Moral hazard may arise in lending when small firms borrow funds from banks for one project (e.g., buy new machinery for a factory) and actually use the funds in other ways (e.g., buy the manager a new corporate jet). What is the source of the asymmetric information problem in this case?
A) The bank has more information about the true cost of the corporate jet than the firm.
B) The bank has more information about the opportunity cost of the loaned funds.
C) The firm has more information about the actual use of the funds than the bank.
D) The firm has more information about the interest rate on the loan than the bank.

Question

Quizplus · Accepted Answer

The asymmetric information problem in this case is that the small firm has more information about the actual use of the funds than the bank. The bank may have only verified that the loan was for a specific project, such as buying new machinery, but they may not know how the funds were actually used after they were disbursed. This creates a moral hazard problem because the small firm may use the funds for other purposes that are not productive, which increases the risk of default for the bank.

Moral Hazard May Arise in Lending When Small Firms Borrow