Question at position 15 A bank starts requiring collateral and adds loan-use restrictions on small business loans.How do these measures reduce asymmetric information problems?They raise profits by increasing interest rates. Collateral reduces adverse selection; restrictions reduce moral hazard.Both primarily address moral hazard.They eliminate the need for borrower monitoring.

Question

BlackTom AI · Accepted Answer

Collateral reduces adverse selection because posting assets signals borrower type and provides recovery in default, while loan-use restrictions reduce moral hazard by limiting post-loan risky behavior.

1) Relevant concepts:
- Asymmetric information arises when one party (borrower) has private information the lender lacks.
- Adverse selection: hidden information about borrower quality before the loan is made (high-risk borrowers more likely to seek loans).
- Moral hazard: hidden actions after the loan is made (borrower may take on riskier projects or divert funds).
- Collateral: lender claim on borrower assets if default occurs.
- Loan-use restrictions/covenants: contractual limits on how loan funds may be used or on borrower behavior.

2) Step-by-step reasoning:
Step 1 — Adverse selection problem: Lenders cannot perfectly observe borrower risk before lending. Without a screening device, high-risk and low-risk borrowers pool, driving up expected default.
Step 2 — Collateral mitigates adverse selection: Requiring collateral imposes a cost on default. Low-risk borrowers, confident in repayment, are willing to post collateral; high-risk borrowers are less willing. Thus collateral screens borrowers and separates types, reducing the proportion of risky borrowers in the loan pool and improving the lender’s information and expected returns.
Step 3 — Moral hazard problem: After disbursal, borrowers might engage in riskier projects or misuse funds because losses are borne by the lender.
Step 4 — Loan-use restrictions mitigate moral hazard: Covenants restrict risky actions and specify allowable uses, aligning borrower behavior with lender interests and making monitoring and enforcement easier.
Step 5 — Combined effect: Together these tools address the two distinct asymmetric-information problems—collateral primarily addresses adverse selection; restrictions primarily address moral hazard.

3) Why other options are incorrect:
- “They raise profits by increasing interest rates.” Raising rates can worsen adverse selection (driving out safe borrowers); the bank’s measures are informational and incentive devices, not simply rate hikes.
- “Both primarily address moral hazard.” Collateral mainly screens borrower types before lending (adverse selection), not just post-loan behavior.
- “They eliminate the need for borrower monitoring.” Restrictions reduce but do not eliminate monitoring or enforcement costs; collateral secures recovery but doesn’t remove the need to monitor conduct.

Conclusion: Therefore the correct answer is: Collateral reduces adverse selection; restrictions reduce moral hazard. This matches the provided answer.

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