Optimal Information and Security Design

Abstract

An asset owner designs an asset-backed security and a signal about its value. After experiencing a liquidity shock and privately observing the signal, he sells the security to a monopolistic buyer. Within double-monotone securities, asset sale is uniquely optimal, which corresponds to the most informationally sensitive security. Debt is a constrained optimum under external regulatory liquidity requirements on securities. Thus, the “folk intuition” behind optimality of debt due to its low informational sensitivity holds only under additional restrictions on security/information design. Within monotone securities, a live-or-die security is optimal, whereas additional-tier-1 debt is optimal under the regulatory liquidity requirements.

Keywords: security design, asymmetric information, information design

JEL Classification: D82, D86, G32