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Equilibrium in financial markets with adverse selection

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  • Takalo, Tuomas
  • Toivanen, Otto

Abstract

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

  • Takalo, Tuomas & Toivanen, Otto, 2003. "Equilibrium in financial markets with adverse selection," Bank of Finland Research Discussion Papers 6/2003, Bank of Finland.
  • Handle: RePEc:zbw:bofrdp:rdp2003_006
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    Cited by:

    1. Vesala, Timo, 2004. "Asymmetric information in credit markets and entrepreneurial risk taking," Research Discussion Papers 14/2004, Bank of Finland.
    2. Llewellyn, David T. & Mayes, David G., 2003. "The role of market discipline in handling problem banks," Bank of Finland Research Discussion Papers 21/2003, Bank of Finland.
    3. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, University Library of Munich, Germany.
    4. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, University Library of Munich, Germany.
    5. Guender, Alfred V., 2003. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Bank of Finland Research Discussion Papers 12/2003, Bank of Finland.
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    More about this item

    Keywords

    financial market efficiency; adverse selection; financial contracts; creation of firms;
    All these keywords.

    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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