Question

Suppose a known reliable borrower approaches a commercial bank with a randomly occurring liquidity crisis that necessitates an extension of its bank line of credit. The bank then offers terms for the loan renewal: an interest rate, a principal amount, collateral requirements, and a loan term. After the borrower accepts the terms, a random process intervenes to present several uncertain business opportunities to the borrower. While the bank expects the borrower to exercise great care and good business judgment, the borrower may be tempted to instead pursue high-risk, high-return business ventures.

Which of the following terms of a line of credit may worsen this moral hazard problem?

High interest rate

Small principal

Secured loan

Short-term loan

Answer 1

Part A) High interest rate

A high interest rate will worsen the situation of the borrower as incase his new business venture fails, he will not only face losses due to failure but it will also become difficult for him to pay high interest rates for his line of credit.

Loan being short term, small principle or secured will actually be relieving situation for the borrower as his liabilities minimise in this case as opposed to facing a high interest rate which maximises his liabilities.

Pls Upvote. Thanks :)