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Equilibrium in financial markets with adverse selection


  • Tuomas Takalo

    (Bank of Finland)

  • Otto Toivanen

    (Economics Department, Helsinki School of Economics)


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.

Suggested Citation

  • Tuomas Takalo & Otto Toivanen, 2004. "Equilibrium in financial markets with adverse selection," Finance 0405001, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0405001
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    References listed on IDEAS

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    Cited by:

    1. Llewellyn, David T. & Mayes, David G., 2003. "The role of market discipline in handling problem banks," Research Discussion Papers 21/2003, 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. 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.
    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.

    More about this item


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

    JEL classification:

    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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