Suppose Hilary comes into a large sum of money and decides to lend the money to

Question

Suppose Hilary comes into a large sum of money and decides to lend the money to earn interest. She realizes that even if she were able to evaluate whether the borrower is creditworthy before making the loan, she cannot ensure that her borrower uses the money as promised once she lends the money. Therefore, because a financial intermediary has the ability to track customers' uses of money more easily and the ability to take action quickly if needed, she decides to lend through a financial intermediary. This is an example of how financial intermediaries can help to solve the problem of:

Insolvency?

Moral hazard?

Adverse selection?

Explanation / Answer

1. Intermediaries are able to solve the problem of insolvency.

2. It reduces moral hazard by monitoring what borrowers are doing with borrowed funds.

3. It reduces adverse selection by collecting information on borrowers and screening them to check their creditworthiness.

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