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A Dynamic Theory of Collateral Quality and Long-Term Interventions

Michael Lee () and Daniel Neuhann

No 894, Staff Reports from Federal Reserve Bank of New York

Abstract: We study a dynamic model of collateralized lending under adverse selection in which the quality of collateral assets is endogenously determined by hidden effort. Complementarities in incentives lead to non-ergodic dynamics: Asset quality and output grow when asset quality is high, but stagnate or deteriorate otherwise. Inefficiencies remain, even in the most efficient competitive equilibrium?investment and output are vulnerable to spells of lending market illiquidity, and these spells may persist because of suboptimal effort. Nevertheless, benevolent regulators without commitment can destroy welfare by prioritizing liquidity over incentives. Optimal interventions with commitment call for large, long-term subsidies in excess of what is required to restore liquidity.

Keywords: government intervention; collateral; liquidity; adverse selection (search for similar items in EconPapers)
JEL-codes: G18 E50 G01 E44 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-dge and nep-mac
Date: 2019-08-07
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