Information and credit frictions in financial markets

Abstract

This thesis investigates theoretically how information and credit frictions affect the functioning of financial markets. I suggest that asymmetry of information about opaque assets may cause instability. The widespread use of these assets as collateral contributed to a severe credit contraction during the recent crisis. In this context, I propose a theory of collateral re-use, a technique designed to overcome shortages of high quality assets to secure credit. The first chapter shows that information frictions generate liquidity uctuations whereby asset prices move endogenously. In the model, buyers meet sellers in a decentralized market and do not know their asset quality. Prices and volume increase with the average quality of sellers since buyers are more willing to trade. However, high trading volume depletes the pool of future high quality sellers. Cyclical equilibria in price and volume are thus sustained endogenously. Temporary asset purchase programs can revive the market and smooth out uctuations. Finally, I show that increasing market centralization may harm liquidity provision and reduce welfare. The second chapter introduces collateral re-use in an economy where agents face limited commitment and must pledge a durable asset to borrow. Lenders may then re-sell a pledged asset or re-pledge it to secure further borrowing. Since lenders may now default and fail to return the collateral, net gains from collateral circulation are ambiguous. I show that benefits are larger in decentralized markets when agents trade trough intermediaries. The third chapter, joint with Piero Gottardi and Cyril Monnet, complements this analysis, focusing on repurchase agreements. In a repo, the borrower sells an asset to raise income and commits to a repurchase price to limit exposure to future market risk. If defaulting borrowers incur a cost over and above the loss of collateral, re-use is beneficial and increases leverage. We show that intermediation now arises endogenously: trustworthy agents - those with high cost of default - re-use collateral to borrow on behalf of riskier counterparties.