NUST BUSINESS SCHOOL

ASSIGNMENT-2

NAMES:
Syed Haris Ali Shah
Uzair Abdullah
CMS ID:
353797 – Haris
336081 – Uzair
SUBJECT:
Introduction to Bank Management
SECTION: BSAF 2K20-A
SUBMITTED TO: DR. Farasat Ali Shah

DATE: 4th December 2023

Question #1
Moral hazard is a concept that arises in situations where a party is more likely to take risks
because the negative consequences of those risks will be borne by someone else. It is most
commonly discussed in the context of economics and finance, but can apply in many other areas
as well.

Introduction to Moral Hazard

Definition: Moral hazard occurs when one party in a transaction has the opportunity to take risks
that the other party will have to pay for. This can lead to inefficient outcomes and risky behavior
that would not occur if the risk-taker were fully responsible for the consequences of their actions.

Common Examples:

Insurance: When individuals or companies are insured, they may take greater risks because they
know that the insurer will cover the losses.

Banking and Financial Markets: Financial institutions may take excessive risks if they believe
they will be bailed out by governments in case of failure.

Information Asymmetry: Moral hazard is often associated with information asymmetry, where
one party has more or better information than the other. This can make it difficult for the less-
informed party to assess and manage the risk appropriately.

Overcoming Moral Hazard in Modern Finance

Modern finance employs several methods to mitigate the problem of moral hazard:

Regulation and Oversight:

Financial Regulation: Governments and regulatory bodies impose rules and standards to
prevent excessive risk-taking. This includes capital requirements, risk management standards,
and regular audits.

Transparency Requirements: By enforcing disclosure norms, regulators make it more difficult

for companies to hide risky behaviors.

Incentive Structures:

Performance-based Compensation: Aligning the interests of managers and shareholders through

stock options or bonuses tied to performance can mitigate moral hazard.

Deductibles and Co-Payments in Insurance: These features ensure that the insured party bears
some of the cost, thereby reducing the temptation to take undue risks.
Market Discipline:

Reputation Effects: Companies are aware that taking excessive risks can damage their reputation,
which can be a powerful deterrent.

Credit Ratings: Credit rating agencies assess the riskiness of borrowers, influencing their access
to capital and the terms of borrowing.

Contract Design and Legal Frameworks:

Covenants in Loan Agreements: These are conditions imposed on borrowers to limit certain
behaviors and encourage responsible decision-making.

Legal Liability and Sanctions: The threat of legal consequences for irresponsible or unethical
behavior can reduce moral hazard.

Risk Management Practices:

Internal Controls and Audits: These help in identifying and mitigating risks within
organizations.

Diversification and Hedging: Strategies to spread risk can reduce the impact of any one risky
decision.

Education and Ethical Standards:

Professional Training: Educating finance professionals about the risks and ethical considerations
can help in making more informed decisions.

Ethical Standards and Corporate Culture: Promoting a culture of responsibility and ethical
behavior within organizations.

In conclusion, while moral hazard is an inherent risk in many financial transactions, modern
finance has developed a variety of tools and strategies to manage and mitigate this risk. These
measures aim to align incentives, increase transparency, enforce regulations, and promote
responsible behavior.

Question #2
Introduction to Adverse Selection

Adverse selection is a term used in economics and finance to describe a situation where an
imbalance in information causes a transaction to favor one party over another. It typically occurs
when the party with better information about the quality or risk of the transaction is able to use
that information to their advantage, often at the expense of the other party.
Key Points of Adverse Selection:

Information Asymmetry: This is a condition where one party in a transaction has more or better
information compared to the other party.

Selection of Riskier Participants: In many cases, those who are most likely to produce a negative
outcome are the ones who are most eager to engage in the transaction.

Market Inefficiency: Adverse selection can lead to market inefficiencies and can even cause
markets to fail, as the less-informed party may withdraw from the market or alter their behavior
to protect against the perceived risks.

Examples and Evaluation in Different Contexts

In the Insurance Business:

Health Insurance:

Problem: Individuals with pre-existing health conditions or high-risk lifestyles are more likely to
seek health insurance, while healthier individuals might opt out.

Impact: This can lead to a pool of insured individuals that is riskier than the average population,
increasing premiums for everyone.

Mitigation: Insurers use medical underwriting, set coverage limitations, and impose waiting
periods for pre-existing conditions to manage this risk.

Car Insurance:

Problem: Drivers with a history of accidents or violations are more likely to seek comprehensive
insurance.

Impact: Insurers might raise premiums, but this can also deter safe drivers from buying
insurance.

Mitigation: Pricing premiums based on driving history, vehicle type, and other risk factors can
help align costs more closely with the actual risk.

In Private Finance:

Credit Markets:

Problem: Borrowers who are most eager to obtain loans might be those who are at higher risk of
default.
Impact: Lenders may increase interest rates to compensate for this risk, which can inadvertently
push away low-risk borrowers.

Mitigation: Credit scoring, requiring collateral, and detailed financial assessments help lenders
differentiate between high and low-risk borrowers.

Investment:

Problem: In the sale of financial products like bonds or stocks, the seller might have more
information about the risks or potential performance.

Impact: Investors may be wary of buying securities, fearing that they are being offered because
the seller knows of hidden risks.

Mitigation: Disclosure requirements, audits, and regulatory oversight increase transparency and
help reduce information asymmetry.

