Selection and Moral Hazard in the Financial Markets
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