A Dynamic Theory of Collateral Quality and Long-Term Interventions

58 Pages Posted: 7 Aug 2019

See all articles by Michael Junho Lee

Michael Junho Lee

Federal Reserve Banks - Federal Reserve Bank of New York

Daniel Neuhann

University of Texas at Austin, McCombs School of Business

Date Written: August 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 suboptimal 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: liquidity, government intervention, adverse selection, collateral

JEL Classification: E44, E50, G01, G18

Suggested Citation

Lee, Michael Junho and Neuhann, Daniel, A Dynamic Theory of Collateral Quality and Long-Term Interventions (August 2019). FRB of New York Staff Report No. 894, August 2019. Available at SSRN: https://ssrn.com/abstract=3433358 or http://dx.doi.org/10.2139/ssrn.3433358

Michael Junho Lee (Contact Author)

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

33 Liberty Street
New York, NY 10045
United States

Daniel Neuhann

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

Austin, TX 78701
United States

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