ECS3701
Assignment 2 Semester 2 2026
Unique number: 371590
Due date: 11 September 2026
2.01 Financial Crises and Asymmetric Information
2.01 (i) Asymmetric information and adverse selection
Asymmetric information exists when borrowers know more about their own financial
position, intentions and risk than lenders do. This creates adverse selection before a
loan is granted because borrowers with the riskiest projects often have the strongest
reason to seek credit, while lenders cannot always separate them from safer
borrowers. If lenders cannot identify good and bad risks accurately, they may charge
higher interest rates or reduce lending to protect themselves. Higher borrowing costs
can then discourage safer borrowers while riskier borrowers may still be willing to
borrow because they expect high returns if their projects succeed. The result is that
the quality of the borrower pool can worsen and useful lending can fall, which
reduces the efficiency of financial markets (Mishkin, 2013).
, 2.01 Financial Crises and Asymmetric Information
2.01 (i) Asymmetric information and adverse selection
Asymmetric information exists when borrowers know more about their own financial
position, intentions and risk than lenders do. This creates adverse selection before a
loan is granted because borrowers with the riskiest projects often have the strongest
reason to seek credit, while lenders cannot always separate them from safer
borrowers. If lenders cannot identify good and bad risks accurately, they may charge
higher interest rates or reduce lending to protect themselves. Higher borrowing costs
can then discourage safer borrowers while riskier borrowers may still be willing to
borrow because they expect high returns if their projects succeed. The result is that
the quality of the borrower pool can worsen and useful lending can fall, which
reduces the efficiency of financial markets (Mishkin, 2013).
2.01 (ii) Deterioration in borrowers' balance sheets, adverse selection and
moral hazard
A deterioration in borrowers' balance sheets means that their assets, net worth or
cash flow weaken relative to their liabilities. Lower net worth leaves borrowers with
less collateral to offer and gives lenders less protection if a loan is not repaid. This
worsens adverse selection because lenders find it harder to identify borrowers who
are still financially sound, and it also worsens moral hazard because borrowers with
little of their own wealth at risk may be more willing to undertake risky projects.
Banks respond by tightening lending standards or reducing the amount of credit
supplied, which lowers investment and spending. If the deterioration becomes
widespread, the contraction in lending can weaken economic activity and contribute
to a financial crisis (Mishkin, 2013).
2.01 (iii) Three stages of a financial crisis in an advanced economy
The first stage is the initiation of the financial crisis. Falling asset prices, rising
uncertainty, higher interest rates or weaker financial institution balance sheets can
increase adverse selection and moral hazard, causing lenders to reduce credit and
economic activity to slow. The second stage is a banking crisis, where bank failures
or bank panics reduce the number of institutions that collect information about
Assignment 2 Semester 2 2026
Unique number: 371590
Due date: 11 September 2026
2.01 Financial Crises and Asymmetric Information
2.01 (i) Asymmetric information and adverse selection
Asymmetric information exists when borrowers know more about their own financial
position, intentions and risk than lenders do. This creates adverse selection before a
loan is granted because borrowers with the riskiest projects often have the strongest
reason to seek credit, while lenders cannot always separate them from safer
borrowers. If lenders cannot identify good and bad risks accurately, they may charge
higher interest rates or reduce lending to protect themselves. Higher borrowing costs
can then discourage safer borrowers while riskier borrowers may still be willing to
borrow because they expect high returns if their projects succeed. The result is that
the quality of the borrower pool can worsen and useful lending can fall, which
reduces the efficiency of financial markets (Mishkin, 2013).
, 2.01 Financial Crises and Asymmetric Information
2.01 (i) Asymmetric information and adverse selection
Asymmetric information exists when borrowers know more about their own financial
position, intentions and risk than lenders do. This creates adverse selection before a
loan is granted because borrowers with the riskiest projects often have the strongest
reason to seek credit, while lenders cannot always separate them from safer
borrowers. If lenders cannot identify good and bad risks accurately, they may charge
higher interest rates or reduce lending to protect themselves. Higher borrowing costs
can then discourage safer borrowers while riskier borrowers may still be willing to
borrow because they expect high returns if their projects succeed. The result is that
the quality of the borrower pool can worsen and useful lending can fall, which
reduces the efficiency of financial markets (Mishkin, 2013).
2.01 (ii) Deterioration in borrowers' balance sheets, adverse selection and
moral hazard
A deterioration in borrowers' balance sheets means that their assets, net worth or
cash flow weaken relative to their liabilities. Lower net worth leaves borrowers with
less collateral to offer and gives lenders less protection if a loan is not repaid. This
worsens adverse selection because lenders find it harder to identify borrowers who
are still financially sound, and it also worsens moral hazard because borrowers with
little of their own wealth at risk may be more willing to undertake risky projects.
Banks respond by tightening lending standards or reducing the amount of credit
supplied, which lowers investment and spending. If the deterioration becomes
widespread, the contraction in lending can weaken economic activity and contribute
to a financial crisis (Mishkin, 2013).
2.01 (iii) Three stages of a financial crisis in an advanced economy
The first stage is the initiation of the financial crisis. Falling asset prices, rising
uncertainty, higher interest rates or weaker financial institution balance sheets can
increase adverse selection and moral hazard, causing lenders to reduce credit and
economic activity to slow. The second stage is a banking crisis, where bank failures
or bank panics reduce the number of institutions that collect information about
