Question

How adverse selection problem occurs during lending activity?

Answer 1

Adverse selection refers to the problem where the sellers have more information about the product than the buyers or vice versa.

In case of lending, the buyers may take a loan to use it for some risky situation such as to gamble or to spend them in unproductive activities which will result in them losing all the money and so the lenders of the money will be negatively affected as they won't be able to get the money back.

To solve this problem, the loan usually undertakes a guarantee or premium from the lenders which will make them fully liable to pay the loan amount back and so they will spend the loan amount carefully and repay the loan in future as defaulting will result in loss of assets.