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The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification

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  • Boyd, J.h.
  • Smith, B.D.

Abstract

We consider credit rationing in an environment with adverse selection and costly state verification. The presence of costly state verification permits debt contracts to emerge under conditions that we specify. When debt contracts are observed, so is credit rationing. This rationing occurs even if it is possible for rationed borrowers to bid up expected returns to lenders and hence is voluntary. We also show how the adverse selection and costly state verification problems interact and investigate how improvements in information gathering technology impact on the extent of credit rationing.
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Suggested Citation

  • Boyd, J.h. & Smith, B.D., 1991. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," RCER Working Papers 289, University of Rochester - Center for Economic Research (RCER).
  • Handle: RePEc:roc:rocher:289
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    References listed on IDEAS

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    1. Richard Arnott & Joseph E. Stiglitz, 1988. "Randomization with Asymmetric Information," RAND Journal of Economics, The RAND Corporation, pages 344-362.
    2. Bencivenga, Valerie R & Smith, Bruce D, 1992. "Deficits, Inflation, and the Banking System in Developing Countries: The Optimal Degree of Financial Repression," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 767-790, October.
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    5. John Bryant & Neil Wallace, 1984. "A Price Discrimination Analysis of Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 51(2), pages 279-288.
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    10. Villamil, Anne P., 1988. "Price discriminating monetary policy : A nonuniform pricing approach," Journal of Public Economics, Elsevier, pages 385-392.
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    Citations

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    Cited by:

    1. Germano, Fabrizio & Meier, Martin, 2013. "Concentration and self-censorship in commercial media," Journal of Public Economics, Elsevier, vol. 97(C), pages 117-130.
    2. G. Carlier & L. Renou, 2006. "Debt contracts with ex-ante and ex-post asymmetric information: an example," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 461-473.
    3. Gersbach, Hans & Uhlig, Harald, 1997. "Debt Contracts, Collapse and Regulation as Competition Phenomena," CEPR Discussion Papers 1742, C.E.P.R. Discussion Papers.
    4. Gardner, L. A. & M. F. Grace, "undated". "Efficiency Comparisons between Mutual and Stock Life Insurance Companies," Working Papers 012, Risk and Insurance Archive.
    5. Gaetano Antinolfi, 2012. "Costly Monitoring, Dynamic Incentives, and Default," 2012 Meeting Papers 892, Society for Economic Dynamics.
    6. Alberto Martin, 2008. "Adverse selection, credit and efficiency: The case of the missing market," Economics Working Papers 1085, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2009.
    7. Antinolfi, Gaetano & Carli, Francesco, 2015. "Costly monitoring, dynamic incentives, and default," Journal of Economic Theory, Elsevier, vol. 159(PA), pages 105-119.
    8. Pietro Reichlin & Paolo Siconolfi, 2004. "Optimal debt contracts and moral hazard along the business cycle," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 75-109.
    9. Edward J. Green & Soo-Nam Oh, 1991. "Can a "credit crunch" be efficient?," Quarterly Review, Federal Reserve Bank of Minneapolis, pages 3-17.
    10. Michael R. Baye & Dan Kovenock & Casper G. Vries, 2005. "Comparative Analysis of Litigation Systems: An Auction-Theoretic Approach," Economic Journal, Royal Economic Society, vol. 115(505), pages 583-601, July.
    11. Dionne, Georges & Artis, Manuel & Guillen, Montserrat, 1996. "Count data models for a credit scoring system," Journal of Empirical Finance, Elsevier, pages 303-325.
    12. Longhofer, Stanley D., 1997. "Absolute Priority Rule Violations, Credit Rationing, and Efficiency," Journal of Financial Intermediation, Elsevier, pages 249-267.
    13. Georges Dionne & Olfa Ghali, 2005. "The (1992) Bonus-Malus System in Tunisia: An Empirical Evaluation," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 72(4), pages 609-633.
    14. Martin, Alberto, 2009. "A model of collateral, investment, and adverse selection," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1572-1588, July.
    15. Gersbach, Hans & Uhlig, Harald, 2006. "Debt contracts and collapse as competition phenomena," Journal of Financial Intermediation, Elsevier, pages 556-574.
    16. Alberto Martin, 2008. "Adverse selection, credit and efficiency: The case of the missing market," Economics Working Papers 1085, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2009.
    17. Chen, Jeff Zeyun & Lobo, Gerald J. & Wang, Yanyan & Yu, Lisheng, 2013. "Loan collateral and financial reporting conservatism: Chinese evidence," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 4989-5006.
    18. Boyd, John H. & Smith, Bruce D., 1999. "The Use of Debt and Equity in Optimal Financial Contracts," Journal of Financial Intermediation, Elsevier, pages 270-316.
    19. Ludovic Renou, 2008. "Multi-lender coalitions in costly state verification models," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 407-433.
    20. M. F. Grace & J. L. Hotchkiss, 1994. "External Impacts on the Property-Liability Insurance Cycle," Risk and Insurance 9407002, EconWPA.
    21. Stanley D. Longhofer, 1994. "Bankruptcy rules and debt contracting: on the relative efficiency of absolute priority, proportionate priority, and first-come, first-served rules," Working Paper 9415, Federal Reserve Bank of Cleveland.
    22. Stanley D. Longhofer, 1997. "Absolute priority rule violations, credit rationing, and efficiency," Working Paper 9710, Federal Reserve Bank of Cleveland.

    More about this item

    Keywords

    economic equilibrium ; investments;

    JEL classification:

    • H1 - Public Economics - - Structure and Scope of Government
    • L5 - Industrial Organization - - Regulation and Industrial Policy
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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