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| Title: | | Adverse selection, liquidity, and market breakdown  |
| Authors: | | Kirabaeva, Koralai |
| Issue Date: | | 2010 |
| Series/Report no.: | | Bank of Canada Working Paper 2010,32 |
| Abstract: | | This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness. |
| Subjects: | | Financial institutions Financial markets Financial stability |
| JEL: | | G01 G11 D82 |
| Document Type: | | Working Paper |
| Appears in Collections: | | Bank of Canada Working Papers
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