Bailout Addiction: Does Bailout Anticipation Induce Adverse Selection?

Abstract

The anticipation of a future bailout of distressed firms worsens ex ante adverse selection, causing a market freeze at present and inviting government intervention ("bailout trap"). When firms of heterogenous qualities raise financing, high-quality firms are willing to bear adverse selection costs because they anticipate profitable opportunities to buy assets of lower-quality firms with a higher future failure probability. But search frictions in private trading impede efficiency, inviting a bailout. This reduces the ex post trading profits of buyers, dissuading ex ante participation by high-quality firms, possibly causing a freeze. This invites market-unfreezing interventions that are unnecessary absent bailout anticipation. We propose that a "capital assistance fund" may be a distortion-reducing regulatory response.

Keywords: Adverse Selection, Market Freeze, Government Bailout

JEL Classification: D82, G01, G28