On December 12, 2019, Fed in Print will introduce its new platform for discovering content. Please direct your questions to Anna Oates

Home About Latest Browse RSS Advanced Search

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

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.

Download Full text
Download Summary
Cite this item
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.
More from this series
JEL Classification:
Subject headings:
Keywords: liquidity; government intervention; adverse selection; collateral
For corrections, contact Amy Farber ()
Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

Privacy Legal