The Downside of Asset Screening for Market Liquidity

Abstract

This paper explores the tension between asset quality and market liquidity. I model an originator who screens assets whose cash flows are later sold in secondary markets. Screening improves asset quality but gives rise to asymmetric information, hindering trade of the asset cash flows. In the optimal mechanism (second-best), costly retention of cash flows is essential to implement asset screening. Market allocations can feature too much or too little screening relative to second-best, where too much screening generates inefficiently illiquid markets. Furthermore, the economy is prone to multiple equilibria. The optimal mechanism is decentralized with two tools: retention rules and transfers.