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Federal Reserve Bank of New York
Staff Reports
A Dynamic Theory of Collateral Quality and Long-Term Interventions
Michael Junho Lee
Daniel Neuhann
Abstract

We study a dynamic model of collateralized lending under adverse selection in which the quality of collateral assets is endogenously determined by hidden effort. Complementarities in incentives lead to non-ergodic dynamics: Asset quality and output grow when asset quality is high, but stagnate or deteriorate otherwise. Inefficiencies remain, even in the most efficient competitive equilibrium—investment and output are vulnerable to spells of lending market illiquidity, and these spells may persist because of suboptimal effort. Nevertheless, benevolent regulators without commitment can destroy welfare by prioritizing liquidity over incentives. Optimal interventions with commitment call for large, long-term subsidies in excess of what is required to restore liquidity.


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Michael Junho Lee & Daniel Neuhann, A Dynamic Theory of Collateral Quality and Long-Term Interventions, Federal Reserve Bank of New York, Staff Reports 894, 07 Aug 2019.
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Keywords: liquidity; government intervention; adverse selection; collateral
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