Question

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 corporations 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 a large number of people were laid off at the same time the economy was in a downturn.

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

2. If 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?

Answer 1

1.

Moral hazard refers to the market failure by  taking of the additional risk, whose consequences will be taken up by others. For example, managers for the speculative investments and if loss takes place, then it is the investors who suffer. It was a case of adverse selection or asymmetry in information at the part of the manager that led to the moral hazard behavior.

2.

Manager could go for the actual plan of the use of the funds that was to be used by the corporation. It will make manager know what is to be done by the funds. It will prevent moral hazard.

3.

Adverse consequences of moral hazard are as follows:

A. loss to the organization, causing shareholders to suffer the losses

B. Creation of bad debt if it is the bank or financial institutions who has given the loans

C. Decrease in investors and consumers confidence in the economy

D. Loss of jobs of the employees in the organization after fallout

4.

Asymmetric information means difference of information owned by the different parties in the negotiation. For example, seller and buyer of a used car, has asymmetric information as sellers know more about the used car, than that of buyers.

5.

Yes, presence of regulations will reduce the asymmetric information and all the parties will have more information. It will reduce the gap between information owned by each party. For this, if there is a government regulation to bring disclosures in the form of business proposal, financial statements and other documents that could prove the actual use of the funds, then it will reduce the asymmetric information.