How does adverse selection hur

How does adverse selection hurt banks?

Why wouldn’t banks just charge higher interest rates forloans?

How does moral hazard hurt banks?

What are some of the factors used in creditscoring?

Payment history, amounts owed, length of credit history, creditmix in use, new credit.

What does it mean to “perfect” collateral?

Why did credit analysis fail to prevent the subprimemortgage crisis?

What are the Five C’s of Credit?

Explain some of the questions that financialinstitutions try to answer to assess the Five C’s for a businessloan application.

What are some of the problems with using ratio analysisto assess creditworthiness?

Explain each of these strategies for managing creditrisk and give an example of each

Loan covenants

Conditions precedent


What are some of the potential problems of using creditscoring models such as Altman’s Z Score to assesscreditworthiness?


Ans a)  That is what happen when banks try to makemore profit by charging higher interest rate where borrower willmore likely to not pay its debt and create a adverse selctionproblem to banks. This is called adverse selection: the most eagerborrowers will be the least desirable, making lenders less willingto lend.

Ans b) Bank can’t charge higher interest rate bacause it willcreate more problem to borrower because business has to get morerevenue to fulfil its debt obligations which can’t be possible ifinterest rate will be very high.

Ans c) The other problem that financial systems encounter inprocessing information is moral hazard. Once a borrower has hisloan, he may try to cheat. In investing the money, the most he canlose is the amount of the loan. But he may calculate that thegreater the risk he takes with the money, the higher his chances ofdoing very well. Because his losses are capped, he is encouraged totake a bigger risk with his investment than he otherwise would.

Ans e) Collateral is used for the hedging it is mainly used bythe lender to minimize its risk exposure. There is very difficultto find perfect collateral. Perfect collateral is the asset which’svalue is direcltly realted to the loan value. In that way ifborrower default on loan then lender can get the whole money byusing perfect collateral.

Ans f) Most of the credit rating agencies were not able tounderstand the financial insturments formed using securitizationand unable to guage the risk associated with it that’s why itcreated the issue during credit analysis. There is also a conflictof interest happens during credit analysis which leads to very laxcredit analysis of these financial products. Due to these reasonscredit analysis perormed by credit rating agencies failed toprevent the subprime mortgage crisis.

Ans g) Five C’s of credit:

1. Character: Credit history

2. Capacity : Borrower’s ability ot repay its loan

3. Capital

4. Collateral: borrower secure loans

5. Conditions: such as interest rate, amount of principal

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