The Information View of Financial Crises

39 Pages Posted: 10 Jul 2019 Last revised: 2 Aug 2019

See all articles by Tri Vi Dang

Tri Vi Dang

Columbia University - Department of Economics

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER); Yale University - Yale Program on Financial Stability

Bengt R. Holmström

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

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Date Written: July 8, 2019

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. Moreover, backing short-term debt with debt (i.e. using debt as collateral) minimizes information sensitivity across all types of collateral with equal value. 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. In a crisis, there is a shift from information insensitive to information sensitive debt.

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.

Suggested Citation

Dang, Tri Vi and Gorton, Gary B. and Holmström, Bengt R., The Information View of Financial Crises (July 8, 2019). Yale ICF Working Paper No. 2019-15, Available at SSRN: https://ssrn.com/abstract=3416824 or http://dx.doi.org/10.2139/ssrn.3416824

Tri Vi Dang

Columbia University - Department of Economics ( email )

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Gary B. Gorton (Contact Author)

Yale School of Management ( email )

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Yale University - Yale Program on Financial Stability

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Bengt R. Holmström

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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