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A detrimental feedback loop: deleveraging and adverse selection

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  • Bertsch, Christoph

    () (Monetary Policy Department, Central Bank of Sweden)

Abstract

Market distress can be the catalyst of a deleveraging wave, as in the 2007/08 financial crisis. This paper demonstrates how market distress and deleveraging can fuel each other in the presence of adverse selection problems in asset markets. At the core of the detrimental feedback loop is agents' desire to reduce their reliance on distressed asset markets by decreasing their leverage which in turn amplifies the adverse selection problem in asset markets. In the extreme case, this leads to a market breakdown. I find that adverse selection creates both an "ex-ante" inefficiency because it distorts agents' long-term leverage choices and an "interim" inefficiency because it distorts agents' short-term liquidity management. I derive important implications for central bank policy.

Suggested Citation

  • Bertsch, Christoph, 2013. "A detrimental feedback loop: deleveraging and adverse selection," Working Paper Series 277, Sveriges Riksbank (Central Bank of Sweden).
  • Handle: RePEc:hhs:rbnkwp:0277
    as

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    File URL: http://www.riksbank.se/Documents/Rapporter/Working_papers/2013/rap_wp277_131010.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Leverage; endogenous borrowing constraints; financial crisis; liquidity; asymmetric information; central bank policy;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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