Working Paper

The Role of Dispersed Information in Pricing Default: Evidence from the Great Recession

Abstract: The recent Global Games literature makes important predictions on how financial crises unfold. We test the empirical relevance of these theories by analyzing how dispersed information affects banks' default risk. We find evidence that precise information acts as a coordination device which reduces creditors' willingness to roll over debt to a bank, thus increasing both its default risk and its vulnerability to changes in expectations. We establish two new results. First, given an unfavorable median forecast, less dispersed beliefs greatly increase default risk; this is consistent with incomplete information models that rely on coordination risk while in contrast with a wide range of models that neglect this component. Second, less dispersion of beliefs amplifies the reaction of default risk to changes in market expectations; importantly, precise information raises banks' vulnerability by more than standard measures of banks' fragility. Taken together, our results suggest that enhanced transparency, by providing agents with more precise information, increases banks' vulnerability to changes in sentiment and raises the default risk of weaker banks. Finally, we address concerns of endogeneity of market expectations by introducing a novel set of instruments.

Keywords: CDS Spreads; Coordination Risk; Dispersed Information; Financial Crisis; Global Games;

JEL Classification: D83; G01; G21;

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Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2015-08-13

Number: 2015-79

Pages: 57 pages