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Equilibrium in financial markets with adverse selection

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  • Tuomas Takalo

    (Bank of Finland)

  • Otto Toivanen

    (Economics Department, Helsinki School of Economics)

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 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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Web page: http://128.118.178.162

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

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Cited by:
  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.
  2. Vesala , Timo, 2004. "Asymmetric information in credit markets and entrepreneurial risk taking," Research Discussion Papers 14/2004, Bank of Finland.
  3. David T. Llewellyn & David G. Mayes, 2004. "The role of market discipline in handling problem banks," Finance 0404020, EconWPA.
  4. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA.
  5. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA.

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