What is Adverse Selection?
Adverse selection in lending occurs when an organisation has less information about customer creditworthiness relative to others in the market.
In practical terms, a lender that is blind to a predictive risk characteristic is more likely to acquire a high risk customer than a lender which has this information.
If there is no reward for higher risk in terms of interest rate or fees, the acquiring lender will suffer adverse selection.
In relation to Comprehensive Credit Reporting (CCR), lenders that do not have additional risk information, such as repayment history or knowledge of undisclosed debts, are more likely to acquire a high risk customer relative to a lender with access to CCR information.
A classic example of adverse selection is the case of a customer with poor Repayment History Information (but not defaults listed on their credit file) and a large number of loans with multiple lenders. Analysis of CCR data by Equifax has shown that poor RHI and loans with multiple lenders are very good indicators of high risk. For example, the customer in the case above would have a very low credit score (high risk) in CCR but a very high credit score (low risk) under negative credit reporting. The lender with access to CCR data is likely to decline the loan application from the customer (or charge a higher interest rate). It is more likely that the customer will meet the lending criteria of the lender that does not have access to CCR data and hence suffer adverse selection.
The extent of adverse selection will vary depending on a number of factors including the depth of a lenders credit analysis, availability of alternate data (including data held by the lender) and market segments in which the lender operates.