A Dynamic Theory of Collateral Quality and Long-term Interventions
57 Pages Posted: 13 Dec 2017 Last revised: 30 Jul 2019
Date Written: July 28, 2019
We study a dynamic model of collateralized lending under adverse selection in which the quality of collateral assets is endogenously determined by hidden effort. Complementarities in incentives lead to non-ergodic dynamics: asset quality and output grow when asset quality is high, but stagnate or deteriorate otherwise. Inefficiencies remain even in the most efficient competitive equilibrium -- investment and output are vulnerable to spells of lending market illiquidity, and these spells may persist because of sub-optimal effort. Nevertheless, benevolent regulators without commitment can destroy welfare by prioritizing liquidity over incentives. Optimal interventions with commitment call for large, long-term subsidies in excess of what is required to restore liquidity.
Keywords: Collateral, Liquidity, Financial Regulation, Financial Intermediation, Adverse Selection, Moral Hazard, Financial Crises
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation