Informational Frictions in Intermediated Credit Markets

Abstract

In the presence of informational frictions, bond markets aggregate the private information of firms and intermediaries, and bond prices serve as signals about the financial sector and the real economy. Such frictions amplify the credit constraints faced by intermediaries, depressing firm investment, leverage, and asset valuations and raising credit spreads. These observations are consistent with evidence on the introduction of TRACE and help explain the under-leverage and credit spread puzzles, the excess bond premium, intermediary asset pricing in bond markets, and bond market dysfunction during the last financial crisis. Informational frictions can improve welfare, suggesting limits to promoting market transparency.