A Dynamic Theory of Collateral Quality and Long-term Interventions

57 Pages Posted: 13 Dec 2017 Last revised: 30 Jul 2019

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: July 28, 2019

Abstract

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

Lee, Michael and Neuhann, Daniel, A Dynamic Theory of Collateral Quality and Long-term Interventions (July 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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