Question

Explainwhethereachofthefollowingsituationinvolvesadverseselectionandmoralhazardor not:

1. i) I am financing a new car. In applying for a loan, I withhold information about my student loan, and the loan does not show up on my credit report. (2.5 marks)

2. ii) Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the5 limit and declare bankruptcy. (2.5 marks)

3. iii) I take out a loan to manufacture a product. My costs end up being higher than expected, and there seems to be little market for my product. I am unable to repay the loan on time.

Answer 1

Credit worthiness has evolved as an important aspect in today’s financing environment. Credit Scores and Ratings on the creditworthiness of the companies and their debt instruments is a critical compliance part to monitor risk evaluation at regular intervals.

Unlike past wherein the financing is sanctioned based on the initial credit assessments and documentation, now a days, this has become a regular monitoring process and the customers are required to oblige to these compliance requirements. Mandatory annual ratings and Credit score analysis is a continuous monitoring process of the financial institutions to assess their customer credit worthiness. Any deviation in this shall have serious impacts on both the sides – customers as well as the financial institutions.

For Customers, any poor credit scores shall drastically impact their future borrowing capacity and for financial institutions, any non-monitoring of these poor scoers shall result in Non-Performing assets on their Loan books.

i) I am financing a new car. In applying for a loan, I withhold information about my student loan, and the loan does not show up on my credit report. (2.5 marks)

Answer: Withholding information shall seriously impact the calculations of the borrowing power. This is a moral hazard. Any misrepresenting or misleading information provided to the financial institutions is not considered fair.

Although this may result in the higher borrowing power, the real problem shall come up at the time of instalment payments due to the reason that the actual borrowing power shall be lower than the projected borrowing power.

Today’s compliance system is so robust that every possible information is well connected and monitored through social security number, Tax identification numbers, UIN numbers etc and it can be traced very easily by the financial institutions. Once this is traced, there is a clear possibility that the financing can be rejected / or considered as default / non-compliance. If this is proved illegitimate, the credit score could be blacklisted to prevent from any future borrowings.

Hence, it is advisable to reveal all the required financial related information to the lenders to assess the correct borrowing power.

ii) Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the5 limit and declare bankruptcy. (2.5 marks)

Answer: This can be considered as a clear case of intentional and planned financial crime. This is a pure moral hazard.

Credit cards are a requirement to be used incase of any emergency fund requirement or to the extent of utilising the credit period provided by the financial institutions. Regular payments on the credit card dues are considered as a healthy aspect of creditworthiness. Credit card spends and repayments are closely monitored by the banks regularly and any accumulation of unpaid dues are seriously viewed, unless converted in to a temporary loan, backed by security or so.

iii) I take out a loan to manufacture a product. My costs end up being higher than expected, and there seems to be little market for my product. I am unable to repay the loan on time.

Answer: Budget assessments are very important to calculate the requirement of the loan and assessments of the cash flows from the project, to further service the debt and its interest component without default.

This case can be considered as a Operational hazard, but not a moral hazard.

There can be cases that the actual costs might turn up higher than that of the expected projections and also the sales market might go down due to market or economical factors or so. This shall result in a situation of lower cashflows and thus risk of default on loan repayments.

Operational hazards are quite normal in the businesses and hence the loans are generally backed by certain securities as collateral.