Question

A bank advertises a very competitive loan interest rate. Explain what measures the bank can take to address adverse selection.

Answer 1

Since the bank is offering loans at a competitive interest rate, it may fall prey to the problem of adverse selection i.e. the difficulty to select and distinguish healthy applicants from riskier ones.

Banks can address the adverse secetion problem by:

(1)"Screening" loan applicants

In this process, the bank spends significant resources to collect enormous amounts of information about potential borrowers in order to estimate the likelihood that a loan will be repaid.

(2) Charging differential interest rates

Banks may charge different interest rates from different borrowers, depending upon their credit score. Borrowers with higher scores will be charges comparatively lower interest rates and vice versa.