houses went south people realised that the loans are more expensive than the current value of the house hence they defaulted. ) which in turn led to a reassessment of the whole mortgage backed securities market now the valuation of these loans becomes much more difficult as the risk profile of newly issued loans is different then what we saw in previous loans as a consequence, assets that were previously thought as homogeneous in nature and easy to value suddenly became more diverse and as the degree of informational asymmetry was perceived to widen the investors became much more concerned about a lemons problem.