Working Paper: NBER ID: w26074
Authors: Tri Vi Dang; Gary B. Gorton; Bengt R. Holmstrom
Abstract: Short-term debt that can serve as a medium of exchange is designed to be information insensitive. No one should be tempted to acquire private information to gain an informational advantage in trading that could destabilize the value of the debt. Short-term debt minimizes the incentive to acquire information among all securities of equal value backed by the same underlying asset. These features align with observed practice in money markets (markets for short-term debt). They are also consistent with financial crises occurring periodically. In the information view adopted here, financial crisis can occur when the collateral backing the short-term debt is thought to have lost enough value to raise doubts among the traders that some may acquire private information. The purpose of this paper is to review some of the burgeoning empirical literature that bears on the information view sketched above. We focus on evidence related to three key implications of information insensitive debt: (i) adjustments to external shocks will occur along non-price dimensions (less debt issued, higher haircuts, added collateral, etc); (ii) in a crisis some of the short-term debt turns information sensitive; (iii) money markets feature low transparency as well as purposeful opacity.
Keywords: financial crises; information insensitivity; short-term debt; money markets
JEL Codes: D53; E3; G01; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Collateral backing short-term debt perceived to have lost sufficient value (G33) | Financial crises are precipitated (G01) |
| Loss of confidence in collateral (G33) | Traders consider acquiring private information (G14) |
| Loss of confidence in collateral (G33) | Short-term debt becomes information-sensitive (G32) |
| Short-term debt becomes information-sensitive (G32) | Adverse selection where no one wants the debt due to fear of loss (D82) |
| Short-term debt switches from being information-insensitive to sensitive (G19) | Creates a crisis situation where quantities adjust to zero (D59) |
| Opacity of money markets (E44) | Leads to systemic risks (F65) |
| Behavioral differences between sophisticated and unsophisticated investors (G41) | Selective redemptions and adjustments in portfolio management (G11) |