Time Varying Adverse Selection

Although most market imperfections have been shown to be coun-tercyclical in severity, adverse selection costs may be procyclical. On one hand, given a fixed set of borrowers, improvements in economic conditions raise creditworthiness, which lowers the interest rates de-manded by competitive lenders. However, the quality of the borrower pool is not fixed: improved economic opportunities can draw in pro-gressively lower quality firms, preventing higher quality firms from capturing the additional surplus in economic expansions. ∗Assistant Professor of Finance, Leeds School of Business, University of Colorado. I would like to thank Kerry Back, Jeroen Swinkels and John Nachbar for comments on a chapter of my dissertation on which this article is based. I would like to thank Jaime Zender and Eric Hughson for additional comments