Information Panics and Liquidity Crises

Abstract

This paper studies endogenous liquidity crises as the result of information panics. Collective ignorance is welfare maximizing but it is fragile, susceptible to self-fulfilling fears about asymmetric information. When investors become worried about the potential of adverse selection, they raise interest rates. In turn, fearing unfairly high rates, borrowers have incentives to acquire information about their probability of repayment. More information worsens the average credit risk of borrowers in the market, and thus justifies investors' initial concerns. Adverse selection may obtain in equilibrium even though it is not justified by the fundamentals in the economy. Information panics amplify small aggregate shocks to asset qualities causing large detrimental effects to real economic activity.