Adverse Selection and the Government Intervention Trap

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ID: 329398
2026
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Abstract
Abstract In a dynamic setting, high-quality firms may tolerate current adverse selection when raising financing because they expect future opportunities to profitably acquire assets from failed lower-quality firms. But search frictions in asset trading impede efficiency, inviting government intervention. Anticipation of such intervention affects ex ante adverse selection and project investment because it reduces buyers’ ex post trading profits. Depending on parameter values, this anticipation can have either pernicious or salutary effects. The pernicious effect reduces participation by high-quality firms, worsens adverse selection, and depresses project investment, potentially triggering investment-enhancing government assistance (an “intervention trap”). The salutary effect mitigates adverse selection and increases project investment.
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openalex_W7213987662 Use this key to autocite in the manuscript while using SciMatic Manuscript Manager or Thesis Manager
Authors Fenghua Song, Anjan Thakor
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Journal review of financial studies
Year 2026
DOI
10.1093/rfs/hhag081
URL
https://doi.org/10.1093/rfs/hhag081
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