NUST Business School

Introduction to Bank Management (FIN-403)

Assignment 2

Submitted to:
Dr. Farasat Ali Shah Bukhari.

Submitted by:
Anas Awais Khan.
Sarim Raqeeb.
BSACF-2K20

Date: 4th December, 2023

1. “If you give someone the opportunity to manipulate, they’ll do it. […] If you’re not
being detected you will continue – it’s human nature.” Nick Leeson. Provide brief
 introduction to the concept of moral hazard and then focus on how does modern
finance overcome the problem of moral hazard?
Answer) Moral hazard, a foundational concept in economics and finance, describes the tendency for
increased risk-taking behavior when individuals or entities are protected from the consequences of their
actions. As Nick Leeson aptly observed, the opportunity for manipulation without detection often aligns
with human nature, contributing to the inherent challenges associated with moral hazard.

Modern finance implements a comprehensive set of strategies to address the issue of moral hazard.
Firstly, there has been a global enhancement of regulatory oversight, particularly following significant
events like the 2008 financial crisis. Regulatory bodies enforce stringent rules to ensure financial
institutions adhere to sound risk management practices. Tools like stress testing are employed to assess
institutions’ resilience under adverse conditions, thereby holding them accountable for potential
consequences and discouraging undue risk-taking.

Secondly, elevated capital requirements act as a safeguard against moral hazard. Mandating financial
institutions to maintain higher levels of capital ensures they have a tangible financial stake in the risks
they undertake, diminishing the likelihood of reckless behavior. This approach encourages responsible
risk management practices.

The very concept of “skin in the game” constitutes another pivotal strategy. Ensuring that individuals and
entities bear a proportionate share of the risks they engage in aligns incentives with outcomes. For
instance, within the mortgage-backed securities market, stipulating that originators retain a portion of
the risk associated with the loans they bundle incentivizes more responsible underwriting practices, as
they directly share in the performance of the assets.

Executive compensation structures also play a critical role. By aligning executive pay with long-term
performance and risk management, financial institutions discourage short-term risk-taking. Deferred
bonuses, stock options, and claw back provisions ensure that executives have a vested interest in the
organization's sustained success.

Safeguards within the insurance industry, such as deductibles and co-pays, compel policyholders to share
a portion of the risk, promoting responsible behavior to minimize potential losses.

Credit rating agencies contribute to mitigating moral hazard by furnishing accurate information about
the creditworthiness of financial instruments. Efforts have been made to enhance transparency and
accountability in their evaluations.
Government intervention, when necessitated, often comes with stipulations. For example, bailout
packages may require financial institutions to implement reforms or undergo restructuring, serving as a
deterrent against moral hazard.

Derivative market reforms focus on increasing transparency and reducing the opacity of complex
financial instruments, bolstering the market’s resilience to potential abuses.

Consumer protection regulations in retail finance ensure equitable practices and provide consumers with
transparent information, contributing to the overall mitigation of moral hazard.

Fostering a culture of accountability within financial institutions, where boards and executives are held
responsible for their organizations’ actions, provides additional defense against moral hazard. This shift
in accountability ensures that decision-makers face personal consequences for engaging in excessive risk-
taking.

In summary, modern finance employs a multifaceted approach to address the challenge of moral hazard.
Through regulatory frameworks, risk management practices, alignment of incentives, and specific
strategies targeting various sectors, the financial industry strives to achieve a delicate balance between
innovation and stability while discouraging the risky behavior associated with moral hazard.

2. Provide a brief introduction to the problem of adverse selection and then evaluate this
problem with examples from insurance business and private finance?
Answer) Adverse selection is a phenomenon in asymmetric information scenarios where one party
possesses more information than the other, leading to unfavorable outcomes. This problem is notably
observed in the insurance industry and private finance, influencing market dynamics and risk
management strategies.

In the insurance sector, adverse selection manifests when individuals with higher risk are more inclined
to purchase insurance policies. For instance, consider health insurance. If only those with pre-existing
health conditions actively seek coverage, the insurer faces a skewed risk pool, as the probability of claims
is higher. To compensate, insurers may raise premiums for everyone, making it less attractive for
healthier individuals to participate. This adverse selection dynamic can create a cycle where only high-
risk individuals find insurance economically viable, further exacerbating the problem.

In private finance, adverse selection is apparent in lending scenarios. When lenders cannot accurately
assess a borrower’s creditworthiness, they may face higher default risks. To mitigate this, lenders might
increase interest rates to account for potential losses, affecting even low-risk borrowers. This scenario
discourages creditworthy individuals from borrowing, as they bear the burden of higher rates due to the
adverse selection of riskier counterparts.

