Quiz 8: How Banks Work
Bank provides services to savers and the borrowers. Banks are efficient at pooling funds and gathering information about borrowers. Pooling funds: banks attract the people to deposit the money on banks in small amounts, gather those all small amounts and uses that amount for providing the large loans to the borrowers or to the corporations. Gathering information about borrowers: Banks are specialized in gathering information about borrowers or firms. If anyone wants to earn interest on their savings, they have to give that savings to the firms as loan then the lender have a risk on that, because they have no guarantee for returns. If the firm is in trouble then that will affect the returns of lenders. Here the lender can't know about the firms, But in banks that gives a guaranty on savings, so that there is no risk factor here the bank can know about the firms for how these firms operate and what their financial conditions and can provide the loans to that firms banks allow the economy to be stronger and to grow faster and can provide the more jobs and can expand the business more easily.
One party in a transaction knows more than another is called asymmetric information. By the asymmetric information there have a two problems 1. Adverse selection 2. Moral hazard Adverse selection: The borrower or the lender have a asymmetric information before a contract agreed is called adverse selection in the banks points of view the people or firms who don't want to pay the returns on loans and more likely to enter a contract are called bad borrowers For example: if the bank offers loans at high interest rates at no one will take the loans but who didn't get loans elsewhere will take the loan at high interest rate and if the bank provide a loan to anyone who asks then the borrower could expect that loan may not pay. by this the bank point of view few desirable borrowers will take the loans at high rate. Moral hazard: The existence of a contract changes the behavior of a party to the contract moral hazard happens by asymmetric information that occurs after the contract agreed. For example: if he insured for auto mobile accidents in that case he may drive more recklessly comparing with before insured because they have an asymmetric information for an insurance
The banks started gathering information about the potential borrowers and made restrictions for borrowers those are 1. Requiring collateral 2. Requiring certain amounts of net worth 3. Writing covenants in to the loan contract. Requiring collateral: collateral is an asset that the borrower has to give to the bank as a promise to repay the loan borrowed, indeed, it is a legal bond; for example, if he unable to pay the loan then the bank can take out that assets. Requiring certain amounts of net worth: The borrower should maintain a certain net worth. The bank will not lend if their net worth falls below certain level. This restriction prevents existing borrowers from engaging in moral hazard, the borrower should pay the loan. Covenant: it is a legally enforced part of a loan contract; here, the borrower should use their funds on particular purpose like what they mentioned on loan request. They cannot use for any other purpose, because, it has a legal obligation.