Question

2. In your own words, describe how the ‘lemons’ problem that commercial banks potentially face when making loans is an example of adverse selection? (b) How can commercial banks reduce this occurrence?

Answer 1

"Lemons problem" was first put forward in a research paper "The market for lemons: Quality uncertainty and the market mechanism" in the 1960's by George A Akerlof. This refers to the problems that arise regarding the value of an asset/investment/product due to asymmetric information possessed by the buyer and seller during a transaction. Due to limited knowledge the buyer may want to pay an average price, a price in the middle of a bargain and premium price. So the seller might benefit in certain cases as he will receive at least the average price which might be more than what he expected. Though in case of premium products the buyer may not want to pay the premium price. When it comes to loans offered by commercial banks, an average price would cause those who have better products to shun the offer and those with higher risks or lesser credibility would seek the offer resulting in adverse selection by the bank. When a bank does not get back it's money or interest, and the money is misused through excessive risk taking, it will cause a moral hazard. Moral hazard occurs when the receiver of loan will not use it as intended and takes excessive risk. Banks often feel they are too big to fail and they lend money to less credible borrowers and multiple such borrowers can lead to a moral hazard.

Commercial banks can reduce the above occurence by trying to gain information about potential fund receivers and the best to gauge this is past credit record. Databases, credit scores etc can help commercial banks gain information and remove any asymmetry in information and thus reduce "Lemons problem".