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Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications


Abstract: Our goal is to elucidate the interaction of banks' screening effort and strategic information production in loan-backed asset markets using a general equilibrium framework. Asset quality is unobserved by investors, but banks may purchase error-prone ratings. The premium paid on highly rated assets emerges as the main determinant of banks' screening effort. The fact that rating strategies reflect banks' private information about asset quality helps keep this premium high. Conventional regulatory policies interfere with this decision margin, thereby reducing signaling value of high ratings and exacerbating the credit misallocation problem. We propose a tax/subsidy scheme that induces efficiency.

Keywords: information asymmetry; credit misallocation; mandatory rating; mandatory ratings disclosure; screening effort; information production; rising asset complexity;

JEL Classification: G24; G01; G28;

https://doi.org/10.20955/wp.2018.018

Status: Forthcoming in Journal of Monetary Economics

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Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2019-12-05

Number: 2018-18

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