Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.

Question

Quizplus · Accepted Answer

Adverse selection occurs when one party in a transaction has better information than the other party, causing the less-informed party to make a decision that is not in their best interest. In the context of loan markets, banks face adverse selection because bad credit risks are more likely to seek loans, while good credit risks may not need or want to borrow money. Therefore, banks face the challenge of trying to distinguish between good and bad credit risks and may end up charging higher interest rates to account for the uncertainty. Moral hazard (B) is the risk that a borrower will take on excessive risk because they are protected by insurance or another form of cushion, and intentional fraud (D) is not related to the loan application process. Moral suasion (C) is a persuasion tactic that regulators may use to try to influence banks to behave in certain ways, but it does not apply to the loan application process either.

Banks Face the Problem of ________ in Loan Markets Because