Conclusion

Both in insurance and private finance, adverse selection arises due to unequal information and
leads to higher costs and inefficiencies. To combat this, industries employ a variety of tactics,
including underwriting, risk-based pricing, transparency norms, and regulatory measures.
Despite these efforts, adverse selection remains a challenging issue, often requiring a delicate
balance between risk management and market accessibility.

Question # 3
Problem of Asymmetric Information in Hiring

The problem of asymmetric information in the context of hiring a new employee revolves around
the fact that the job applicant generally has more information about their skills, work ethic, and
background than the potential employer. This disparity can lead to several issues:

1. Overstating Qualifications: Candidates might exaggerate their abilities or experience.

2. Concealing Negative Information: Applicants may hide aspects of their history, such as
reasons for leaving previous jobs, which might reflect poorly on them.
3. Inability to Assess Fit: Employers might struggle to accurately assess whether the
candidate is a good fit for the company culture or the specific demands of the job.

Solutions to Asymmetric Information in Hiring

1. Detailed Screening Processes: Employing thorough interview techniques, skill

assessments, and psychological tests.
 2. Reference Checks and Background Verification: Contacting previous employers and
conducting background checks to verify the candidate's claims.
3. Probation Periods: Hiring employees for a probationary period allows employers to
evaluate their performance before making a long-term commitment.
4. Structured Interviews: Using standardized questions that are relevant to the job can help
in objectively assessing candidates.
5. Use of Recruitment Agencies: Professional recruiters may have better resources and
expertise in vetting candidates.

Persistence of the Problem Post-Hiring

Even after hiring, asymmetric information can remain an issue. Examples include:

Performance Assessment: Assessing the true performance and potential of an employee can be
difficult, especially in complex or creative roles.

Continued Development and Training: Employers may not fully understand the employee's
ongoing training needs or career aspirations.

Solutions Post-Hiring:

Regular Performance Reviews: These can provide ongoing assessments of an employee’s

performance and development needs.

Open Communication Channels: Encouraging a culture of open and honest communication helps
in revealing information over time.

Continuous Training and Development Programs: These can help in uncovering and addressing
any gaps in skills or knowledge.

Fixed Salary Employees and Asymmetric Information

The severity of the problem can vary for employees on a fixed salary. Following are some
examples.

Less Incentive for Performance: Employees on a fixed salary may have less incentive to perform
at their highest level compared to those on performance-based pay, as their compensation does
not directly reflect their productivity.

Complacency Risk: There's a risk of employees becoming complacent, knowing that their salary
is guaranteed regardless of their performance level.

Addressing the Problem for Fixed Salary Employees:

Performance-Based Bonuses: Introducing bonuses or other incentives can motivate employees to
perform better.

Clear Expectations and Goals: Setting clear performance metrics and goals helps in aligning
employee efforts with organizational objectives.

Career Development Opportunities: Providing pathways for advancement and personal growth
can motivate employees to invest more in their roles.

Conclusion

Asymmetric information in the hiring process and in the ongoing employer-employee

relationship is a significant challenge. Employers can mitigate these issues through careful hiring
practices, ongoing performance management, and by fostering a culture of transparency and
continuous development. The issue is nuanced for fixed-salary employees, as it may require
additional motivational strategies to ensure ongoing productivity and engagement.

Question #4

The financial crisis of 2007-2009 was worsened by mortgage securitization, which played a
significant role. The collateral used to support financial products like mortgage-backed securities
(MBS) and collateralized debt obligations (CDOs) did not effectively mitigate the risks due to
several reasons:

1. Subprime Mortgages: Many of the mortgages bundled into these securities were given to
borrowers with lower creditworthiness, known as subprime mortgages. These loans were often
offered with adjustable interest rates or low initial teaser rates, making them riskier from the
beginning. Lax lending standards allowed borrowers with limited ability to repay these
mortgages to still acquire loans.

2. Decline in Housing Prices: The collateral for these securities was primarily real estate. The
assumed value of this collateral was based on continuously rising home prices. However, when
housing prices started to decline, the value of the collateral plummeted, undermining the security
backing the loans. This resulted in the actual value of the homes falling below the outstanding
mortgage amounts, leading to negative equity or underwater mortgages.

3. Inadequate Risk Assessment: Financial institutions and rating agencies failed to accurately
assess the risks associated with these mortgage-backed securities. They underestimated the
potential impact of widespread defaults and the interconnectedness of these securities within the
financial system. The complexity of these financial products also made it challenging for
investors to fully comprehend the underlying risks.

4. Poor Underwriting Standards: The quality of the mortgages bundled into these securities was
compromised due to poor underwriting standards. Lenders, motivated by the securitization
process that allowed them to transfer the risk, were less concerned about the creditworthiness of
borrowers.

Conclusion

The lack of transparency surrounding the assets that supported these securities caused a surge in
high-risk mortgages being included in them. Investors were often unaware of the specific
composition and quality of the mortgages that were bundled within the securities they purchased.
This lack of transparency added to the uncertainty and made it difficult to accurately assess the
risks involved. As a result, the collateral (mortgages) used in mortgage-backed securities and
other financial products failed to effectively mitigate the risks associated with uneven
information. Instead, it worsened the negative effects of the financial crisis by spreading the risks
throughout the entire financial system, leading to widespread defaults, financial institution
failures, and a global economic downturn.