Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications

Abstract

Our goal is to elucidate the interaction of banks' screening effort and strategic information production in loan-backed asset markets using a general equilibrium framework. Asset quality is unobserved by investors, but banks may purchase error-prone ratings. The premium paid on highly rated assets emerges as the main determinant of banks' screening effort. The fact that rating strategies reflect banks' private information about asset quality helps keep this premium high. Conventional regulatory policies interfere with this decision margin, thereby reducing signaling value of high ratings and exacerbating the credit misallocation problem. We propose a tax/subsidy scheme that induces efficiency.

Keywords: credit misallocation, information asymmetry, information production, screening effort, rising asset complexity, mandatory rating, mandatory ratings disclosure

JEL Classification: G01, G24, G28