Sowing the Seeds of Financial Crises: Endogenous Asset Creation and Adverse Selection

Abstract

What sows the seeds of financial crises and what policies can help avoid them? To address these questions, I model the interaction between the ex-ante production of assets and ex-post adverse selection in financial markets. My results indicate that taking into account the endogenous asset supply is crucial. Positive shocks that increase market liquidity and prices exacerbate the production of low-quality assets. Indeed, I show that this can increase the likelihood of a financial market collapse. Government policies also have subtle effects. I show that an increase in government bonds increases total liquidity and reduces the incentives to produce bad assets, but can exacerbate adverse selection in private asset markets. Optimal policy balances these two effects, requiring more issuances when the liquidity premium is high. I also study transaction taxes and asset purchases, showing that policy should lean against the wind of market liquidity.