By Koralai Kirabaeva
Abstract: This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.
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