Question

Information asymmetry that exists in lending creates what type of risk for banks? Discuss the ways for a bank to handle or minimize this risk.

Answer 1

Because of information asymmetry, banks do not correctly know the risk profiles of the borrowers. Also, information asymmetry gives rise to adverse selection in which people with low creditworthiness and higher default risks are more likely to apply for loans. Therefore, banks are exposed to the risk of defaults i.e. the event of non-payments by the borrowers.

Banks can handle or minimize this risk by a number of ways. Firstly, banks can ask for a collateral while providing loans. A collateral can help a bank recover its losses due to non-repayment of loans. Secondly, the bank can might require a guarantor or a co-signor for the loan who will share the liability of the loan. Thirdly, the bank can avail the service of an underwriter which will bear the costs in case of default by a borrower. Fourthly, banks can refer to credit scores given by credit rating agencies to the borrowers.