Bailout Addiction: Does Bailout Anticipation Induce Adverse Selection?

The anticipation of a future bailout of distressed firms worsens ex ante adverse selection, causing a market freeze at present and inviting government intervention ("bailout trap").

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Anjan Thakor (Washington University in St. Louis, Olin Business School)

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IWH, conference room and via Zoom

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Anjan Thakor is Interim Dean, John M. Olin Business School, Director of the WFA Center for Finance and Accounting Research and John E. Simon Professor of Finance. His research interests are corporate finance, financial intermediation and economics of asymmetric information.

The anticipation of a future bailout of distressed firms worsens ex ante adverse selection, causing a market freeze at present and inviting government intervention ("bailout trap"). When firms of heterogenous qualities raise financing, high-quality firms are willing to bear adverse selection costs because they anticipate profitable opportunities to buy assets of lower-quality firms with a higher future failure probability. But search frictions in private trading impede efficiency, inviting a bailout. This reduces the ex post trading profits of buyers, dissuading ex ante participation by high-quality firms, possibly causing a freeze. This invites market-unfreezing interventions that are unnecessary absent bailout anticipation. We propose that a "capital assistance fund" may be a distortion-reducing regulatory response.

To join the lecture via ZOOM, please contact Melina Ludolph.