Question

Explain how financial intermediaries help to solve adverse selection problems and moral hazard problems when it comes to lending and borrowing.

Short answer

Financial intermediaries help in solving adverse selection problems by extensively screening and evaluating potential borrowers to determine their creditworthiness. They mitigate moral hazard problems by monitoring borrowers' actions and imposing restrictions on them to ensure the loan is repaid. These intermediaries are essential for maintaining the overall health of the financial system.

Step-by-step solution

Understand Key Concepts

Start by defining the key concepts. Financial intermediaries are institutions like banks, credit unions, insurance companies etc., that 'stand between' savers and borrowers in the economy. Adverse selection is a process that happens before a transaction occurs when potential borrowers who are the most likely to produce an unfavorable (adverse) outcome are the ones who most actively seek a loan or are the ones that get selected. Moral hazard is a situation that happens post transaction where the borrower might engage in activities that are undesirable from the lender's point of view because they make it less likely that the loan will be paid back.

Explain Solution to Adverse Selection

Financial intermediaries have the ability to overcome adverse selection problems. They do this through the process of screening and evaluating potential borrowers, which helps them assess creditworthiness. The information they gather includes borrowers' credit history, financial status, and other factors that could impact their ability to repay the loan. Through this detailed scrutiny, intermediaries are able to distinguish between low-risk and high-risk borrowers, thereby reducing the risk of adverse selection.

Explain Solution to Moral Hazard

Once a loan has been made, financial intermediaries manage moral hazard by monitoring borrowers and placing restrictions on their actions. This may include specifying what the borrowed funds can be used for, requiring collateral, or putting in place loan covenants. By monitoring, financial intermediaries ensure that funds are used as intended and that borrowers don't take on excessive risk that could jeopardise repayment.

Summarize Importance of Financial Intermediaries

In conclusion, financial intermediaries play a crucial role in financial markets. They assist in solving adverse selection by discerning good credit risks from bad credit risks and help alleviate moral hazard by monitoring the actions of borrowers and implementing restrictions. Without them, the health and viability of a country's financial system could be compromised.