Working Paper: NBER ID: w16145
Authors: Christopher L. House; Yusufcan Masatlioglu
Abstract: We present a model in which banks trade toxic assets to raise funds for investment. The toxic assets generate an adverse selection problem and, as a consequence, the interbank asset market provides insufficient liquidity to finance investment. While the best investments are fully funded, socially efficient projects with modest payoffs are not. Investment is inefficiently low because acquiring funding requires banks to sell high-quality assets for less than their "fair" value. We then consider whether equity injections and asset purchases can improve market outcomes. Equity injections do not improve liquidity and may be counterproductive as a policy for increasing investment. By allowing banks to fund investments without having to sell high-quality assets, equity injections reduce the number of high-quality assets traded and further contaminate the interbank market. Paradoxically, if equity injections are directed to firms with the greatest liquidity needs, the contamination effect causes investment to fall. In contrast, asset purchase programs, like the Public-Private Investment Program, often have favorable impacts on liquidity, investment and welfare.
Keywords: toxic assets; equity injections; asset purchases; liquidity; adverse selection
JEL Codes: D53; D82; E22; E44; E5; G01; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| equity injections (O16) | liquidity (E41) |
| equity injections (O16) | investment (G31) |
| equity injections (O16) | sell fewer high-quality assets (G19) |
| sell fewer high-quality assets (G19) | liquidity (E41) |
| adverse selection (D82) | market price for toxic assets (G19) |
| lower market price for toxic assets (E44) | trading activity (F19) |
| asset purchase programs (G32) | liquidity (E41) |
| asset purchase programs (G32) | investment (G31) |
| asset purchases (G32) | trading in secondary market (G10) |
| asset purchases (G32) | liquidity of toxic assets (G33) |
| asset purchases (G32) | social welfare (I38) |
| equity injections (O16) | equilibrium default rate (E43) |
| equity injections (O16) | overall investment (G31) |