ECS3701
ASSIGNMENT 2
DUE DATE: 11 SEPTEMBER 2026
,ECS3701 ASSIGNMENT 2 2026
DUE 11 SEPTEMBER 2026
QUESTION
(i) Explain how asymmetric information can lead to adverse selection in financial
markets
Asymmetric information occurs when one party to a financial transaction has more or
better information than the other. In credit markets, borrowers usually know more about
their own risk characteristics, intended use of funds and likelihood of repayment than
lenders do
(Mishkin, Chapter 8; Study Guide Learning Unit 8).
This information asymmetry produces adverse selection before the transaction takes
place. The potential borrowers who are most eager to obtain loans are frequently the
worst credit risks (those most likely to default). Because lenders cannot easily distinguish
good borrowers from bad ones, they face a “lemons problem”. As a result they may
charge higher interest rates to all borrowers or withdraw from the market altogether.
Good credit risks are then driven out, and the flow of funds to productive investment is
reduced
(Mishkin, Chapter 8, “The Lemons Problem”; consolidated notes pp. 38–39).
, (ii) Explain how a deterioration in borrowers’ balance sheets in relation to adverse
selection and moral hazard can contribute to a financial crisis
A deterioration in borrowers’ balance sheets (a fall in net worth or equity capital)
intensifies both asymmetric-information problems. Lower net worth means less collateral
is available, so lenders’ potential losses from adverse selection rise; they therefore
become more reluctant to lend. At the same time, lower net worth increases moral
hazard: owners have less of their own capital at stake and therefore have stronger
incentives to take excessive risks (Mishkin, Chapter 9; Study Guide Learning Unit 9).
The resulting contraction in lending reduces investment spending and aggregate
demand, amplifying the downturn and helping to precipitate a full-scale financial crisis in
which financial markets can no longer channel funds efficiently from savers to borrowers
(Mishkin, Chapter 9, Stage One and Stage Two).
(iii) Briefly explain the three stages through which a financial crisis in an advanced
economy can develop [6]
Mishkin (Chapter 9) identifies three stages:
Initiation of the crisis - Triggered by mismanagement of financial
liberalisation/innovation, sharp declines in asset prices (stock-market or housing
crash), or increases in uncertainty (failure of major firms). These events raise
asymmetric information, worsen adverse selection and moral hazard, cause lending
to contract and lead to a decline in economic activity.
Banking crisis - Deteriorating bank balance sheets and rising loan losses produce
bank failures or panics. The loss of the information capital held by banks further
ASSIGNMENT 2
DUE DATE: 11 SEPTEMBER 2026
,ECS3701 ASSIGNMENT 2 2026
DUE 11 SEPTEMBER 2026
QUESTION
(i) Explain how asymmetric information can lead to adverse selection in financial
markets
Asymmetric information occurs when one party to a financial transaction has more or
better information than the other. In credit markets, borrowers usually know more about
their own risk characteristics, intended use of funds and likelihood of repayment than
lenders do
(Mishkin, Chapter 8; Study Guide Learning Unit 8).
This information asymmetry produces adverse selection before the transaction takes
place. The potential borrowers who are most eager to obtain loans are frequently the
worst credit risks (those most likely to default). Because lenders cannot easily distinguish
good borrowers from bad ones, they face a “lemons problem”. As a result they may
charge higher interest rates to all borrowers or withdraw from the market altogether.
Good credit risks are then driven out, and the flow of funds to productive investment is
reduced
(Mishkin, Chapter 8, “The Lemons Problem”; consolidated notes pp. 38–39).
, (ii) Explain how a deterioration in borrowers’ balance sheets in relation to adverse
selection and moral hazard can contribute to a financial crisis
A deterioration in borrowers’ balance sheets (a fall in net worth or equity capital)
intensifies both asymmetric-information problems. Lower net worth means less collateral
is available, so lenders’ potential losses from adverse selection rise; they therefore
become more reluctant to lend. At the same time, lower net worth increases moral
hazard: owners have less of their own capital at stake and therefore have stronger
incentives to take excessive risks (Mishkin, Chapter 9; Study Guide Learning Unit 9).
The resulting contraction in lending reduces investment spending and aggregate
demand, amplifying the downturn and helping to precipitate a full-scale financial crisis in
which financial markets can no longer channel funds efficiently from savers to borrowers
(Mishkin, Chapter 9, Stage One and Stage Two).
(iii) Briefly explain the three stages through which a financial crisis in an advanced
economy can develop [6]
Mishkin (Chapter 9) identifies three stages:
Initiation of the crisis - Triggered by mismanagement of financial
liberalisation/innovation, sharp declines in asset prices (stock-market or housing
crash), or increases in uncertainty (failure of major firms). These events raise
asymmetric information, worsen adverse selection and moral hazard, cause lending
to contract and lead to a decline in economic activity.
Banking crisis - Deteriorating bank balance sheets and rising loan losses produce
bank failures or panics. The loss of the information capital held by banks further
