ECONOM 3229 Lecture Notes - Lecture 11: Adverse Selection, Moral Hazard, Credit Risk
6 Apr 2015
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Document Summary
There are two kinds of obstacles in matching counter-parties. Financial institutions lower transactions costs by providing the following services: Pooling savings: accept small deposits to make larger loans. Safekeeping, payments system access and accounting: provide ways to pay for things (do it cheaply by taking advantage of economies of scales) Providing liquidity: banks transform short-term liabilities into long-term assets, still giving us access to liquidity. Diversifying risk: taking many deposits and making many different kinds of loans. Adverse selection (lender or investors worry before transaction) Moral hazard (lender or investors worry after transaction) Suppose there are two kinds of cars in the market: well maintained (peach) and lemons. Buyers are willing to pay ,000 for peach and only for a lemon. Seller will only sell peach for ,500 or more and lemon for ,000 or more. Buyers can"t tell which one is which. Without more information, buyers are willing to pay only average price = ,250.
