Overcoming Adverse Selection: How Public Intervention Can Restore Market Functioning

Abstract

The paper provides a first analysis of market jump starting and its two-way interaction between mechanism design and participation constraints. The government optimally overpays for the legacy assets and cleans up the market of its weakest assets, through a mixture of buybacks and equity injections, and leaves the firms with the strongest legacy assets to the market. The government reduces adverse selection enough to let the market rebound, but not too much, so as to limit the cost of intervention. The existence of a market imposes no welfare cost. (JEL D82, D83, G01, G31, H81)

A Model of Optimal Corporate Bailouts

“…Our's is a direct subsidy (because any government stake raises the required subsidy to entice private participants). In Tirole (2011), there is a spillover aspect of bailouts. The bailout of one firm raises the cost of the next bailout.…”

Interventions in Markets with Adverse Selection: Implications for Discount Window Stigma

“…More recently, Gauthier et al (2015), Li, Milne, and Qiu (2016), and Gorton and Ordoñez (2016) also discuss models where discount window stigma plays a role. Philippon and Skreta (2012) and Tirole (2012) tackle the general question of how to optimally design government programs aimed at intervening in financial markets. While some form of stigma can certainly be present in their setups, they do not provide a thorough discussion of the nature of stigma in those environments.…”

“…3 In both models, firms are in possession of a legacy asset and a new investment project, for which they need external funding. In Tirole (2012), the return on new investment is observable and verifiable, which allows firms to enter contracts that are contingent on it (including buybacks). This is the main difference with the model in Philippon and Skreta (2012), where only total income of the firm is observable.…”

“…This is the main difference with the model in Philippon and Skreta (2012), where only total income of the firm is observable. Additionally, the return on new projects is non-stochastic in Tirole (2012), limiting the role of imperfect inference and stigma in the static game he considers. 4…”

Should We Have or Should We Have Not, and Who Should Have Paid?

“…Veronesi and Zingales 2010 as well as Bayazitova and Shivdasani 2009). Our analysis is most closely related to the literature which examines the impact of intervention in environments with informational asymmetries (see, e.g., Dang, Gorton and Holmström 2009, Tirole 2010, Uhlig 2009 and the literature therein). While the focus of that literature is on liquidity provision, we are mainly interested in the risk-related allocative role of the financial market and the dynamics of the economy within a simple informational structure.…”