Loan Insurance, Adverse Selection and Screening

Martin Kuncl and Toni Ahnert

VfS Annual Conference 2019 (Leipzig): 30 Years after the Fall of the Berlin Wall - Democracy and Market Economy from Verein für Socialpolitik / German Economic Association

Abstract: We examine insurance against loan default when lenders can screen in primary markets at a heterogeneous cost and learn loan quality over time. In equilibrium, low-cost lenders screen loans but some high-cost lenders insure them. Insured loans are risk-free and liquid in a secondary market, while uninsured loans are subject to adverse selection. Loan insurance reduces the amount of lemons traded in the secondary market for uninsured loans and improves liquidity and welfare. This pecuniary externality implies insufficient loan insurance in the liquid equilibrium. To achieve constrained efficiency, a regulator (i) guarantees a minimum price in the market for uninsured loans to eliminatea welfare-dominated illiquid equilibrium; and (ii) imposes Pigouvian subsidies on loan insurance in the liquid equilibrium to correct for the externality.

JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2019
New Economics Papers: this item is included in nep-ias
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:vfsc19:203565

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