Which of the following situations is an example of moral hazard in credit markets?

Question

Which of the following situations is an example of moral hazard in credit markets?

BlackTom AI · Accepted Answer

Moral hazard occurs when one party changes their behavior to take on greater risk because another party bears the cost of that risk. Key concepts: asymmetric information (lender cannot fully observe borrower actions after the loan), principal-agent problems (lender=principal, borrower=agent), and ex-post risk-taking (actions taken after contract that affect default probability).

Step-by-step reasoning:
1. Identify the defining feature of moral hazard: risky behavior undertaken after a contract is signed that shifts potential losses onto the other party.
2. Examine each option against that feature.
   - Option: "After receiving a loan, a borrower invests in a high-risk venture, increasing default chances." The borrower’s post-loan choice to pursue riskier investments increases the probability of default; the lender bears the downside. This is textbook moral hazard because the borrower’s behavior changed after obtaining the loan and the lender cannot fully control or observe it.
   - Option: "Lenders provide loans only to borrowers with known credit histories." This is not moral hazard. It is a screening/mitigation strategy to reduce asymmetric information and adverse selection before lending, not risky behavior after contracting.
   - Option: "A bank lowers its lending standards, attracting more borrowers and maximizing profits." While this describes risky behavior by the bank, it’s not the classic borrower-once-funded moral hazard in credit markets; it could reflect other problems (incentive misalignment or regulatory issues). In typical exam contexts this is not the canonical moral hazard example.
   - Option: "A borrower with poor credit pays a higher interest rate, reducing default likelihood." Charging higher rates is price discrimination/ risk-based pricing; if higher rates reduce default incentive, that mitigates moral hazard rather than exemplifies it.

Why the correct answer is correct: it directly shows post-contract risky behavior by the borrower that increases the lender’s exposure, matching the definition of moral hazard.

Conclusion: The correct choice is "After receiving a loan, a borrower invests in a high-risk venture, increasing default chances." This matches the provided answer.

Which of the following situations is an example of moral hazard in credit markets?Single choice

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