1. The global financial crisis has resulted in a dramatic increase in uncertainty in financial markets In particular, the resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity. Discuss by giving real life example(s) from the American, UK or European financial markets with actual figures.
Adverse selection takes place before the transaction and it is basically when financial intermediaries are likely to select risky borrowers.
* How can banks be certain ...view middle of the document...
* Cash flow drops as a result of an increase in interest rates, and this leads to adverse selection problem becoming more severe, again decreasing lending, investment, and economic activity.
Stock market decline:
* A decline in the stock market means that the net worth of corporations has fallen, because share prices are the valuation of a corporation s net worth.
* The decline in net worth makes lenders less willing to lend because, the net worth of a firm plays a role similar to that of collateral. When the value of collateral declines, it provides less protection to lenders, meaning that losses on loans are likely to be more severe
* Because lenders are now less protected against the consequences of adverse selection, they decrease their lending, which in turn causes investment and aggregate output to decline.
* Bank panics result in an increase in adverse selection problem, these problems produce an even sharper decline in lending to facilitate productive investments and lead to an even more severe contraction in economic activity.
* could be due to a recession or stock market crash and this makes it hard for lenders to screen good from bad credit risks.
* And because banks inability to solve adverse selection problem makes them less wiling to spend and again lead to a decrease investment and aggregate economic activity.