In Economics, adverse selection is defined as a market situation where buyers and sellers have different information, so that a participant might participate selectively in trades which benefit them the most, at the expense of the other trader
Adverse selection is a problem that appears in financial markets as a consequence of the presence of asymmetric information, which is when one party does not know enough about the other party to make accurate decisions.
This inequality tends to appear for example when a borrower who decides to take out a loan has better information than the lender about the potential return and risks associated with the investment projects for which the funds are intended.
Adverse selection is the problem that occurs when borrowers have information that lenders do not have, and is created by asymmetric information before the transaction occurs.
This problem arises from the fact that potential borrowers who are the most likely to produce an undesirable outcome (the bad credit risks) are the ones most actively looking for a loan and therefore are the ones most likely to be selected. This means that adverse selection in financial markets can lead to a situation where lenders may decide to not make any loans, even though good credit risks exist in the marketplace, because those that more actively look for loans are the bad credit risks.
To better understand this concept here is an example: suppose that you have two friends, John and Michael, that have very different approaches with money. In fact, John is a conservative type who borrows money only when he has an investment that he is almost certain that will pay off, otherwise he prefers to use his own money or to avoid investing. Michael, on the other hand, is a gambler who has just come across a new get-rich-quick scheme that he is 100% sure that will make him a millionaire, even though as with most get-rich-quick schemes, the probability that the investment will pay off are very low.
Now, which of your two friends is more likely to call you to ask for a loan? Michael of course. Luckily, given that they are two of your closest friends, you know them well and therefore you won’t have a problem because you know that Michael is a bad risk and therefore you probably will not lend any money to him.
However, suppose that you are a person that does not know him so much as you, in this case, you would be more likely to lend to Michael than to John because Michael will be haunting you for the loan.
Nonetheless, because of the possibility of adverse selection, you might decide not to lend to either of your friends even though there are times when John, who is an excellent credit risk, might need a loan for a worthwhile investment.
The role of financial intermediaries
Fortunately, financial intermediaries can alleviate the problems created by adverse selection, in fact, thanks to the presence of financial intermediaries in the economy, even small savers can provide their funds to financial markets by lending their excess funds to a trustworthy intermediary, which will lend them out either by making loans or by buying securities (e.g. bonds or stocks).
Financial intermediaries can help a lot to mitigate the effects of adverse selection in the market because they are better equipped than individuals to screen out bad credit risks from good ones. This means that intermediaries can increase their returns on their investments and therefore they can also afford to pay interest to savers.
This is one of the reasons why, without a well-functioning set of financial intermediaries, it is very hard for an economy to reach its full potential.