Three essays on financial markets and banking

Abstract

This thesis comprises theoretical work on financial markets and banking. The first essay features a model of liquidity provision. I analyze how the severity of adverse selection problems in one market is affected if alternative sources of finance, which are not subject to adverse selection problems, become more easily available. In particular, I find that the adverse selection problem can be either mitigated or amplified, giving rise to new implications for equilibrium welfare, efficiency and policy. Furthermore, I examine how and under what conditions a central bank can address a market failure during a financial crisis by using existing market institutions to re-allocate liquidity in the economy. The second essay develops a new contagion mechanism in coordination games. With our model we offer an explanation why a contagious spread of a crisis can occur even if agents learn that their country (or bank) is not exposed to crisis events elsewhere. What is more, we show that the likelihood of a spread of the crisis can be higher if agents learn that their country is not exposed to the crisis in the other country, than if agents stay uninformed about the actual exposure and believe that a cross-country exposure is possible. The third essay examines the effect of state aid on the collective competitive behavior in a repeated-game setting. We consider an application to the banking sector and find that a systematic bailout regime may increase the likelihood of (tacit) collusion in an industry characterized by idiosyncratic shocks. The reason being that state aid increases the expected profits from cooperation and simultaneously raises the probability that competitors will still be in business to carry out punishment against cheaters.