Adverse selection, liquidity, and market breakdown

Arbeitspapier

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.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Bank of Canada Working Paper ; No. 2010-32

Classification and Topics

• Classification: Wirtschaft ; Financial Crises ; Portfolio Choice; Investment Decisions ; Asymmetric and Private Information; Mechanism Design
• Subject: Financial institutions ; Financial markets ; Financial stability

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Kirabaeva, Koralai
• Event: Veröffentlichung
• (who): Bank of Canada
• (where): Ottawa
• (when): 2010

Further information

• DOI: doi:10.34989/swp-2010-32
• Handle: http://hdl.handle.net/10419/53828
• Last update: 10.03.2025, 11:43 AM CET