Abstract:
We examine insurance against loan default when lenders can screen in primary markets at a heterogeneous cost and learn loan quality over time. In equilibrium, low-cost lenders screen loans but some high-cost lenders insure them. Insured loans are risk-free and liquid in a secondary market, while uninsured loans are subject to adverse selection. Loan insurance reduces the amount of lemons traded in the secondary market for uninsured loans and improves liquidity and welfare. This pecuniary externality implies insufficient loan insurance in the liquid equilibrium. To achieve constrained efficiency, a regulator (i) guarantees a minimum price in the market for uninsured loans to eliminatea welfare-dominated illiquid equilibrium; and (ii) imposes Pigouvian subsidies on loan insurance in the liquid equilibrium to correct for the externality.
