Discuss agency problems for financial institutions including:
(1) Asymmetric information; (2) Adverse Selection; (3) Moral Hazard; and
(4) Conflicts of Interest problems for financial institutions.
For the U.S. Subprime Loan Crisis, discuss how these agency problems may have contributed to the crisis.

Question

Quizplus · Accepted Answer

The Answer is Given the nature of operations for financial institutions with financial contracts between parties, common problems include:
(1) Asymmetric Information, the inequality of information between savers and borrowers and financial institutions given the private nature of financial contracts and for at times incomplete information about future prospects of borrowers.
(2) Adverse Selection, a higher likelihood that potential customers that are more un-credit worthy or that take on greater risks are more likely to seek out financial products, such as loans and insurance.
(3) Moral Hazard, the risk or hazard that a borrower once having received a loan or insurance policy, for instance might be tempted to engage in undesirable and risk-taking activities that increase the risk that a loan might not be paid back or that an insurance company will have to payout more than expected for future losses.
(4) Conflicts of Interest when a party in a financial contract has incentives
to act in his/her own interests versus the interests of other parties.
During the U.S. Subprime Loan Crisis, a good example of asymmetric information was the bundling together of subprime loans for securitizations that were very complex with little information available on the quality of individual loans within a securitization. This led to credit analysts not being able to carefully analyze issues and giving too high credit rating for risky securitizations.
Adverse selection was also evident during the financial crisis with low documentation loans attractive to borrowers who were more risky applying for low doc loans, increasing the risk of these loans.
Moral hazard was also evident with subprime borrowers buying houses that they could not afford with the intent on speculating on them by flipping them after house prices rose in the future to be able to pay back the loan. When housing prices collapsed instead, many of these speculative borrowers walked away from their loans.
Conflicts of interest was rampant during the U.S. Subprime Loan Crisis with lenders receiving fees for making large volumes of loans versus accessing the quality of the loans made, leading to poor underwriting decisions and taking on large volumes of risky, subprime loans. Conflicts of interest were also evident with credit agents receiving fees and continued business with favorable ratings.

Discuss Agency Problems for Financial Institutions Including