“A detrimental feedback loop: deleveraging and adverse selection” (This version: February 2015; First version: September 2013).
Market distress can be the catalyst of a deleveraging wave, as in the 2007/08 financial crisis. This paper demonstrates how market distress and financial sector deleveraging can fuel each other in the presence of adverse selection problems in an opaque asset market segment. At the core of the detrimental feedback loop is investors’ desire to reduce their reliance on the distressed opaque market by decreasing their leverage which in turn amplifies adverse selection in the opaque market segment. In the extreme, trade in the opaque asset market segment breaks down. I find that adverse selection is at the root of two inefficiencies: it distorts both investors’ long-term leverage choices and investors’ short-term liquidity management. I derive implications for central bank policy and highlight the ambiguous role played by transparency. (JEL D82, E58, G01, G20)