Understanding Adverse Selection and Moral Hazard

Adverse selection and moral hazard are the problems arising from information asymmetry that can lead to market failure. Information asymmetry occurs when parties of a transaction do not have equal relevant information to execute a fair transaction. For instance, when buying a second-hand car, the buyer does not know its defects as much as the owner does. The owner would know an underlying price for his car, while the buyer may not have equal information to negotiate down to a fair price that best matches the car’s true value. In this case, the information asymmetry can lead to second-hand car market failure by preventing the buying-selling transaction from happening because the buyer believes whatever price the seller agrees to sell would be more advantageous to the seller. Information asymmetry is the term coined by Nobel Prize winner economist George Akerlof in 1970.

Information asymmetry can be observed in different types of transaction. In bank loans, borrowers generally know better about their own repayment capacity than the bank from which they seek the loans, making it difficult for the banks to determine a fair price (i.e., interest rate) that best suits the borrower’s creditworthiness. In a credit guarantee, information asymmetry is when a lending institution that seeks guarantees on loans has more information about the loans and the borrowers than the credit guarantor. Information asymmetry can lead to two problems – adverse selection and moral hazard.

When there is an information asymmetry, the banks might be unable to distinguish between bad and good borrowers. Facing this risk, the banks may set an interest rate that is too high for good borrowers. Good borrowers will then leave the market; only bad borrowers remain to seek loans. This is called adverse selection. As such, one way to increase credit market efficiency is to narrow the information gap between lenders and borrowers. That is why banks usually require as much information as possible from the borrowers before lending to reduce the risk of adverse selection. Adequate, reliable, and timely information about the borrowers would help the banks to narrow information gaps and offer fair loan conditions that can make both parties better off. Similarly, an adverse selection in credit guarantee is the risk that the lending institution, having better information about the borrowers and loans, only selects the bad loans for guarantees from a credit guarantee institution.

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