Working Paper: NBER ID: w2422
Authors: Deborah Lucas; Robert McDonald
Abstract: Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders, and assets sold will be subject to a lemons discount. Using a three-period equilibrium model we examine the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for T-bills against future liquidity needs depends both on the regulatory environment and the informational structure. If banks are ex ante identical, issuing risky debt to fund a deposit outflow is preferred to holding T-bills ex ante. However, if banks have partial knowledge of loan quality, and if their asset choice is observable, they may hold T-bills to signal their quality, enabling them to issue risky debt at a lower interest rate.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asymmetric information about asset quality (D82) | banks' decisions (G21) |
| deposit outflow (F21) | issue risky debt (F34) |
| banks' private information about loan quality (G21) | financing decisions (G32) |
| partial knowledge of loan quality (G21) | hold treasury bills (H63) |
| hold treasury bills (H63) | issue risky debt at lower interest rates (G21) |
| asymmetric information (D82) | discount on loan sales (G21) |
| optimal behavior of banks (G21) | mix of risky and risk-free assets (G11) |
| better information about assets (D83) | mitigate costs associated with asymmetric information (D82) |