Adverse Selection at its best in Maldives…

I remember one of my professors explaining to me the difference between regulating a restaurant and a bank. He says that even if five restaurants closed down within a week, it doesn’t affect much to the macro economy; however, if even one bank was to fail each week, then it sure will impact the macro economy of the country. It is because of this reason, we need an authority (an effective one), to regulate, supervise, and monitor the activities of commercial banks and other financial institutions.

The under-developed financial sector of Maldives has six commercial banks, a leasing company, and a housing development finance corporation. The commercial banks mainly rely on their lending to the tourism sector for most of their profits. According to the published statistics from the regulating authority, MMA, 59 percent of the total lending of the banks is to the tourism sector, as at end of 2009. There is an outstanding amount of over $700 million (Rf 9 billion) lent to the tourism sector at the end of 2009. According to the website of MMA, the lending rates of the commercial banks in Rufiya ranges between 8 through 13 percent, and for US Dollars it is 5.5 through 13 percent.

The banks normally think that their profits will increase if they lend at higher interest rates; as high as 13 percent. However, what they don’t realize is that at such higher rates, there will come many borrowers who do not have the intention of repaying back. There will come many businessmen, with risky projects, having very high uncertainty of recovering the investments. The banks hence face the problem of adverse selection. This is exactly what has happened to some banks in Maldives. In order to record higher bank profits, the bank managers decided to lend huge amounts to very risky borrowers, when these risky borrowers did not have the intention of repaying back, in the first place. So, we can argue that with the increase in interest rate (lending rate), the probability of repaying back falls, and the profitability of banks fall.

Another very good example of adverse selection was seen in the tourism sector few years back, when the Ministry of Tourism opened several invitations to bid for new islands for resort development. Many parties proposed incredibly high rents, and they were awarded the island. What the government did not realize was; the probability of the investor making regular rent payments; and even the probability of the investor ever being able to develop the island and open the resort, decreases with every percentage increase in the rent proposed. In other words, by selecting the party with highest rent, the government is effectively selecting the party with the lowest probability of making the rent payments, and the party with the lowest probability of ever being able to develop the island. I think the evidence we see now supports this claim. There are still more than fifty islands unable to start their operations. And one of the main reasons they are unable to attract finance is due to the incredibly high rents that they need to pay the government.