Presentation and written submission - Essay Example

Those trades that took place were carried out at substantial discounts. These disruptions in market activity had a fundamental role in the transmission and amplification of the US financial market. The global financial crisis of 2007 - 2009 led to uncertainty in the US financial market causing the problem of adverse selection. Adverse selection is a situation where only one party to a financial contract has better information as compared to the other leading to only low-quality products being available in the market.

The aim of this paper is to discuss the role of adverse selection in causing reduced lending, investment and economic activity as a result of little willingness to lend among US lender. Adverse Selection Adverse selection refers to an asymmetric information problem which takes place before a transaction is carried out. It is when possible bad credit risks are the most active in seeking out loans. This therefore leads to the likelihood of those that are most likely to create an undesirable/adverse result being selected (Philippon & Skreta, 2010, p. 22). For instance, those that seek to carry on big risks are more likely to be the most keen to take loans since they know they aren’t likely to pay it back. . An asset’s market price will manifest the quality expected based on the quality of all assets that are for sale in the market if buyers can’t be able to assess its quality.

Adverse selection can arise from this asymmetric information between buyers and sellers. Sellers of high quality assets will pull back from the market as prices fall hence leaving assets that are of only low-quality (lemons) for sale. The result may be the reduction or halt in the trade of the asset since buyers are wary they will be left with an asset that is overpriced (lemon) if they transact. Moreover, this leads to the credit crunch since such assets can no longer act as collateral for other transactions.

In both post-crisis episodes and the global financial crisis of 2007–09, adverse selection played a key role (Coval, Jurek & Stafford, 2009, p. 19). Increases in Uncertainty It gets more difficult for lenders to screen out good credits from the bad ones whenever there is a striking increase in uncertainty in financial markets. A reduction in investment, lending and aggregate activity is caused by lenders becoming less willing to lend due to their inability to solve adverse selection. The increase in uncertainty can grow out of a recession or failure of large financial or nonfinancial institution.

However, uncertainty regarding interest rate dynamics and government policies seem to have in recent times of financial instability in developed market countries played a major role in reduction of investment, lending and aggregate economic activity (Caballero & Krishnamurthy, 2009, p. 86 - 88). Data A table of USA’s financial and economic data from the year 2003 to 2011 Year Lending