Opacity: Insurance and Fragility

Abstract

What are the effects of banks holding opaque, complex assets? Should regulators require bank assets to be more transparent? I study these questions in a model of financial intermediation where opacity determines how long the realized value of an asset remains unknown. By allowing a bank to sell assets before the realization is known, opacity provides insurance to the bank's depositors. However, higher opacity also increases depositors' incentives to join a bank run. In choosing the level of opacity, therefore, a bank faces a trade-off between providing insurance and increasing fragility. If depositors can accurately observe the level of opacity, banks will choose the socially-efficient level. If depositors are unable to observe this choice, however, banks will have an incentive to become overly opaque and regulation to limit opacity can improve welfare.

Keywords: Bank runs, Financial fragility, Opacity

JEL Classification: G21,G28