Asymmetric group loans,non-assortative matching and adverse selection

This paper shows that an asymmetric group debt contract, where one borrower co-signs for another, but not vice versa, leads to heterogeneous matching. The analysis suggests that micro finance organizations can achieve the first best by offering asymmetric group contracts.     

Equilibrium in a decentralized market with adverse selection

Summary. This paper deals with trade volume and distribution of surplus in markets subject to adverse selection. In a model where two qualities of a good exist, I show that if trade is decentralized (i.e. conducted via random pairwise meetings of agents), then all units of the good are traded, and all agents have positive ex-ante expected payoffs. This feature is present regardless of the quality distribution, and persists in the limit as discounting is made negligible. This offers a sharp contrast to models of centralized trade with adverse selection (Akerlof, Wilson). Received: April 2, 2001; revised version: March 29, 2002 RID="*" ID="*" This research was funded by a grant from UQAM. I wish to thank Roberto Serrano and seminar participants at UQAM, Queen's University at Kingston, the 2001 CEME General Equilibrium Conference (Brown University), and the 2001 North American Summer Meeting of the Econometric Society (University of Maryland) for comments.     

Industrial loans and market structure

Based on the observation that financing is one of the main obstacles to create new firms, this paper deals with the interactions between the market structure of both the banking sector and the borrowing industries. We consider that firms’ installation costs are financed by means of industrial loans from specialized banks. With endogenous entry in banking activity as well as in the borrowing industry, we find that a natural oligopoly emerges in both sectors if the entry cost in the industrial sector is small enough, relative to the banks’ entry cost.     

Minimum standards, insurance regulation and adverse selection: evidence from the Medigap market

This paper examines the implications of minimum standards for insurance markets. I study the imposition of binding minimum standards on the market for voluntary private health insurance for the elderly. The central estimates suggest that the introduction of the standards was associated with an 8 percentage point (25%) decrease in the proportion of the population with coverage in the affected market, with no evidence of substitution toward other, unregulated sources of insurance coverage. To explore possible factors contributing to the impact of the minimum standards, I develop comparative static predictions of the impact of imposing minimum standards in an insurance market with adverse selection. The observed changes in market equilibrium associated with the minimum standards are broadly consistent with these predictions, providing evidence of the existence of adverse selection in this insurance market. More importantly, they suggest that the presence of adverse selection—which in principle may provide an economic rationale for minimum standards—in practice may have exacerbated the declines in insurance coverage associated with the minimum standards.     

Interest rate policy and interbank market breakdown

Using a DSGE-model with interbank market frictions, calibrated to match the frequency of financial crises, I investigate central banks' ability to prevent credit-related recessions by following an interest rate rule which accounts for financial conditions —an approach called ‘leaning against the wind’. The model's key feature is that boom-bust cycles emerge as a result of a savings glut and moral hazard in the banking sector. Although financial conditions predict crises, the policy maker cannot break the boom-bust cycle and reduce the crisis-frequency. When crises become more likely, low inflation forces the central bank to decrease the interest rate despite its intention to do otherwise. Responding to crisis-predictors eventually dilutes the primary objective of stabilizing inflation and leads to higher inflation volatility. The results suggest that central banks should refrain from leaning against the wind.     

Liquidity supply and adverse selection in a pure limit order book market

This paper analyzes adverse selection costs and liquidity supply in a pure open limit order book market. We relax assumptions of the Glosten/Såndas modeling framework regarding marginal zero profit order book equilibrium and the parametric market order size distribution. We show that using average zero profit conditions considerably increases the empirical performance while a nonparametric specification for market order size combined with marginal zero profit conditions does not. A cross sectional analysis corroborates the finding that adverse selection costs are more severe for smaller capitalized stocks. We also find additional support for one of the central hypothesis put forth by the theory of limit order book markets, which states that liquidity supply and adverse selection costs are inversely related. Furthermore, adverse selection cost estimates based on our structural model and those obtained using popular model-free methods are strongly correlated. This indicates the robustness of the theory-based approach.     

Multiple equilibrium overnight rates in a dynamic interbank market game

We analyse a two-period model of the interbank market, i.e. the market where banks trade liquidity. We assume that banks do not take the interbank interest rate as given, but instead negotiate on interest rates and transaction volumes with each other. The solution concept applied is the Shapley value. We show that there are a multiplicity of average equilibrium interest rates of the first period so that the average interest rate in this period does not convey any information on the expected liquidity situation on the interbank market. As the banks control not only the transaction volumes, but also the interest rates, they can leave the interest rates constant and adjust the transaction volumes when, for example, a liquidity deficit becomes more likely.     

Conformism,peer pressure and adverse selection

To examine the effects of peer pressure in adverse selection problem, we define a peer pressure function that represents the psychological costs and incorporate it into the agent's utility function. Based on these assumptions, the efficient agent who has conformity preference produces less outputs than the first-best level, while the inefficient agent produces more than the second-best level of standard adverse selection output when the agents feel peer pressure among themselves. Although the production gap between the utility functions under peer pressure narrows, the gap of the ex post information rent goes wider as the information rent of efficient agents increases. Our theoretical results are consistent with some empirical/experimental findings.     

Assortative matching, adverse selection, and group lending

This note reconsiders a theoretical result asserted to explain the success of group lending programs in LDCs. It has been claimed that if groups are allowed to form themselves, risky and safe borrowers will sort themselves into relatively homogenous groups. This “positive assortative matching” can be exploited by lenders to solve an adverse selection problem that would otherwise undermine the effectiveness of such lending programs. I show that the positive assortative matching result does not necessarily hold if earlier models are extended to incorporate dynamic incentives.     

