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Risk, Adverse Selection and Capital Market Failure

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  • de Meza, David
  • Webb, David

Abstract

This paper investigates the implications of adverse selection for capital market equilibrium when borrowers are risk averse. K. J. Arrow and R. C. Lind (1970) argue that when capital markets fail to spread risk properly interest rates are too high. The market adds a risk premium that the social planner would not. This paper shows that when projects differ in quality, in a pooling equilibrium, the private market sets interest rates too low even accounting for the risk premium. Hence, there is overinvestment. The result is shown to be robust to the introduction of moral hazard. Copyright 1990 by Royal Economic Society.

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Bibliographic Info

Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 100 (1990)
Issue (Month): 399 (March)
Pages: 206-14

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Handle: RePEc:ecj:econjl:v:100:y:1990:i:399:p:206-14

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Cited by:
  1. Xavier Gine & Pamela Jakiela & Dean Karlan & Jonathan Morduch, 2006. "Microfinance Games," Working Papers 2102, The Field Experiments Website.
  2. Robert E. Carpenter & Bruce C. Petersen, 2002. "Capital Market Imperfections, High-Tech Investment, and New Equity Financing," Economic Journal, Royal Economic Society, vol. 112(477), pages F54-F72, February.
  3. Ibrahimo, M.V. & Barros, C.P., 2009. "Relevance or irrelevance of capital structure?," Economic Modelling, Elsevier, vol. 26(2), pages 473-479, March.
  4. repec:ise:isegwp:wp432009 is not listed on IDEAS
  5. Bas Jacobs & Sweder J. G. van Wijnbergen, 2007. "Capital-Market Failure, Adverse Selection, and Equity Financing of Higher Education," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 63(1), pages 1-32, March.
  6. Pooran Wynarczyk & Robert Watson, 2005. "Firm Growth and Supply Chain Partnerships: An Empirical Analysis of U.K. SME Subcontractors," Small Business Economics, Springer, vol. 24(1), pages 39-51, February.
  7. Kevin Keasey & Robert Watson, 1995. "The Bank Financing of Small Unlisted Firms in the UK: An Analysis of Recent Conflicts," Journal of Entrepreneurial Finance, Pepperdine University, Graziadio School of Business and Management, vol. 4(2), pages 143-63 , Fall.
  8. Parker, Simon C, 2002. "Do Banks Ration Credit to New Enterprises? And Should Governments Intervene? President's Lecture Delivered at the Annual General Meeting of the Scottish Economic Society 4-5 September 2001," Scottish Journal of Political Economy, Scottish Economic Society, vol. 49(2), pages 162-95, May.
  9. repec:ise:isegwp:wp322008 is not listed on IDEAS
  10. repec:ise:isegwp:wp52010 is not listed on IDEAS
  11. Jose L Wynne, 2001. "Financial Frictions in Business Cycles, Trade and Growth," Levine's Working Paper Archive 625018000000000127, David K. Levine.

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