Overcoming Adverse Selection: How Public Intervention Can Restore Market Functioning

As illustrated by liquidity support, equity injections and asset repurchases in financial crises and by IMF credit lines to countries, authorities often intervene in order to revivemarkets that have dried up or to create new ones. In such situations, agents participate only if they receive from the governmental scheme more than in the marketplace, while the market outcome depends on who joins the scheme. The paper provides a first analysis of market jumpstarting and its two-way interaction between mechanism design and participation constraints. In themodel, sellers in need of cash have private information about the value of their legacy asset. The absence of buyer confidence forces authorities to intervene to jump-start the market. We characterize the optimal intervention, and draw two main implications. First, the government should clean up the market, through buybacks of the weakest assets and then through some equity injections, and leave the agents with the strongest legacy assets to the market. In particular, authorities should not substitute fully for the market, even when they have no comparative disadvantage in acquiring assets or shares thereof. Second, the government creates its own competition by cleaning up the market from its most toxic pieces. At the optimal intervention the government always strictly overpays for the legacy asset. Yet, and unlike what would be suggested by Coasian profit evasion, the existence of a later market imposes no welfare cost. While it is cast in a public intervention context, the analysis of mechanismdependent reservation utilities also admits important private sector applications.