Adverse Selection

This has been used from our blog.Brinks of economic thoughts.

 

Adverse Selection

 

Adverse selection is a problem which is created as of asymmetric information before the transaction occurs. Adverse selection in the market will occur when potential borrowers those who are very much sure to produce the undesired result, are the ones who will be seeking the loans, and are probably the ones who are likely to be selected.

 

Now adverse selection is the situation that it is more likely that loans might be given to bad credit risks, so lenders may decide to stop making any loans, even though good  credit risk are in the market place.

 

This is widely witnessed while we are lending loans, if our information is not asymmetric, we will not have a problem. We will be well aware about the credibility to whom we are lending ,,and we will avoid lending to some one who has weak credibility in terms of repaying back,,,just as of the problem of adverse selection,,,we will decide ,,or may be in apposition when we are forced to deicide to stop lending ,,,even if we know about the past record of the one to whom we are lending.

 

Eg,,,sub prime mortgage crisis.

 

Now this has been a phenomenon which has been witnessed even during sub prime mortgage  crisis. There were easily  available loans which were available during time when real state boom was prospering in USA,,,which when busted resulted in world world wide financial crisis of 2008.

Adverse selection was when there were plenty of loans which were distributed to the peoples with weak past record,,,

 

In india we time and again talk about the norms of KYC,,know your customer,,this is just to ensure that banks have proper idea of the person with whom they are dealing just to ensure that they face minimal chance of any kind of default. Thus also ensuring that our sum of money is actually repaid back to banks,,,and they are not in loss.

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