A Model of Collateral, Investment, and Adverse Selection

Abstract

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.

Securitization Under Asymmetric Information Over the Business Cycle

“…Kurlat (2013) models a similar adverse selection problem in an extension of Kiyotaki and Moore (2012) and shows that the proportion of sellers of high-quality assets is lower in a recession, which can lead to market shutdowns. Martin (2009) shows that the relationship between entrepreneurial wealth and aggregate investment, which is the basis of the already-mentioned "financial accelerator," may not be monotonic. In particular, in states with low entrepreneurial wealth, screening of borrowers using collateral requirements may be too costly, and therefore the economy is in a pooling equilibrium, in which good borrowers cross-subsidize bad borrowers.…”

Adverse Selection, Credit, and Efficiency: The Case of the Missing Market

“…In a sense, then, markets that remain inactive in equilibrium do so despite their expected returns and not because of them. 12 …”

“…for which  ≤ ) are such that bad entrepreneurs are indifferent between issuing in them or not. 12 The methodology to determine whether a certain allocation is an equilibrium or not boils down to checking whether entrepreneurs find it profitable to deviate from it and issue promises in a different market ( ), where possibly only the external agent is active. If there is such a market ( ) to which -for a given price of promises…”

“…Also as in monitored markets, Equation (12) illustrates that it is important to specify the returns of those unmonitored markets that are inactive in equilibrium.…”

“…1 In its modeling of the particular form of asymmetric information in a production economy our paper draws mostly from Martin (2009), which is in turn closely related to the work of Stiglitz and Weiss (1981) and Bester (1985Bester ( , 1987. A key difference between our setting and most of those analyzed by the previous literature is that we allow for a concave investment function, so that the size of projects is determined endogenously in equilibrium.…”