Addressing adverse selection requires strategic measures. In insurance, implementing risk-based pricing
is crucial. Insurers can use data analytics to assess individual risk profiles accurately, tailoring premiums
to reflect the actual risk associated with each policyholder. This discourages adverse selection by making
insurance more appealing to a broader range of individuals.

Similarly, in private finance, thorough risk assessments and credit scoring models can help lenders
distinguish between high and low-risk borrowers more effectively. By employing these tools, lenders can
offer competitive interest rates based on individual creditworthiness, reducing the adverse selection
impact on interest rate structures.

In conclusion, adverse selection poses challenges in both the insurance industry and private finance. The
implementation of sophisticated risk management strategies, such as risk-based pricing and robust risk
assessments, is crucial to mitigating the impact of adverse selection and fostering fair and sustainable
markets.

3. Describe the problem of asymmetric information that an employer faces in hiring a

new employee. What solutions can you think of? Does the problem persist after the
person has been hired? If so, how and what can be done about it? Is the problem more
or less severe for employees on a fixed salary? Why or why not?
Answer) The hiring process grapples with the inherent challenge of asymmetric information, where
candidates possess more insights into their skills and work ethic than the employer. This information gap
can lead to difficulties in identifying the ideal candidate for the job.

Solutions:
- Comprehensive Interviews: Delving beyond resumes, in-depth interviews provide a nuanced
understanding of a candidate’s qualifications and cultural fit.
- Reference Checks: Contacting previous employers or colleagues offers insights into a candidate’s work
history, behavior, and performance.
- Skill Assessments: Practical tests or assignments provide tangible evidence of a candidate’s abilities,
supplementing traditional assessments.

Probationary Periods:
To address the screening challenge posed by asymmetric information, implementing probationary
periods can be a straightforward solution. This allows the employer to assess the new employee’s
performance and suitability for the role, providing an opportunity for termination if expectations are not
met.

Post-Hiring Asymmetric Information and Monitoring:

Once employed, the employer faces uncertainties regarding the employee’s work ethic and
commitment. Monitoring becomes a crucial issue, as it may not be feasible to constantly supervise every
aspect of an employee’s activities.

Performance-Based Salaries as a Mitigation:

To tackle monitoring challenges, salaries based on performance emerge as a strategic solution. Such
incentive structures provide employees with the motivation to work diligently without requiring constant
oversight. Knowing that their compensation is tied to performance encourages individuals to exert effort
and contribute positively to organizational goals.

Challenges of Fixed Salaries:

Conversely, fixed salaries present a dilemma in creating optimal incentives for employees to perform at
their best. The lack of performance-based rewards may lead to a potential mismatch between individual
effort and compensation.

The severity of the Problem with Fixed Salaries:

The problem is likely to be more severe under fixed salary structures. Without direct ties between effort
and reward, employees may lack the incentive to go above and beyond. In such scenarios, the challenge
lies in fostering a culture of intrinsic motivation and job satisfaction, as external performance-based
rewards are not in play.

In navigating the complexities of hiring and post-employment management, a strategic combination of

comprehensive assessments, probationary periods, and performance-based incentives contributes to
effective talent acquisition and employee motivation. Recognizing the nuanced nature of these
challenges allows organizations to tailor solutions that align with their objectives and foster a conducive
work environment.

4. One of the solutions to the adverse selection problem associated with asymmetric
information is the pledging of collateral. However, the collateral may be riskier than
initially thought. As an example, explain why the collateral did not work adequately to
 mitigate the mortgage securitization problems associated with the financial crisis of
2007–2009.
Answer) Collateral is frequently enlisted as a remedy to the adverse selection problem. In the realm of
mortgage securitization, assets such as homes serve as collateral to secure loans and ostensibly dilute
the risk of default.

During the financial crisis of 2007–2009, collateral in the form of mortgage-backed securities (MBS) was
believed to disperse risk across the financial landscape. However, the underlying collateral, primarily
comprised of subprime mortgages, proved to be riskier than initially perceived. The complexity of
financial instruments, coupled with a lack of transparency, resulted in widespread defaults, exacerbating
the severity of the crisis.

Hence, the ultimate collateral behind the mortgage-backed securities were the houses purchased with
the mortgages underlying these securities. When house prices fell, the value of the collateral was not
sufficient to cover the investments. If the collateral is riskier than thought, the loans are mispriced. The
lender should ask for a larger down payment, charge a higher interest rate, or both.