ECS3701 ASSIGNMENT 02 – SEMESTER 2
Unique Number: 371590
Due Date: Friday 11 September 2026
, QUESTION 2.01
(i) How asymmetric information leads to adverse selection in financial markets [5]
Adverse selection is a pre-transaction problem. One party has better info than the other.
Think about a used car lot. The seller knows the car is a lemon. The buyer does not. Same
thing happens in finance. Borrowers know their own finances. Banks do not.
So what happens? People with shaky credit are eager to borrow. They have nothing to lose.
People with solid finances? They might not need a loan. Or they get scared o by high interest
rates.
Banks try to protect themselves by raising rates. That makes the problem worse. Good
borrowers leave. Bad borrowers stay. The bank ends up with a portfolio full of risky loans.
The result? Banks get cautious. They tighten lending. Credit dries up. Solid businesses and
individuals cannot get funding. The whole economy slows down.
(ii) How a deterioration in borrowers' balance sheets contributes to a financial crisis [5]
Balance sheets matter. Assets minus liabilities equals net worth.
Take a mortgage. Someone buys a house for R1.2 million. They put down R150 000. Then the
market crashes. The house drops to R900 000. That deposit is gone. They owe more than the
house is worth.
Why does this matter for the economy?
First, net worth is protection. Borrowers with something to lose behave carefully. Borrowers
with nothing to lose take reckless chances. If it works, they win. If it fails, the bank loses.
Second, low net worth makes screening impossible. Banks cannot tell who is safe anymore.
Everyone looks bad. So banks stop lending.
Third, this spirals. Less lending means less spending. Businesses fail. Jobs vanish. Asset
prices drop further. Net worth falls again. The cycle keeps getting worse. This is how a
recession becomes a crisis.
(iii) The three stages of a financial crisis in an advanced economy [6]
Unique Number: 371590
Due Date: Friday 11 September 2026
, QUESTION 2.01
(i) How asymmetric information leads to adverse selection in financial markets [5]
Adverse selection is a pre-transaction problem. One party has better info than the other.
Think about a used car lot. The seller knows the car is a lemon. The buyer does not. Same
thing happens in finance. Borrowers know their own finances. Banks do not.
So what happens? People with shaky credit are eager to borrow. They have nothing to lose.
People with solid finances? They might not need a loan. Or they get scared o by high interest
rates.
Banks try to protect themselves by raising rates. That makes the problem worse. Good
borrowers leave. Bad borrowers stay. The bank ends up with a portfolio full of risky loans.
The result? Banks get cautious. They tighten lending. Credit dries up. Solid businesses and
individuals cannot get funding. The whole economy slows down.
(ii) How a deterioration in borrowers' balance sheets contributes to a financial crisis [5]
Balance sheets matter. Assets minus liabilities equals net worth.
Take a mortgage. Someone buys a house for R1.2 million. They put down R150 000. Then the
market crashes. The house drops to R900 000. That deposit is gone. They owe more than the
house is worth.
Why does this matter for the economy?
First, net worth is protection. Borrowers with something to lose behave carefully. Borrowers
with nothing to lose take reckless chances. If it works, they win. If it fails, the bank loses.
Second, low net worth makes screening impossible. Banks cannot tell who is safe anymore.
Everyone looks bad. So banks stop lending.
Third, this spirals. Less lending means less spending. Businesses fail. Jobs vanish. Asset
prices drop further. Net worth falls again. The cycle keeps getting worse. This is how a
recession becomes a crisis.
(iii) The three stages of a financial crisis in an advanced economy [6]
