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Equilibrium in financial markets with adverse selection

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  • Takalo, Tuomas

    ()
    (Bank of Finland Research)

  • Toivanen, Otto

    ()
    (Helsinki Center of Economic Research (HECER))

Abstract

We study a financial market adverse selection model where all agents are endowed with initial wealth and choose to invest as entrepreneurs or financiers, or not to invest. We show that often a lack of outside finance leads to the emergence of financial markets where availability of outside finance leads to autarky. We find that i) there exist Pareto-efficient and inefficient equilibria; ii) adverse selection has more severe consequences for poorer economies; iii) increasing initial wealth may cause a shift from Pareto-efficient to inefficient equilibrium; iv) increasing the proportion of agents with positive NPV projects causes a shift from inefficient to efficient equilibrium; v) equilibrium financial contracts are either equity-like or ‘pure’ debt contracts; vi) agents with negative (positive) NPV projects earn rents only in (non-)wealth-constrained economies; vii) agents earn rents only when employing pure debt contracts; and viii) removing storage technology destroys the only Pareto-efficient equilibrium in non-wealth-constrained economies. Our model enables analysis of various policies concerning financial stability, the need for sophisticated financial institutions, development aid, and the promotion of entrepreneurship.

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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 6/2003.

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Length: 48 pages
Date of creation: 04 Mar 2003
Date of revision:
Handle: RePEc:hhs:bofrdp:2003_006

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: financial market efficiency; adverse selection; financial contracts; creation of firms;

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Citations

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Cited by:
  1. Vesala , Timo, 2004. "Asymmetric information in credit markets and entrepreneurial risk taking," Research Discussion Papers 14/2004, Bank of Finland.
  2. Guender, Alfred V., 2003. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Research Discussion Papers 12/2003, Bank of Finland.
  3. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA.
  4. David T. Llewellyn & David G. Mayes, 2004. "The role of market discipline in handling problem banks," Finance 0404020, EconWPA.
  5. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA.

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