Question

Financial Institutions (FIs) such as Commercial Banks (CBs) assist in providing a smooth economy by resolving certain information asymetries while acting as an intermediary. An information asymetry exists when one party to a transaction has more information than the other party. For instance, when one party agrees to sell a house to another party, the seller usually (but not always) has more familiarity with the property and, therefore, has more knowledge in the transaction than the buyer.

1) What are the information asymetries regarding loans?

2) What are the information asymetries exist in the liabilities of the FIs such as deposits?

Answer 1

1)

• Project Risks of businesses: When a business approach bank for a loan, the borrower has more understanding of the risk of the business than the lender eventhough the lender does due diligence. This causes information assymetry
• Credit Score and Credit worthiness of the customer- Lender may not know the past default of the borrower with other lenders. But FIs could reduce this by publishing such data. But default history with lenders other than FIs are not obtained.
• Borrower unaware of the interest rate charged by other lenders and from other borrowers with similar credit score- Banks have to publish the minimum interest rates , but they can charge different interest from customers with same credit worthiness

2)

• Banks know more about their deposit scheme. The customer may not be informed about different schemes and they may just keep the money in the current account without getting any interest. The bank gets more liquidity.
• Customer do not know how their deposit will be utilised by the bank. They are not aware if bank's assets and investments are risky. So they may keep it with the bank assuming it is safe and less risky and accept a low interest rate. But in real case, it might be risky