Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek bank loans.

Question

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Adverse selection is a situation where one party has more information than the other, and uses that information to the detriment of the less-informed party. In the context of loan markets, banks may face adverse selection because potential borrowers who are bad credit risks may be more likely to seek loans from them. This is because borrowers who are more creditworthy may have other options, such as cheaper forms of financing or access to capital through their own savings or investments. As a result, banks may end up with a loan portfolio that is disproportionately filled with high-risk borrowers, which can lead to higher default rates and other problems.

Banks Face the Problem of Adverse Selection in Loan Markets