Bad loans,soft budget constraints and the political economy of financial market reform in transition economies

Financial market imperfections and especially the bad debt problem are among the most important factors impeding economic restructuring in transition economies. This paper analyses the implications of non-performing loans for the lending policy of banks and for the ensuing allocation of credit. It is shown that a lending bias exists in favour of old debtors, which not only impedes structural change but may also counteract policies intended to harden budget constraints and to promote restructuring. The paper also discusses from a political economy perspective, why despite these negative implications financial market reforms were not pursued more forcefully in most countries.     

A model of collateral, investment, and adverse selection

This paper characterizes the relationship between entrepreneurial wealth and aggregate investment under adverse selection. Its main finding is that such a relationship need not be monotonic. In particular, three results emerge from the analysis: (i) pooling equilibria, in which investment is independent of entrepreneurial wealth, are more likely to arise when entrepreneurial wealth is relatively low; (ii) separating equilibria, in which investment is increasing in entrepreneurial wealth, are most likely to arise when entrepreneurial wealth is relatively high and; (iii) for a given interest rate, an increase in entrepreneurial wealth may generate a discontinuous fall in investment.     

Dynamic adverse selection and the supply size

In this paper we examine the problem of dynamic adverse selection in a stylized market where the quality of goods is a seller׳s private information while the realized distribution of qualities is public information. We obtain that full trade occurs in every dynamic competitive equilibrium. Moreover, we show that if prices can be conditioned on the supply size then a dynamic competitive equilibrium always exists, while it fails to exist if prices cannot be conditioned on the supply size and the frequency of exchanges is high enough. We conclude that the possibility to condition prices on the supply size allows us to reach efficiency in the limit for exchanges becoming more and more frequent, while otherwise the welfare loss due to delays of exchanges remains bounded away from zero.     

Conservative traders,natural selection and market efficiency

This paper examines the impact of conservative traders on market efficiency in an evolutionary model of a commodity futures market. This paper shows that the long-run market outcome is informationally efficient, as long as in every period there is a positive probability that entering traders are more conservative than their predecessors. Conservative traders are those who correctly predict the spot price with a positive probability, and more importantly, who in their mistakes err on the side of caution, and rarely overpredict the spot price as buyers, and underpredict the spot price as sellers. This result does not require entry of traders with better information than their predecessors.     

Internal selection and market selection in economic Genetic Algorithms

Genetic algorithms have been established as an alternative to neoclassical optimization for the illustration of economic agents’ behavior. Critics however, doubt they depict the particularities of social evolution, because they fail to describe intentional behavior. The current paper argues that advocates as well as critics of the procedure have overlooked the crucial necessity to distinguish between internal and external selection in the economy and to include both in economic Genetic Algorithms. The paper claims that such a differentiation will allow the model to depict intentional decisions as well as market selection and help to understand the effects of bounded rationality. It illustrates this point with a brief example modeled after the new-versus-new competition between lean-burn engines and catalysts in the 70th.     

Moral hazard,adverse selection,and the optimal provision of social insurance

The single-period social insurance model of Diamond and Mirrlees is extended to allow for a diversity of types (in the probability of becoming disabled). When individual type is observable, the utilitarian optimum has both consumption when working and disability benefits increasing with the probability of disability. When type is not observable (adverse selection is present), the optimum is a single ‘pooling’ policy over a wide range of welfare weights which includes the utilitarian case. These results also provide insights into the potential distributional effects of moral hazard and the ways moral hazard and adverse selection problems may interact.     

Search costs and the severity of adverse selection

In view of some recent empirical evidence, I suggest a relationship between the magnitude of search costs and the severity of adverse selection in the context of a dynamic model with asymmetric information. In markets with small search costs sellers with low quality products misrepresent their quality and demand a high price. If search costs are not negligible, sellers׳ price offers are truthful and all product qualities are traded over time. In markets with small search costs, a budget balanced mechanism can mitigate adverse selection: sellers should pay a per period market participation tax and receive a rebate after trading.     

Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?

Credit risk associated with interbank lending may lead to domino effects, where the failure of one bank results in the failure of other banks not directly affected by the initial shock. Recent work in economic theory shows that this risk of contagion depends on the precise pattern of interbank linkages. We use balance sheet information to estimate a matrix of bilateral credit relationships for the German banking system and test whether the breakdown of a single bank can lead to contagion. We find that in the absence of a safety net, there is considerable scope for contagion that could affect a large proportion of the banking system. The financial safety net (in this case institutional guarantees for saving banks and cooperative banks) considerably reduces—but does not eliminate—the danger of contagion. Even so, the failure of a single bank could lead to the breakdown of up to 15% of the banking system in terms of assets.     

Reputation for quality and adverse selection

We analyze a dynamic market with a seller who can make a one-time investment that affects the returns of tradable assets. The potential buyers of the assets cannot observe the seller׳s investment prior to the trade or verify it in any way after the trade. The market faces two types of inefficiency: the ex-ante inefficiency, i.e., the seller׳s moral hazard problem, and the ex-post inefficiency, i.e., inefficient ex-post allocations due to the adverse selection problem. We analyze how the observability of information by future buyers, through which the seller builds a reputation, affects the two types of inefficiency as well as the interplay between them.