Vantown is a credit union that offers the same services as a bank. It identifies two types of borrowers: The risky ones and the safe ones. In order to cover for the potential default risks, it would like to charge an interest rate of at least 7% to a risky borrower, and an interest rate of at least 4% on safe borrowers. A risky borrower is willing to accept an interest rate of up to 8% whereas a safe borrower is willing to accept an interest rate of up to 5%. Assume the demand for funds at Vantown (coming from borrowers) is higher than the supply of funds (coming from Vantown).

(a) (2 points) Assume Vantown knows what type each customer is. What interest rates will it charge? Will it depend on the type of borrower?

(b) (3 points) Assume now that neither borrowers nor Vantown know their type. Vantown and the borrowers only know that 60% of borrowers are safe, and 40% are risky. What is the minimum interest rate Vantown is willing to charge? Will it depend on the type of borrower? What interest rate will borrowers be willing to accept? What interest will Vantown propose? Will borrowers accept? Compare with your answer in (a).

(c) (4 points) Assume borrowers know their type, but Vantown does not. What is the minimum interest rate Vantown is willing to charge? Will it depend on the type of borrower? Will a risky borrower accept? A safe borrower? What is the potential problem called?

(d) (3 points) In practice, credit institutions require borrowers to provide their credit history before granting a loan. Explain how that can help solve the adverse selection problem.

(e) (3 points) Credit markets can feature moral hazard problems. Explain how they can occur and why, and how credit institutions can solve that issue (in particular, how they do it in the mortgage credit market).