Money,bankingFinancial intermediaries can manage the problem of adverse selection and moral hazard.

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Karen P.L. Hardison eNotes educator| Certified Educator

The financial intermediary (bank, insurance company, mutual fund, stock brokerage, etc) relies on what is called "proxy indicators" when determining the (1) present or potential success of a borrower and (2) of the goal. "Adverse selection" refers to the notion that risk assessment measures are imperfect: they may be what is termed "perverse": contrary to the expectation. "Moral hazard" refers to the notion that a borrower may focus so intently on the proxy indicators by which they shall be judged credit or loan worthy that they redirect their attention away from the objective for which the capital is desired: their actions may be "perverse," misleading.

pohnpei397 eNotes educator| Certified Educator

In the case of moral hazard, financial intermediaries tend to be good at determining who is a good risk and who is not.  If I want to loan money out on my own, I have to figure out who will invest wisely and who will just waste the money.  I don't have enough information about that particular moral hazard.  A bank would have much more experience at determining who is a good risk and who is not so I should let the bank decide who I will loan to.

belarafon eNotes educator| Certified Educator

While it is a better financial choice to let the bank decide investment, you might not be as satisfied from a moral standpoint. Morality is an entirely subjective area, and so you have to decide whether it is better to not know where your money is going as long as you get good returns, or to switch to a lower return in favor of benefiting your morally approved investments.

accessteacher eNotes educator| Certified Educator

Banks and other financial intermediaries are particularly good at determining who to lend money to and how to minimise risk through a shrewd assessment of whether these people will be able to pay back that money or not. This is one key way in which hazard is reduced, because financial intermediaries are very wise and canny about determining risk.

vangoghfan eNotes educator| Certified Educator

The companies that were charged with overseeing and evaluating banks (such as Standard and Poors) did not do a particularly good job, unfortunately, of foreseeing the banking crisis and the home mortgage crisis.  We need such companies, obviously, but it would be nice if they were more reliable than they sometimes seem to be.