“Persuading Multiple Audiences: An Information Design Approach to Banking Regulation”
Abstract: A policy maker concerned with the potential default of a bank sequentially conducts an asset quality review and a liquidity stress test under the scrutiny of multiple types of market participants (audiences). Surprisingly, the optimal comprehensive assessment (asset quality review and stress test) is opaque when the bank has high-quality assets, and transparent when the bank has poor-quality assets. The optimal policy also imposes contingent recapitalizations. Without them, disclosure of information may backfire and the bank may fare worse than under laissez faire. To deal with sudden liquidity shocks the policy maker optimally designs a persuasion mechanism that resembles an emergency lending facility, which (a) provides funds to banks in exchange for assets, and (b) discloses information about the bank’s liquidity. Interestingly, imposing capital requirements hurts the effectiveness of the emergency lending program. In fact, public and private sector interventions are substitutes, and combinations of the two are strictly suboptimal. There exists a non-monotone pecking order: the private sector funds banks with either high or poor-quality assets, while institutions with intermediate-quality assets participate in the government’s emergency lending mechanism. My results shed light on the role information disclosure as a regulatory tool in environments with multiple audiences and multi-dimensional fundamentals.
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