General information about the adverse

selection problem

 Adverse Selection: It arises when borrowers who are likely to produce

undesirable results are the one who are actively seeking loans.

 The way to eliminate the adverse selection problem in a transaction is to

find a way to establish trust between the parties involved, by bridging the
perceived information gap between the two parties by helping them know as
much as possible.
How financial intermediaries solve
the adverse selection
by financial intermediation

Become an expert in producing

information about firms

Avoid the free-rider problem by

making private loans
 1. Become an expert in producing information about firms

 Intermediaries: who minimize the asymmetric information gap by becoming

experts and establishing trust between buyers and sellers.

 Banks produce information through the

transactions on the borrowers’ bank
accounts. From the transactions,
banks will be able to determine the
suitability of credit and ability to
repay the loan.
 2. Avoid the free-rider problem by making private loans
(not purchasing securities in the open market)

 The free-rider problem: occurs when people who do not pay for
information take advantage of the information that other people
have paid for.

 A private loan is not traded, other investors can not watch what
the bank is doing and bid up the loan’s price to the point that the
bank receives no compensation for the information it has
produced.

→ The bank’s role as an intermediary that holds mostly non -

traded loans is the key to its success in reducing asymmetric
information in financial markets.
 2. Avoid the free-rider problem by making private
loans (not purchasing securities in the open market)

 Banks are the most important source of external funds for financing
businesses.

 This is particularly important in developing countries, where information about

the quality of firms is hard to gather. The smaller role played by securities
markets leaves a greater role for financial intermediaries such as banks.

 Well-known corporations in industrialised countries rely less on banks

because their securities are more fairly valued due to the availability of
information on them.