Understanding the role of debt in the financial system

Bengt Holmstrom

No 479, BIS Working Papers from Bank for International Settlements

Abstract: 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 (search for similar items in EconPapers)
Pages: 43 pages
Date: 2015-01
New Economics Papers: this item is included in nep-ban, nep-cta and nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (37)

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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:479

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