Understanding the Role of Debt in the Financial System

42 Pages Posted: 22 Jan 2015

See all articles by Bengt Holmstrom

Bengt Holmstrom

Massachusetts Institute of Technology (MIT)

Date Written: January 2015


Money markets are fundamentally different from stock markets. Stock markets are about price discovery for the purpose of allocating risk efficiently. Money markets are about obviating the need for price discovery using over-collateralised debt to reduce the cost of lending. Yet, attempts to reform credit markets in the wake of the recent financial crisis often draw on insights grounded in our understanding of stock markets. This can be very misleading. The paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why opacity often enhances liquidity in credit markets and therefore why all financial panics involve debt. These basic insights into the nature of debt and credit markets are simple but important for thinking about policies on transparency, on capital buffers and other regulatory issues concerning banking and money markets.

Keywords: financial crisis, liquidity, money markets, shadow banking, debt, information sensitivity, pawn shops, bailouts, banking regulation

JEL Classification: E32, E52, G01, G15, G18, G20, G21, G28, G29

Suggested Citation

Holmstrom, Bengt, Understanding the Role of Debt in the Financial System (January 2015). BIS Working Paper No. 479, Available at SSRN: https://ssrn.com/abstract=2552018

Bengt Holmstrom (Contact Author)

Massachusetts Institute of Technology (MIT)

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