Loan insurance, market liquidity, and lending standards

We examine insurance against loan default when lenders can screen in primary markets at a heterogeneous cost and learn loan quality over time. In equilibrium, low-cost lenders screen loans, but some high-cost lenders insure them. Insured loans are risk-free and liquid in a secondary market, while uninsured loans are subject to adverse selection. Loan insurance reduces the amount of lemons traded in the secondary market for uninsured loans, improves liquidity, and lowers lending standards. This pecuniary externality implies insufficient loan insurance in the liquid equilibrium. Therefore, a regulator achieves constrained efficiency by imposing a Pigouvian subsidy on loan insurance.