Is Financial Expertise Ultimately an Arms Race?

Abstract (Via SSRN)

We propose a model in which firms involved in trading securities overinvest in financial expertise. Intermediaries or traders in the model meet and bargain over a financial asset. As in the bargaining model in Dang (2008), counterparties endogenously decide whether to acquire information, and improve their bargaining positions, even though the information creates adverse selection. We add to this setting the concept of “financial expertise” as resources invested to lower the cost of later acquiring information about the value of the asset being traded. These investments are made before the parties know about their role in the bargaining game, as proposer or responder, buyer or seller. A prisoner’s dilemma arises because investments to lower information acquisition costs improve bargaining outcomes given the other party’s information costs, even though the information has no social benefit. These investments lead to breakdowns in trade, or liquidity crises, in response to random but infrequent increases in asset volatility.

Interesting Introduction (Via SSRN)

We develop a model in which the investments by rms in nancial expertise, such as hiring Ph.D. graduates to design and value nancial instruments of ever increasing complexity, becomes an arms race.” By this phrase we mean two things:

Investment in nancial expertise confers an advantage on any one player in competing for axed surplus that is neutralized in equilibrium by similar investment by his opponents.

Investment in fi financial expertise is dangerous, in that it creates a risk of destruction of the surplus itself when there is an exogenous shock.

Our model shows that financial arms involved in trading assets with uncertain value may nd optimal to acquire socially undesirable levels of expertise and this might interfere with the efficient functioning of financial markets. In the model, traders (or finnancial intermediaries generally) acquire expertise in processing information about an asset. The resulting efficiency in acquiring information gives them an advantage in subsequent bargaining with competitors. Neither the information, nor the expertise in acquiring and evaluating it, has any social value in the model. Yet intermediaries build such expertise despite the knowledge that it may increase adverse selection in subsequent trading and cause breakdowns in liquidity.
A basic problem in viewing nancial expertise as an arms race is addressing the more fundamental question of why anyone would acquire information about a common-value object when doing so creates adverse selection problems that limit gains to trade. In most models with adverse selection in nance, some party is exogenously asymmetrically informed. If they could (publicly) avoid becoming informed, they would do so.

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09. February 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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