Running Head: MONEY AND BANKING MIDTERM EXAM 1

Money and Banking Midterm Exam

Name: EDWIN OMENTA

Date: 12/06/2021
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Question 1). Because there is an imbalance of information in a lending situation, we must deal
with the problems of adverse selection and moral hazard. Define these terms and discuss how
financial intermediaries in UAE can reduce these problems. (Minimum 1000 words)

Introduction;

Asymmetrical information arises when one party is in an advantageous position compared to the
other. This could be in the form of information possessed that the party does want to disclose or
simply when the party takes advantage of the situation that, they are in. The imbalance is what
gives birth to adverse selection and moral hazard terminologies as elaborated below.

Adverse Selection;

Adverse selection was first pioneered by George Akerlof in his article “The Market for Lemons:
Quality Uncertainty and the Market Mechanism”, which examined the markets for insurance,
used motor vehicles, employment and credit. It is an asymmetrical situation between the buyer
and the seller, where, the seller possesses more important information concerning the product
compared to the buyer. Therefore, the buyer is at a disadvantage due to lack of critical
information and it makes it difficult for the party to assess the value or risk of the deal before an
agreement is reached. Finally, the seller has more information that distorts the negotiating
process and creates failure in the market efficiency (Suri AK, Adnan. J, 2016).
This consequently leads to inefficient outcome and a lower quality of goods and services in the
market.

Example;

Nobel Prize winner George Akerlof proposed the lemon theory and showed how information
asymmetry in the market creates an unbalanced information where poor quality cars (lemons)
wipe out good quality cars in the market. Akerlof’s model was originally developed in the
context of used cars in the market where the lemon problem was frequently observed. For
instance, there are two parties with typically the same make of used cars and both of them want
to sell the cars. Party A’s car is in good condition because it is regularly serviced and it is
commonly used for grocery shopping or when attending places of worship. On the other hand,
party B had been driving their car recklessly leading to it breaking down multiple times after
which it was repaired. In these two instances, the buyer does not know the history of the cars.
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What they can only see is their condition in the current moment. Therefore, the buyer will make
a decision concerning the purchase without considering these factors because they are
unbeknown to him. Thus, the buyer is willing to pay a maximum price between the value of the
good car and the bad car. This, in turn, makes it less attractive for sellers to sell good quality
cars, which leads them to sell more bad cars. Ultimately, bad cars drive out the good because
they sell at the same price as good cars (Akerlof GA, 1970).

Moral Hazard;

Moral hazard is the reverse of adverse selection. It is post contractual asymmetric information
and arises when one party opts to take the risks knowing the consequences will be borne by the
other party. It occurs when both parties have incomplete information about the other. Varian
defines moral hazard as situations where one side of the market cannot observe the actions of the
other economic agent and referred it as hidden action problem. In his book “Asymmetric
Information in Insurance Markets,” Gibson illustrates how the moral hazard problem hinders the
market from reaching its equilibrium. He relates this to individuals’ lack of moral obligation of
not worrying about their post contractual actions in regards to the insured event.

Examples;

When individuals insure their vehicles, they tend to drive them carelessly compared to when
their vehicles are uninsured. This is because they know that whatever happens, they are covered
and are eligible for compensation. The cost of replacing or even repairing the car is borne by the
insurance company.

When the Federal Government in the US provided subsidized insurance for homeowners living
in flood prone areas, individuals took this an opportunity to construct flashy homes in flood
prone areas. Initially, there were only few houses in these areas but due to the subsidy in
insurance; more houses were put up because in case of any risk, the individuals would be
compensated. The National Flood Insurance Programme (NFIP) recipients are concentrated
along the coasts i.e. they are waterfront properties prone to the risk of flooding (Brannon, Blask,
2017).
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How financial Intermediaries in UAE can reduce Adversity Selection and Moral Hazard;

Asymmetric information normally occurs during acquisition, where the vendor has information
that the buyer does not have; in financial markets where borrowers know their ability to pay the
debt to the lender; in insurance business when the person being insured might not give full
information about their health and in the labor market where the employer doesn’t have full
details about the applicant. In as much as this cannot be avoided, it can be reduced through the
following measures:

 Financial intermediaries can reduce adverse selection by collecting information on

borrowers and screening them to check their creditworthiness. On the other hand, they
can reduce moral hazard by establishing an agreement with the borrower that the
financial intermediary is allowed to monitor what the borrower is doing with the
borrowed funds. By doing this, they enable the borrower to be responsible with the
borrowed money.
 Establishing Trust-Financial intermediaries can seek to establish trust between the
involved parties. This will in turn bridge the information gap thus establishing
transparency. In order for asymmetric information to be eliminated from financial
markets, it is prudent for sellers of securities commonly referred to as the (borrowers) to
provide the relevant information to buyers of securities (investors).
 Penalizing bad behavior-For instance, if a car was insured against accident and
information comes out that the owner of the car was drunk driving, then the intermediary
can seek not to compensate the owner of the car due to situations that led to the accident.
 Private production of information-Companies can be established to step in and provide
for this need. Before obtaining this information, the party has to pay and explain reasons
why they need to obtain that particular information.
 Government Regulations-The UAE government can provide a partial solution to these
problems by mandating for information transparency in order to curb information
asymmetry. This will in turn make the economic sector more efficient.
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References

Akerlof G.A. (1970). The Market for “Lemons”: Quality Uncertainty and the Market
Mechanism. Q J Econ 84: 488-500.
Varian H.R. (1990). Intermediate Microeconomics: A Modern Approach. WW Norton and
Company, USA.
Gibson H.R. (1987). Asymmetric Information in Insurance Markets: A Situation of Moral-
Hazard.
Suri A.K, Adnan J. (2016). Educational Institutions and Information Asymmetry Observation in
UAE. Journal of Global Economics
Laios, G.L. (2004). Macroeconomic Conditions and Bank Funding.
Mishkin, F.S. (2004). The Economics of Money, Banking and Financial Markets. Boston:
Pearson.
Zion Market Research Report. 23rd Jan, 2017. Retrieved from
Brannon, Blask ‘The Government’s Hidden Housing Subsidy for the Rich Report’. 8th Aug 2017.
Retrieved from