The Hidden Costs of Strategic Opacity

Abstract

We explore a model in which banks strategically hold interconnected and opaque portfolios, despite increasing the likelihood they are subject to financial crises. In our framework, banks choose their degree of exposure to other banks to influence how investors can use their information. In equilibrium banks choose portfolios which are neither fully opaque, nor fully transparent. However, their portfolios are interconnected beyond what is beneficial for diversification purposes. Banks can create a degree of opacity that decreases welfare, and makes bank crises more likely. Our model is suggestive about the implications of asset securitization, as well as government bailouts.