1. If information between lender and borrower were not asymmetric, would the pro
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Question
1. If information between lender and borrower were not asymmetric, would the problem of adverse selection still exist? Could a moral hazard problem still exist? Explain. Explain how the emergence of financial intermediaries reduces the problems of adverse selection and moral hazard. Does it eliminate those problems? Observers have noted that in periods in which bank loan rates are very high, the number of "bad loans" increases appreciably. Explain how this may be related to the problem of adverse selection. What could banks do to try to reduce this problem?Explanation / Answer
Adverse selection describes an undesired result due to the situation where one party of a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information.If information between lender and borrower were not asymmetric, problem of adverse selection will no longer exist as both the parties to a transaction will be able to decide the efficient price of a product based on the information available and problem of market failure will no longer exist.
Moral hazard occurs when a party provides misleading information and changes his behavior when he does not have to face consequences of the risk he takes. In the presence of symmetric information the problem of Moral hazard would no longer exist as both the parties to a transaction would have correct information about ecah other behaviour and can bring about required changes in the agreement to resolve the problem.
Financial intermediaries can solve the problems of adverse selection and moral hazard.
Financial intermediaries can only reduce the problem of adverse selection and moral hazard but cannot eliminate these problems altogether as in the end, the vast majority of firms' finance comes from internal sources, suggesting that information problems are too big for even financial intermediaries to solve.
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