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Department of Finance Seminar with Professor Giulio Trigilia, University of Rochester (NY) Opaque Assets and Fragile Liabilities: a Theory of Optimal Bank Intermediation?
Abstract: We develop a theory that explains why banks are optimally designed to have fragile liabilities, consisting in runnable deposits, and opaque assets, the value of which is privately observed by the bank itself. We show that fragility and opacity are jointly necessary to implement efficient, second-best allocations in the presence of asymmetric information between borrowers and lenders. Specifically, opacity and fragility work together to prevent banks from facing a soft budget constraint problem whenever the credit market is sufficiently risky. In contrast, more transparent intermediaries, such as fintech lenders, dominate bank lending whenever the credit market is sufficiently safe. Our new channel for why opacity and fragility are central in banking activities generates novel, testable implications, and overturns standard intuition from existing models prevalent in the banking literature.