IronBank introduces a new small-business lending program. After loans are approved,
some borrowers begin undertaking projects that are much riskier than those originally
described in their loan applications.

Which explanation from the lecture best describes this behaviour and the appropriate
bank response?

Question

IronBank introduces a new small-business lending program. After loans are approved,
some borrowers begin undertaking projects that are much riskier than those originally
described in their loan applications.

Which explanation from the lecture best describes this behaviour and the appropriate
bank response?

Accepted Answer

Moral hazard, because borrowers may take actions after receiving funds that increase risk; banks respond by monitoring borrower behaviour.

Answer

Liquidity risk, because borrowers change projects unexpectedly; banks respond by holding more liquid assets.

Answer

Transaction cost risk, because monitoring is expensive; banks respond by limiting loan size.

Answer

Adverse selection, because risky borrowers reveal their type after receiving funds; banks respond by raising interest rates.

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IronBank introduces a new small-business lending program. After loans are approv...

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