Equilibrium in Financial Markets with Adverse Selection

Bank of Finland Discussion Paper No. 6/2003

48 Pages Posted: 2 Oct 2003

See all articles by Tuomas Takalo

Tuomas Takalo

Bank of Finland

Otto Toivanen

Aalto University - Department of Economics; KU Leuven - Faculty of Business and Economics (FBE); CEPR; Helsinki Center of Economic Research (HECER)

Date Written: March 4, 2003

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.

JEL Classification: D58, G14, G20, G28, G32

Suggested Citation

Takalo, Tuomas and Toivanen, Otto, Equilibrium in Financial Markets with Adverse Selection (March 4, 2003). Bank of Finland Discussion Paper No. 6/2003, Available at SSRN: https://ssrn.com/abstract=438422 or http://dx.doi.org/10.2139/ssrn.438422

Tuomas Takalo (Contact Author)

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

Otto Toivanen

Aalto University - Department of Economics ( email )

PO Box 1210
FI-00101 Helsinki
Finland

KU Leuven - Faculty of Business and Economics (FBE) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

CEPR ( email )

London
United Kingdom

Helsinki Center of Economic Research (HECER)

FI-00014 Helsinki
Finland

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