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Equilibrium in financial markets with adverse selection

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Author Info
Tuomas Takalo (Bank of Finland)
Otto Toivanen (Economics Department, Helsinki School of Economics)

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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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Paper provided by EconWPA in its series Finance with number 0405001.

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Date of creation: 03 May 2004
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Handle: RePEc:wpa:wuwpfi:0405001

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Related research
Keywords: financial market efficiency; adverse selection; financial contracts; creation of firms;

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Find related papers by JEL classification:
D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G20 - Financial Economics - - Financial Institutions and Services - - - General
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. 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. [Downloadable!]
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  2. Vesala , Timo, 2004. "Asymmetric information in credit markets and entrepreneurial risk taking," Research Discussion Papers 14/2004, Bank of Finland. [Downloadable!]
  3. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA. [Downloadable!]
  4. David T. Llewellyn & David G. Mayes, 2004. "The role of market discipline in handling problem banks," Finance 0404020, EconWPA. [Downloadable!]
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  5. Kauko, Karlo, 2003. "Interlinking securities settlement systems: A strategic commitment?," Research Discussion Papers 26/2003, Bank of Finland. [Downloadable!]
  6. Vauhkonen , Jukka, 2003. "Financial contracts and contingent control rights," Research Discussion Papers 14/2003, Bank of Finland. [Downloadable!]
  7. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA. [Downloadable!]
  8. Vauhkonen, Jukka, 2003. "Are adverse selection models of debt robust to changes in market structure?," Research Discussion Papers 28/2003, Bank of Finland. [Downloadable!]
  9. Vauhkonen , Jukka, 2003. "Banks' equity stakes in borrowing firms: corporate finance approach," Research Discussion Papers 13/2003, Bank of Finland. [Downloadable!]
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