Kathryn Judge (Columbia Law School) has posted Information Gaps and Shadow Banking (Virginia Law Review, (2017)) on SSRN. Here is the abstract:
The healthy functioning of most financial markets depends on the willingness of market participants to acquire financial claims without complete information about the assets underlying those claims. Equity and money markets resolve this challenge in fundamentally different ways. Equity markets, like the New York Stock Exchange, “level up” the informational playing field through publicly observable prices that contain meaningful information about the value of underlying assets. This works because the same processes that reward sophisticated investors for engaging in costly information gathering move prices to more efficient levels. Money markets, by contrast, “level down” the informational playing field through claim structures that make it costly and unrewarding for claimants to acquire superior information about the underlying assets. A person acquiring a money claim, such as a bank deposit or shares in a money market mutual fund, instead relies on a proxy indicating that the claim is exceptionally low risk coupled with a right to exit, quickly and at face value, as a substitute for perfect information. This makes money markets highly liquid most of the time but it also contributes to their inherent instability. In synthesizing insights from financial economists and legal academics and examining the regulatory architecture in light of those understandings, this Article provides the first comprehensive account of the ways that the distinct informational incentives of equity and money claimants can explain much of securities and bank regulation.
This Article uses this foundation to reveal the fundamental mismatch between the existing financial regulatory paradigms and the distinct challenges posed by the large and growing “shadow banking system.” The shadow banking system fulfills many of the economic functions long played by banks but because it operates largely in the capital markets, it is largely governed by the disclosure-oriented rules that arose to govern equity markets. As a result, there are structural reasons to expect shadow banking will lead to large information gaps, that is, pockets of pertinent and theoretically knowable information that is not actually known by any market participant or regulator. The Article further shows how information gaps can render a system more vulnerable to a panic and impede the market-based and regulatory processes that can help restore stability once a panic takes hold. By demonstrating how shadow banking leads to information gaps and the ways those gaps contribute to fragility, this Article sheds new light on the regulatory challenges posed by shadow banking.
Interesting and recommended.