FIM Assignment 1
1. Literature Review
1.1 Adverse selection in corporate lending context
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" products or services are more likely to be selected.
Adverse selection occurs when a product or service is selected by only a certain group of people who offer the worst return for the company. Adverse selection occurs because of information asymmetries and difficulties in selecting customers.
1.2 Consequence of adverse selection
Information imperfections, such as asymmetric information, are important frictions in financial markets. Even in normal times, borrowers in credit markets often know more than lenders about the quality of the collateral and the riskiness of their investments. If high- and low-risk borrowers are indistinguishable, then high-risk borrowers benefit at the expense of low-risk borrowers. The resulting problem of adverse selection (when high-quality borrowers choose not to participate in the market) leads to higher interest rates and a decrease in lending.
In the presence of asymmetric information, a small increase in the interest rate can lead to a large reduction in lending. A higher interest rate increases the likelihood that high-quality borrowers will withdraw from the market, aggravating the problem of adverse selection. As a result, the average quality of the borrowers falls, which in turn raises the interest rate even further. If adverse selection is severe enough, the credit market may collapse. Adverse selection may cause banks to impose credit rationing—putting quantitative limits on lending to some borrowers.
1.3 Measures to tackle adverse selection
In some situations, the problem of adverse selection is mitigated by signaling: letting participants in
1.1 Adverse selection in corporate lending context
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" products or services are more likely to be selected.
Adverse selection occurs when a product or service is selected by only a certain group of people who offer the worst return for the company. Adverse selection occurs because of information asymmetries and difficulties in selecting customers.
1.2 Consequence of adverse selection
Information imperfections, such as asymmetric information, are important frictions in financial markets. Even in normal times, borrowers in credit markets often know more than lenders about the quality of the collateral and the riskiness of their investments. If high- and low-risk borrowers are indistinguishable, then high-risk borrowers benefit at the expense of low-risk borrowers. The resulting problem of adverse selection (when high-quality borrowers choose not to participate in the market) leads to higher interest rates and a decrease in lending.
In the presence of asymmetric information, a small increase in the interest rate can lead to a large reduction in lending. A higher interest rate increases the likelihood that high-quality borrowers will withdraw from the market, aggravating the problem of adverse selection. As a result, the average quality of the borrowers falls, which in turn raises the interest rate even further. If adverse selection is severe enough, the credit market may collapse. Adverse selection may cause banks to impose credit rationing—putting quantitative limits on lending to some borrowers.
1.3 Measures to tackle adverse selection
In some situations, the problem of adverse selection is mitigated by signaling: letting participants in