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Optimal Disclosure and Contagion for Interconnected Banks

The paper analyzes the welfare implications of a policy of mandatory disclosure of information on the value of directly held investments by banks. It is based on a model of payments in a network where the value of a bank’s equity depends on the value of directly held investment of its trading partners, i.e. there is “contagion”. Additionally banks have a profitable investment project for which they need funding from outsiders, but due to agency problems they can only obtain financing if their equity is large enough. Furthermore, banks can, at a cost, disclose the information of their directly held investments. We find that there are equilibrium with no disclosure and no funding for new investments projects. Yet when the disclosure costs are not too large, mandatory disclosure increases ex-ante welfare of banks and outside investors if and only if contagion is severe. The difference for the social and private benefits is that an individual bank’s disclosure of the value of its directly held investment can be uninformative due to counterparty default risk. Instead, mandatory disclosure of information by all banks allows outside investors to assess the financial architecture of the system and direct their funding to the solvent banks.

Authors: 
Fernando Alvarez, University of Chicago
Gadi Barlevy, Federal Reserve Bank of Chicago
Publication Date: 
July, 2013
BFI Initiative: 
Publication Status: 
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