Essays on banking with asymmetric information

This thesis studies the information frictions in the banking system. It comprises three separate essays in Chapters II-IV, respectively.
The first essay develops a model in which a bank seeks funding for two projects at two different points in time but cannot commit to borrowing from the same investor in both periods. Despite this restriction, on-balance sheet funding with cross-subsidisation across projects dominates off-balance sheet funding with voluntary support in mitigating information frictions considered for all parameters, resulting in an efficient outcome (second-best). We uncover two novel channels through which on-balance sheet funding can create value, providing a rationale for the recent rise of Private Debt funds.
The second essay demonstrates that off-balance sheet financing functions in resolving the adverse selection problem constrained by the implicit condition of strong creditor rights, while debt contract financing can be feasible with fewer conditions. Moreover, with regulatory intervention, debt contract financing dominates, as the limited liability created by the off-balance sheet financing weakens banks’ incentive to compensate investors after failure, which may exacerbate the moral hazard problem. This essay also advocates for strong creditor rights, which are beneficial for social surplus.
The third essay focuses on capital requirements and provides a novel rationale for imposing them. Existing literature explores it based on the assumption that the regulator has superior information about bank type, suggesting that risk-sensitive capital requirements should be imposed to mitigate information frictions. However, we demonstrate that information frictions may be mitigated without regulatory intervention, thus relaxing the assumption, and that capital requirements can be imposed, in combination with other regulations, to rectify the divergence between individual banks acting in self-interest and the aspirations of the regulator.