Question

talk about the vulnerability to adverse selection of investment banks and investment companies

Answer 1

Adverse selection arises out the mere fact of information asymmetries. Information asymmetries cause the whole process of selecting an investment company or a bank difficult in a way that there is no surety, that the funds given to them will be used in a proper way or will not be exploited by the bank or the investment company by taking huge risks.

Keeping the above argument in place we can fairly conclude that vulnerability of adverse selection cannot be overlooked and should be handled with utmost care. Also, let's look at a few examples which might be interesting in understanding the vulnerabilities:

The very first thing which comes to my mind is the information asymmetry, to draw an analogy here, suppose we have two people who are willing to take loan for their potential projects, Now the first person is good with risks and knows that his project will do good in the long run, but the other person knows that there are underlying risks involved which are not very evident. However, while processing the request the banker would treat them the same and charge a higher interest to both. At once the person who is good with risk will run away leaving just the person with the bad risk; in a way had the bank would have more information about the person with a good risk it would have charged a low-interest rate for that person and given him the loan.

The second thing which comes to my mind is the tight deadlines or targets which have to be achieved by the executives. This essentially alienate the executive from the institution which is sometimes also referred to as the agency problem. This system of incentive, targets and deadlines make a good case for adverse selection.

Too big to fail: Normally bigger financial corps and investments companies are deemed to be safe and are supposed to be following ethical trade practices, this may not be true as what we have seen during the sub-prime crises.

Credit ratings: Rating's companies which published the credit rating reports are often approached by the investments bank and investment companies which are also their customers, now it might seem weird but in the heat of competition a credit rating company might want to tweak the numbers just to make their clients happy, This might result in the adverse selection.

Finally, Corruption in the government or with the regulators issuing certificates that the companies are good and following ethical trading and investment practices can be an issue and cause adverse selection. This may be a good case in emerging markets.