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Lending to insolvent countries: a paradoxical story

Author: Cadot, Olivier INSEAD Area: Economics and Political Science Series: Working Paper ; 91/07/EPS Publisher: Fontainebleau : INSEAD, 1991.Language: EnglishDescription: 31 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: The paper considers the strategy of a bank faced with a severe case of default in its country-risk portfolio. Using a simple three-period adverse-selection model where bank managers have private information on the exact quality of their portfolio, it is shown that the bank's managers may choose to lend fresh money even to insolvent countries in order to keep them temporarily liquid on paper and postpone the spread of bad news onto financial markets. The concept of Wilson equilibrium is used to identify conditions under which such a strategy is viable
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The paper considers the strategy of a bank faced with a severe case of default in its country-risk portfolio. Using a simple three-period adverse-selection model where bank managers have private information on the exact quality of their portfolio, it is shown that the bank's managers may choose to lend fresh money even to insolvent countries in order to keep them temporarily liquid on paper and postpone the spread of bad news onto financial markets. The concept of Wilson equilibrium is used to identify conditions under which such a strategy is viable

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