1. Adverse Selection and Moral Hazard in the Financial Markets3
2. Adverse Selection: Akerlof’s Model “The Market for Lemons”5
1. Adverse Selection and Moral Hazard in the Financial Markets
Adverse selection is a problem created by asymmetric information. Asymmetric information means that the buyer and seller of a product have different information about the product in question. This may be a car, a financial instrument/loan or any tradable item, but in financial terms it is easiest to imagine it's a loan. The buyer does not have the same information as the seller. The seller knows all the details about the product he is selling, the buyer however only has the information he gets from the seller or the market. The seller does not however know what the buyer will use the money for after he was given a loan, and several problems appear. Adverse selection is something that happens before a transaction is made. As mentioned above adverse selection is also a problem created by asymmetric information. This happens because the people with the highest credit risk (people who are most likely to not be able to pay back a loan) are the most likely to seek out a loan, and thus is the most likely to be selected. The people who need the loan badly are the ones who will push the most to get a loan, and the people with lower credit risk will not be so desperate /forward/pushing to get the loan. This dilemma is probably what started the credit agencies who give companies ratings based on their credit risk(how likely they are to pay back a loan). Good ratings then let the companies get lower interest rates on their loans, then companies in worse financial situations. If the credit agencies had perfect information on all companies, countries and individual people the problem with credit risk would be fixed. If we had no credit agencies everyone would pay the same interest on their loans (as we see in the household sector, because the banks don't have perfect information). The companies who needs a loan for a safe expansion investment would get the same interest as companies investing in high risk speculative financial derivatives. Because the seller knows about this adverse selection, and has no clue if the people his selling to is a high or low credit risk, he might chose to not give out a loan to either two(assuming one is a high risk, and another is a low risk). The problem with adverse selection became clear in the 2008 financial crisis when nobody knew which loans were good credit, and which was junk. The loans had been sold and repacked so many times, and since almost nobody knew what was good or bad nobody in the market would buy, and the market dried up(no liquidity). A second problem appears after the transaction is made (usually loan). It is called moral hazard and is also a problem derived on asymmetric information. Moral hazard appears when a lender gives out loan to a borrower with the interest based on the risk the borrower is saying he will spend the money on, for example a real investment. This has relative low risk and he will get a decent(low) interest rate. The lender however has no idea what he really will use the money on after the transaction has happened. The borrower can for example use the money gambling(high speculative stocks) and taking a way higher risk then the loans interest rate was based on. The possibility that the borrower will not use the money how it was indented and instead take on higher risk, so that the loan is less likely to be repaid is the core of moral hazard. The problem of moral hazard grows even bigger when the lender knows that he will not get serious consequences by not being able to repay his loan. The lender then has a even higher chance of taking on high risk activities. This has been proven by people driving more reckless when having a full car insurance. The problem of moral hazard in a financial situation became clear during the financial crisis of 2008,...