Adverse Selection

In principle, interest rate deregulation improves resource allocation and interest rates can be adjusted by banks to incorporate a premium for perceived risk. Market prices should adjust in this way to establish equality between supply and demand. However, this doesnt happen because the credit market is characterised by asymmetry of information. Banks do not know the true viability of a project. Therefore, even if a borrower is willing to pay the higher premium associated with higher risk, a bank may reject the prospective borrower for fear of giving an unsound loan. In seeking to lend only to prime customers, bank spreads become thinner. Competition can both prevent lending rates from increasing and allow deposit rates to increase. This raises the spectre of bank liquidation and bankruptcy, a phenomenon that has also characterised a country like the United States in the 1980s. To the extent that banks try to increase lending rates and maintain spreads, there is the issue that only high-risk borrowers will

be able to borrow at these rates. This leads to a double problem. First, corporate profitability comes down. Second, since some firms cannot repay loans, non-performing assets (NPAs) go up.

This ties up with cross-border movements of capital, since capital inflows increase funds available with the banking sector. Such funds often find their way into high risk ventures. The extent to which the riskiness of bank portfolios increases, is correlated with the regulatory regime and the quality of bank personnel. For example, credit may be extended on the basis of collateral in real estate, the Thai instance being a case in point. When asset prices crash during a downturn, NPAs go up. Alternatively, the Mexican example indicates that credit can sustain a boom in the consumer good sector and precipitate a balance of payments crisis. The point is not that the Thai or Mexican example is likely to be replicated. The point is that such systemic problems are a function of the health of the financial system.

Systemic problems are much more likely when banks are weak and saddled with a large percentage of NPAs. In addition to prudential norms, should one have a ceiling on the risks to which banks can expose themselves? Should there be a requirement about portfolio diversification? Or about foreign exchange exposure? Should the ratio of long-term fixed rate loans to total capital be prescribed? What about deposit insurance? Because of informational asymmetry, liberalisation of the financial sector cannot be interpreted as an era of no regulation. Stated differently, there are systemic problems that will take more than a credit policy to solve.