A detrimental feedback loop: deleveraging and adverse selection

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.