Adverse Selection, Liquidity, and Market Breakdown
Staff Working Papers from Bank of Canada
This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.
Keywords: Financial institutions; Financial markets; Financial stability (search for similar items in EconPapers)
JEL-codes: D82 G01 G11 (search for similar items in EconPapers)
Pages: 53 pages
New Economics Papers: this item is included in nep-ban, nep-cta and nep-fmk
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:10-32
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