ASSIGNMENT WORK

MONEY AND BANKING

MANPREET SINGH
1633
21062504079
SECTION A
2ND YEAR
QUESTION :- What is the Adverse Selection problem? discuss the
Lemons market problem in light of the financial market. Critically
suggest some remedies to solve the adverse selection problems in
financial markets.

ANSWER :-

ADVERSE SELECTION
Adverse selection refers to a situation where either the buyer or the seller has information about
an aspect of product quality that the other party does not have. Adverse selection is a common
scenario in the insurance sector, where people in high-risk lifestyles or those engaged in
dangerous jobs sign up for life insurance coverage as a way of protecting themselves from
impending risk.

Insurance companies, on the other hand, reduce their exposure to such high-risk claims by limiting
coverage to such categories of people. Also, the insurance company can choose to raise the
premium commensurately with the level of risk exposure as a way of compensating the company
for the risk of covering high-risk policyholders.

Adverse selection occurs when one party in a transaction possesses more accurate information
compared to the other party. The other party, with less accurate information, is usually at a
disadvantage since the party with more information stands to gain more from that transaction .The
information imbalance causes inefficiency in the price charged on specific goods or services. Such
scenarios may occur in the insurance sector, capital markets, and even in the ordinary
marketplaces.

For example, when a buyer is looking for a second hand car to buy, and a seller offers to sell a
car with hidden defects, the buyer will be at a disadvantage unless the seller informs the buyer
about the defects. Adverse selection occurs when the buyer purchases the car without the seller
disclosing the defects that the vehicle has.

Seller of goods convince you to buy a product and try to hide its negatives , highlightes its positive
side . in the same way when customer come to company for a repairs under warranty customer
will highlight the fault of the vehicle to claim warranty easily

ADVERSE SELECTION IN THE CAPITAL MARKETS

In the capital markets, some securities are more prone to adverse selection than others. For
example, a high growth company may offer equity to investors in the capital markets at a high
price. Assuming that the managers at the capital markets have inside information about the
company that outside investors are unaware of, that subjects the investor to adverse selection.

For example, the managers may be aware of an internal assessment of the company’s current
value that shows that the company’s offer price exceeds the private assessment of the company.
Investors will be at a disadvantage because they will purchase the company’s stock without
knowing that the company is overvalued. If the managers inform the investors about the
overvaluation of the company and the investors proceed to buy the stock, there will no longer be a
state of adverse selection.
LEMONS MARKET PROBLEM
The lemons problem refers to the issues that arise regarding the value of an investment or
product due to the asymmetric information available to the buyer and seller .The lemons problem
theory was put forward in 1970 by George A. Akerlof , an economist, who presented his ideas in
paper “THE QUARTERLY JOURNAL OF ECONOMICS” titled, "The Market for "Lemons": Quality
Uncertainty and the Market Mechanism. "The use of "lemon" refers to a slang term for a vehicle
that has many problems and defects that negatively impact its utility .The lemon theory posits that
in the used car market, the seller has more information regarding the true value of the vehicle
than the buyer. This results in the buyer not wanting to pay more than the average price of the
car, even if it is of premium quality. This benefits the seller if the car is a lemon but is a
disadvantage if the car is of good quality .The existence of asymmetrical information is not only
apparent in the used car market, but many markets, such as consumer and business products,
and investing.

A potential buyer of securities such as common stock, can’t distinguish between good firms with
high expected profits and low risk and bad firms with low expected profits and high risk. A price
that lies between the value of securities from bad firms and the value of those from good firms . if
the owner of good firm have better information than investor and know that they are a good firm,
they know that their securities are undervalued and will not want to sell them to investor at the
price he is willing to pay . the only firms willing to sell investor securities will be bad firms and
investor he is not stupid , he doesn’t want to hold securities in bad firms

The analysis is similar if investor considers purchasing a corporate debt instrument in the bond
market rather than an equity share. Investor will buy a bond only if its interest rate is high enough
to compensate him for the average default risk of the good and bad firms trying to sell the debt.
The knowledgeable owners of a good firm realize that they will be paying a higher interest rate
than they should, so they are unlikely to want to borrow in this market. Only the bad firms will be
willing to borrow, and because investors are not eager to buy bonds issued by bad firms, they will
probably not buy any bonds at all. Few bonds are likely to sell in this market, so it will not be a
good source of financing.

