How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

Here we need to discuss how does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problem.

Historically it has been observed that financial crises in the US almost always have started when uncertainty is high, either after a recession has begun or the stock market has crashed.

The failure of a major financial institution is a particularly important source of heightened uncertainty that features prominently in financial crises. Examples in US history abound the Ohio Life Insurance and Trust Company

in 1857; Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; Bear Stearns, Lehman Brothers, and AIG in 2008.

With information harder to come by in a period of high uncertainty, adverse selection and moral hazard problems increase, leading to a decline in lending and economic activity.

In case of general uncertainty, reliable information becomes very scarce. At this time finding someone's true credibility is very difficult. As a result of it in the case of lending and borrowing in the credit market adverse selection and moral hazard, problems become very serious, since for example in the case of lending it would be very high to find out for a bank the creditworthiness of the borrower.

Hence adverse selection problems can easily set in. Also in such a situation, holding crucial information about one's own creditworthiness and then taking credit without telling one's own real status may lead to moral hazard problems such as non-repayment. This would result in more bankruptcy.