Part I: Financial Institutions, Moral Hazard, Adverse Selection, Regulation of Financial Institutions

Financial intermediaries as part of the financial system are very important for a vibrant economy to move funds from surplus units to the deficit units in order to finance a productive investment. The financial system includes banks, insurance companies, mutual funds, stock and bond markets, and so on. All of these are regulated by government. However, the role of information in the financial system plays a critical part in the transfer of funds.

You are a manager of a financial institution that gave a loan to a large corporation involved in trading in the energy market. It has a successful operation, making it among the largest corporation at the time. However, the company crashed and came with large amounts of losses. You as a manager found out that the company has been involved in a complex set of transactions by which it was keeping substantial amounts of debts and financial contracts off of its balance sheet and you were not aware of these transactions. Even after securing additional new financing from other institutions, the company was forced to declare bankruptcy and large numbers of people were laid off at the time that the economy was suffering from a downturn in economic activities. You as a manager are involved in answering several questions in order to minimize the chance of defaults on your loans.

1. What is moral hazard? Do you think in this case moral hazard was an issue, or we need to have more information?

2. In case this was an example of moral hazard, explain how the manager could reduce the problem.

3. What are the adverse economic consequences of moral hazard?

4. What is asymmetric information?

5. Do you think that further government regulations could reduce the existence of asymmetric information of financial institutions? If so, what type of regulation do you suggest for this case?