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Adverse Selection, Liquidity, and Market Breakdown

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  • Koralai Kirabaeva

Abstract

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.

Suggested Citation

  • Koralai Kirabaeva, 2010. "Adverse Selection, Liquidity, and Market Breakdown," Staff Working Papers 10-32, Bank of Canada.
    • Handle: RePEc:bca:bocawp:10-32
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    References listed on IDEAS

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    Cited by:

    1. Bofinger, Peter & Schnabel, Isabel & Feld, Lars P. & Schmidt, Christoph M. & Wieland, Volker, 2015. "Zukunftsfähigkeit in den Mittelpunkt. Jahresgutachten 2015/16 [Focus on Future Viability. Annual Report 2015/16]," Annual Economic Reports / Jahresgutachten, German Council of Economic Experts / Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung, volume 127, number 201516.
    2. Hajime Tomura, 2012. "Asset Illiquidity and Market Shutdowns in Competitive Equilibrium," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(3), pages 283-294, July.
    3. Stephen Morris & Hyun Song Shin, 2010. "Contagious Adverse Selection - Revised November, 2010," Working Papers 1282, Princeton University, Department of Economics, Econometric Research Program..

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    More about this item

    Keywords

    Financial institutions; Financial markets; Financial stability;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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