A Dynamic Theory of Collateral Quality and Intervention Traps
42 Pages Posted: 13 Dec 2017 Last revised: 10 Feb 2022
Date Written: February 28, 2019
We propose a dynamic model of collateralized lending with asymmetric information in which (i) an asset class can be used as collateral only if average quality is sufficiently high, and (ii) quality improves if borrowers exert hidden effort but slowly declines otherwise. Equilibrium asset quality is sensitive to initial conditions and self-fulfilling beliefs about future quality. Under the most favorable beliefs, quality grows only if initial quality is sufficiently high, and small shocks may trigger persistent lending freezes. Even when equilibrium effort is inefficient, optimal policy under limited commitment can induce harmful intervention traps with falling quality and rising subsidies.
Keywords: Collateral, Liquidity, Financial Regulation, Financial Intermediation, Adverse Selection, Moral Hazard, Financial Crises
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation