Chapter 5: Loan Contracts and Credit Risk (Sections 5.1–5.3) Flashcards
(7 cards)
What is moral hazard in lending, and how does it arise?
Moral hazard occurs when borrowers take on riskier behavior after obtaining a loan—because they don’t bear the full downside—often due to limited liability or asymmetric information between bank and borrower.
What is the role of screening versus monitoring in mitigating moral hazard?
Screening occurs before the loan: banks use covenants, collateral requirements, and borrower reputation to sort good from bad risks. Monitoring happens after disbursement: banks check project progress and enforce covenants, adjusting terms or seizing collateral if borrowers shirk.
How do loan covenants help align borrower and lender incentives?
Covenants restrict borrower actions (e.g., limits on additional debt, dividend payouts) so that borrowers cannot divert funds to low-return or high-risk projects, thereby preserving credit quality.
Explain the concept of credit rationing in Stiglitz–Weiss models.
At high interest rates, only the riskiest borrowers apply (“adverse selection”), so banks may optimally withhold additional loans rather than raise rates further, resulting in quantity rationing.
What is collateral, and how does it mitigate default risk?
Collateral is pledged assets (e.g., property) that borrowers forfeit upon default. It (1) reduces expected loss by giving banks a recovery source and (2) creates partial insurance, discouraging strategic default.
In the Bester collateral model, how can collateral avoid credit rationing?
By offering high-quality borrowers contracts with lower required equity stakes (collateral), banks credibly signal safety and extend more credit, preventing good borrowers from being pooled out by average rates.
What limits the effectiveness of collateral in real contracts?
Collateral values can fluctuate (market risk), enforcement costs exist, and over-collateralization may induce its own moral hazard (borrowers might under-invest or hide assets).
