Is off-balance sheet funding effective in mitigating adverse selection?
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This paper focuses on the effectiveness of off-balance sheet funding in mitigating adverse selection problem in competitive credit market. Limited liability created by the off-balance sheet funding allows banks to retain sufficient funds to signal mitigating adverse selection problem.
However, it also aggravates moral hazard problem. Relaxing investors’ zero profit condition in equilibrium, adverse selection can be mitigated by a contract which violates bad banks’ participation constraint combined a small amount of signal, which is more effective.