Loans are the main source of income for financial institutions. There are many types of loans, such as car loan, and house loan. The high number of loans increases the credit risk. According to Investopedia, non-performing loans are loans that are in default, or is close to being in default. However, this can also depend on the contract terms, for example, the failure to promptly pay interest or principal when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment. Borrowers may then default when they are unable to make the required payment or are unwilling to honor the debt. There are many causes of non-performing loans, such as asymmetric information between borrowers and lenders, and the downturn of the economy.
According to Frederic S. Mishkin (2006), asymmetric information is an inequality of information, whereby one party does not know enough about the other person to make accurate decisions. There are two situations under asymmetric information, which is adverse selection and moral hazard. Adverse selections are those problems that happen before asymmetric information. It occurs when a potential borrower wants to take a loan from a bank. Those who have a bad credit risk will most probably get a loan as they will be actively searching for a loan. However, the bank does not have perfect information. Thus, adverse selection happens as the loan has a high chance of default risk and the bank will suffer from bad loan problems.
Due to adverse selection, banks will not give out so many loans, because there is a high chance of giving out bank loans to people with a high credit risk. However, moral hazard is an asymmetric inflation problem that happens after a loan is given out, where ...