The bank of america faces a investor who would like to borrow 10,000 for a project. If this is a good project, it has 4/5 chance of being succeed which lead to a return of $15,000 and 1/5 chance of being failed which lead to a return of $11,000. On the other hand if this is a bad project, it has 1/5 chance of being succeed which lead to a return of $71,000 and 4/5 chance of being failed which lead to a return of $0.
1) If the bank can not distinguish good projects from bad projects, will the market fail assuming the bank can only use simple loans without the collateral policy?
3) Instead of using the collateral policy the bank choose to keep a long term relationship with the investor with good projects. Assuming now, that the investor will bring a same project every year to the bank for the fund support.The bank decide to ask for $11000 as the required repayment if and only if the investor has no default history in the past and to ask for $71000 otherwise. Argue that this is indeed a reasonable policy.