A Dynamic Theory of Collateral Quality and Intervention Traps

42 Pages Posted: 13 Dec 2017 Last revised: 10 Feb 2022

See all articles by Michael Lee

Michael Lee

Federal Reserve Banks - Federal Reserve Bank of New York

Daniel Neuhann

University of Texas at Austin, McCombs School of Business

Date Written: February 28, 2019

Abstract

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

Lee, Michael and Neuhann, Daniel, A Dynamic Theory of Collateral Quality and Intervention Traps (February 28, 2019). Available at SSRN: https://ssrn.com/abstract=3087374 or http://dx.doi.org/10.2139/ssrn.3087374

Michael Lee

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Daniel Neuhann (Contact Author)

University of Texas at Austin, McCombs School of Business ( email )

Austin, TX 78701
United States

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