Adverse selection in corporate lending context Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the “bad” products or services are more likely to be selected. Adverse selection occurs when a product or service is selected by only a certain group of people who offer the worst return for the company.
Adverse selection occurs because of information asymmetries and difficulties in selecting customers. 1. 2 Consequence of adverse selection Information imperfections, such as asymmetric information, are important frictions in financial markets. Even in normal times, borrowers in credit markets often know more than lenders about the quality of the collateral and the rockiness of their investments. If high- and low-risk borrowers are indistinguishable, then high-risk borrowers benefit at the expense of low- risk borrowers.
The resulting problem of adverse selection (when high-quality borrowers choose not to participate in the market) leads to higher interest rates and a decrease in lending. In the presence of asymmetric information, a small increase in the interest rate can lead to a large reduction in lending. A higher interest rate increases the likelihood that high-quality borrowers will withdraw from the market, aggravating the problem of adverse selection. As a result, the average quality of the borrowers falls, which in turn raises the interest rate even further.
If adverse selection is severe enough, the credit market may collapse. Adverse selection may cause banks to impose credit rationing?putting quantitative limits on lending to some borrowers. 1. Measures to tackle adverse selection In some situations, the problem of adverse selection is mitigated by signaling: letting participants in the marketplace who possesses inside information take actions that will reveal the nature of that unique information of those potential participants. In case of corporate customers, one signal could be the actions taken by an insider.
An insider who knows her company is experiencing financial turmoil may give off this signal by selling the company’s stock. If the public happens to see insiders selling out, they too may begin to sell, ultimately driving the value of the Meany’s stock lower in the financial marketplace. An astute banker may notice this falling stock price and may choose a stringent evaluation of credit worthiness of that company. By limiting the supply of loans, banks can reduce the average default risk and therefore alleviate adverse-selection problems.
Another way to reduce adverse selection is to require collateral for the loan. With collateral, even if the borrower defaults, the lender can recover losses by selling the collateral. Therefore, the asymmetric information about the borrower’s default probability becomes less important. 1. Moral hazard in the context of corporate lending Moral hazard is a special case of information asymmetry, a situation in which one party engaged in a transaction has more information than another.
In particular, moral hazard may occur if a party that is insulated from risk has more information about its own actions and intentions than the party paying for the unwanted outcome of the risk. Putting more broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency to behave inappropriately from the perspective of the party with less information. 1.
Reasons of Moral Hazard Moral hazard in the context of corporate lending arises because the debtor company does not take the full consequences and responsibilities of not paying installments timely or being a defaulter altogether. Therefore, the company has a tendency or incentive to act delinquently, leaving the banker to hold some responsibility for the consequences of nonpayment. In the heart of the moral hazard problem are a number of factors.
First, an increase in the interest rate may lead borrowers to choose investments with higher returns when successful but with lower probabilities of success: hence, rise in deposit rates could induce banks to adopt more risky investment strategies. A rise in bank lending rates can have similar incentive effects on the bank’s borrowers. Secondly, the expectation that the government will bail out a distressed bank may weaken incentives on bank owners to manage their asset portfolio prudently and incentives on depositors to monitor banks and choose only banks with a reputation for prudent management.
Moral hazard becomes even more acute when the bank lends to projects connected to its own directors or managers (insider lending). In such cases he incentives for imprudent (and fraudulent) bank management are greatly increased in that all of the profits arising from the project are internalized (in the case of loans to unconnected borrowers the project returns are split between lender and borrower), whereas that part of the losses borne by depositors or taxpayers are externalities.
Not surprisingly, insider lending is a major cause of bank failure around the world. 1. 6 Addressing Moral Hazard Problem In principle, various measures are available to curtail moral hazard. They generally fall under the following headings: (1 ) good corporate governance and management; (2) market discipline exercised by depositors and other creditors; and (3) regulatory discipline exercised by supervisory and, in some countries, deposit insurance authorities. 2.
Client Assessment Criteria & Post Disbursement Monitoring at Dacha Bank Limited (DB) to prevent Adverse Selection & Moral Hazard Problem In its CRM policy, DB set specific policy guidelines which include corporate philosophy of the Bank under which lending guidelines, credit risk assessment & risk grading, approval authority, segregation of duties, and internal control compliance guidelines have been specifically set to establish a benchmark in order to prevent the intentional or accidental adverse selection problem.
On the other hand, the procedural guidelines of the policy is outlined with approval process, credit administration, credit monitoring, and credit recovery to help the employees correct any inadvertently performed adverse selection mishaps to be rectified in an efficient manner. 2. 1 Lending Guidelines a. Industry & Business Segment Focus: The Bank focused on Industry and Business Segmentation to diversify the incarceration or pool of exposures effect, whose collective performance has the potential to affect the bank negatively even if each individual client of an industry is financially sound.
To reduce this effect, the bank directed industry specific expansion, reduction or maintenance of status quo, and exposure cap in terms of lending; it also specified exceptions where lending can be opted beyond these guidelines which must cite clear & financially viable supportive logic favoring the exceptions and be duly approved by the Board of Directors. B. Types of Loan Facilities & Parameters:
Depending upon the nature of financing in respect of purpose, security as well as repayment terms, loan facilities in DB have been put under following broad categories: Overdrafts Cash Credit Demand Loan Term Loan Short Term Loan House Building Loan Transport Loan Lease Finance Syndicated Loan Foreign Bills Purchased Letter of Credit as well as Back-to-Back Payment against Documents [PAD] Loan against Imported Merchandise [LIMIT] Loan against Trust Receipt [LTR] Time Loan Packing Credit Export Cash Credit Foreign Documentary Bill Purchased [PDP] Inland Documentary Bill Purchased CITED] Inland Bills Discounting
Bank Guarantee Similar Islamic Banking Products Consumer Loans: Credit Card, Education Loan, Home Loan, Car Loan SEEM Loans Offshore Banking Facilities Agricultural Finance These loan facilities categorize different customer needs and satisfy the exact ones that in the very first place diminish the probability of adverse selection by a great lot. The set parameters against each loan facility help credit managers identify customer needs quickly and cater them accordingly. C.
Single/Group borrower limit/Large loan ceiling/Product wise lending caps The bank manages its credit risk through segregating client exposure through implying Bangladesh Bank Circular regarding the subject and limiting the funded facilities up to 15% of total capital and total exposure up to 35% of the same. It also maintains a separate large loan ceiling schedule regarding portfolio management options. The bank also depicted in its policy a product wise lending cap to manage its advances in a better way. . Discouraged Business Sectors In its guidelines, the bank restricted a number of business sectors persuasion to which is strongly discouraged and some of which is completely restricted as well. E. Covenants & security/collateral needed: The guidelines set out specific documentation covenants & security/collateral needed separately for limited companies, partnership firm, project finance, readmes garments industries etc. F.
Others: The policy also includes guidelines on clients’ credit rating (both foreign & domestic) to reduce default risk along with cross border risk, specified credit principles, loan pricing strategy etc. 2. 2 Credit Risk Assessment & Risk Grading: Though the bank understands that the future of a credit can anytime go off course due to unforeseeable events, it also emphasizes on the complete and roper appraisal of credit proposals to minimize the probable loss arising from future loan classifications.
It compels that any and every credit facilities should be reassessed on an annual basis beyond its regular periodic assessment. Hence, the policy outlines that while assessing credit risk through a documented process, a credit risk analyst as well as a financial analyst must scrutinize and include the reflection of the following in the credit proposal: Credit policy of DB Diversification of Bank’s Portfolio Familiarity with the borrower Integrity Purpose Competence Credit investigation
Optimum level of credit worthiness Extent of facility Borrowers’ stake in real terms Source and terms of repayment Repayment period Risk factors Balance sheet analysis Profitability Net spread Security Risk appraisal: Business, Finance, Management, Security, Relationship Risks of & Recommendation on the Proposal Financial Statements Analysis Risk Grading (as per Bangladesh Bank Rules) 2. 3 Post Disbursement Monitoring Guidelines: The bank’s CRM policy includes in its latter part the monitoring process & recovery of loans classified.