SOLUTION TO ADVERSE SELECTION

If purchasers of securities can distinguish good firms from bad firms, they will pay the full value of
the securities issued by good firms, and good firms will sell their securities in market . the security
market will then able to move funds to the good firms that have the most productive investment
opportunities

One of the ways that financial companies can avoid adverse selection is by grouping high-risk
individuals and charging them higher interest rates . For example, financial companies
charge different premium rates to clients depending on their age, health condition, weight, lifestyle
risk, medical history, hobbies, driving record, and occupation. The above mentioned factors impact
a person’s health and life expectancy and can determine the company’s potential to pay a claim.
During underwriting, the company should determine whether to give a potential client an insurance
policy and calculate the premium to charge the specific client

Another way of reducing adverse selection is the private production and sale of information.
Before the 1970s, companies like Standard and Poor’s, Bests, Duff and Phelps, Fitch’s, and
Moody’s compiled and analyzed data on companies, rated the riskiness of their bonds, and then
sold that information to investors in huge books. The free-rider problem, though, killed off that
business model. Specifically, the advent of cheap photocopying induced people to buy the books,
photocopy them, and sell them at a fraction of the price that the bond-rating agencies could
charge. So in the mid-1970s, the bond-rating agencies began to give their ratings away to
investors and instead charged bond issuers for the privilege of being rated. The new model greatly
decreased the effectiveness of the ratings because the new arrangement quickly led to rating
inflation similar to grade inflation. After every major financial crisis, including the subprime
mortgage mess of 2007, academics and former government regulators lambaste credit-rating
agencies for their poor performance relative to markets and point out the incentive flaws built into
their business model. Thus far, little has changed, but encrypted databases might allow a return to
the investor-pay model. But then another form of free riding would arise as investors who did not
subscribe to the database would observe and mimic the trades of those investors known to have
subscriptions. Due to the free-rider problem inherent in markets, banks and other financial
intermediaries have incentives to create private information about borrowers and people who are
insured. This helps to explain why they trump bond and stock markets.

Since adverse selection exists because of information asymmetry, there are specific ways to deal
with it to narrow the gap of missing information. One way is to make sure that everyone is a
stakeholder. When one party negatively affects the successful execution and delivery of a project,
it must be clear that they are partly responsible and will not realize the value and benefits of the
project.

Another way is by getting valuable information directly from other sources, such as statistics,
previous projects, and relevant documents. Unfortunately, these steps do not actually make the
other party share information to reduce the asymmetry. In other fields such as insurance, other
methods are used to resolve asymmetric information. Appraisal involves examining a
characteristic (or a vital project requirement) and verifying it through a reliable assessment. If the
information has a financial value, it can be assessed or verified by a certified professional.

Screening is another indirect method where the party with less information identifies a key variable
that leads the party hiding the information to reveal it. The more variables are identified, the more
accurate the information will be. Financial intermediaries are not perfect screeners. They often
make mistakes. Insurers like State Farm, for example, underestimated the likelihood of a massive
storm like Katrina striking the Gulf Coast. And subprime mortgage lenders, companies that lend to
risky borrowers on the collateral of their homes, grossly miscalculated the likelihood that their
borrowers would default. Competition between lenders and insurers induces them to lower their
screening standards to make the sale. At some point, though, adverse selection always rears its
ugly head, forcing lenders and insurance providers to improve their screening procedures and
tighten their standards once again. And, on average, they do much better than you or I acting
alone could do.

Financial Intermediation So far we have seen that private production of information and
government regulation to encourage provision of information lessen, but do not eliminate, the
adverse selection problem in financial markets. How, then, can the financial structure help
promote the flow of funds to people with productive investment opportunities when there is
asymmetric information? A clue is provided by the structure of the used-car market.

A financial intermediary, such as a bank, becomes an expert in producing information about

firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from
depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms,
it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The
resulting profit that the bank earns gives it the incentive to engage in this information production
activity

Financial intermediaries are not perfect screeners. They often make mistakes. Insurers like State
Farm, for example, underestimated the likelihood of a massive storm like Katrina striking the Gulf
Coast. And subprime mortgage lenders, companies that lend to risky borrowers on the collateral of
their homes, grossly miscalculated the likelihood that their borrowers would default. Competition
between lenders and insurers induces them to lower their screening standards to make the sale.
At some point, though, adverse selection always rears its ugly head, forcing lenders and insurance
providers to improve their screening procedures and tighten their standards once again. And, on
average, they do much better than you or I acting alone could do.

Another initiative and natural response is for consumers and competitors to act as monitors for
each other. Consumer Reports, Underwriters Laboratory, notaries public, and online review
services such as help bridge gaps in information. eBay and Amazon seller ratings, Uber driver
reviews, and product ratings are all examples of crowdsourcing reputation in this way. Online
reputation management (ORM) software solutions allow companies to track what consumers say
about a brand on review sites, social media, and search engines.

Another important fact that is explained by the analysis here is the greater importance of banks in
the financial systems of developing countries. As we have seen, when the quality of information
about firms is better, asymmetric information problems will be less severe, and it will be easier for
firms to issue securities. Information about private firms is harder to collect in developing countries
than in industrialized counties, therefore, the smaller role played by securities markets leaves a
greater role for financial intermediaries such as banks. A corollary of this analysis is that as
information about firms becomes easier to acquire, the role of banks should decline. A major
development in the past 20 years in the United States has been huge improvements in information
technology. Thus, the analysis here suggests that the lending role of financial institutions, such as
banks in the United States, should have declined, and this is exactly what has occurred

Our analysis of adverse selection indicates that financial intermediaries in general-and banks in
particular, because they hold a large fraction of nontraded loans should play a greater role in
moving funds to corporations than securities markets do. Our analysis thus explains why indirect
finance is so much more important than direct finance and why banks are the most important
source of external funds for financing businesses