DP7737 | Optimal Interventions in Markets with Adverse Selection

Publication Date

14/03/2010

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

We study interventions to restore efficient lending and investment when financial markets fail because of adverse selection. We solve a design problem where the decision to participate in a program offered by the government can be a signal for private information. We charac terize optimal mechanisms and analyze specific programs often used during banking crises. We show that programs attracting all banks dominate those attracting only troubled banks, and that simple guarantees for new debt issuances implement the optimal mechanism, while equity injections and asset buyback do not. We also discuss the consequences of moral hazard.