Final answer:
When borrowers engage in risky behavior after obtaining loans, a moral hazard arises, leading lenders to tighten credit and increase interest rates. This can result in credit rationing, which reduces overall lending and can slow economic growth.
Step-by-step explanation:
In the debt market, if borrowers initially obtain "good" loans but later engage in risky investments and fail to repay, an asymmetric information problem arises. Prior to the loan, the lender assesses credit risk based on the belief that the borrower will not engage in overly risky behavior. After the loan, if the borrower takes on excessive risk and defaults, the lender faces a type of risk called "moral hazard." Moral hazard occurs because the borrower has information and incentives that the lender does not share and can now behave in a way that is detrimental to the lender's interests.
As a consequence of such behavior, lenders may become more cautious, leading to tighter credit conditions and higher interest rates to compensate for the increased risk. This can result in a reduction of overall lending activity, a phenomenon called "credit rationing." Credit rationing happens when potential borrowers are denied loans or are lent less than they need, despite being willing to pay the interest rate on offer. If unchecked, this can spiral into a broader financial crisis, affecting even creditworthy borrowers and potentially creating economic slowdowns due to the lack of available credit for consumption and investment.