Abstract: Conventional wisdom holds that the models used to stress test banks should be kept secret to prevent gaming. We show instead that secrecy can be suboptimal, because although it deters gaming, it may also deter socially desirable investment. When the regulator can choose the minimum standard for passing the test, we show that secrecy is suboptimal if the regulator is sufficiently uncertain regarding bank characteristics. When failing the bank is socially costly, then under some conditions, secrecy is suboptimal when the bank's private cost of failure is either sufficiently high or sufficiently low.
Winner of the 2014 PhD Outstanding Paper Award in Honor of Stuart I. Greenbaum, Washington University in St. Louis
Abstract: A large finance literature has studied the signaling role of retention. Against this literature, I first present a puzzle: in the presence of search frictions, only liquidity (matching probability) screens sellers; retention is inefficient and not used at all for screening. I then propose a resolution to the puzzle by expanding the space of private information to include not only asset quality but also seller patience, showing that both liquidity and retention may be used to fully separate both dimensions of private information. The expanded model offers new predictions about how price, quantity, and liquidity covary with each other and with seller private information.
Abstract: How informative should bank stress tests be? I use Bayesian persuasion to formalize stress tests and show that regulators can reduce the likelihood of a bank run by performing tests which are only partially informative. Fully disclosing stress tests are never strictly optimal, and I find conditions under which full disclosure is worse than no disclosure. Optimal stress tests give just enough failing grades to keep passing grades credible enough to avoid runs. I find that optimal stress tests, by reducing the probability of runs, reduce the optimal level of banks' liquidity cushions. I also examine the impact of anticipated stress tests on banks' ex ante incentive to invest in risky versus safe assets.