Lending to 'lemons': Adverse selection and the failure of New Bank Tokyo

Abstract

In 2005 the Tokyo Government launched a bank, New Bank Tokyo, with the objective of providing finance to the region's small businesses. Within 3 years the bank had lost the equivalent of one billion US dollars of tax payers' money and, amid allegations of incompetence, fraudulent lending and criminal connections, it had to be rescued by its sponsor. In this study I show how the widely acknowledged phenomenon of adverse selection, the 'lemon' problem, underlay the failure of New Bank, and moreover, I identify a potential new rationale for the Akerlof process that is not predicted in the literature: reputation risk of the borrower. I conclude that the New Bank project was a suboptimal allocation of financial resources to an imprudent lending institution, which might have been avoided by a better understanding and application of banking theory. My research leads me to believe this paper to be the first academic examination of New Bank's ruin and the case itself to be the first documented example of a bank that allowed the process of adverse selection to continue until failure. It is a rare opportunity to observe how the lemon problem snowballs if subjected neither to commercial nor parliamentary oversight. © The Author 2014. Published by Oxford University Press in conjunction with the University of Tokyo. All rights reserved.