Financial expertise as an arms race

Abstract

Federal Reserve Board of Governors provided useful suggestions and comments. Financial Expertise as an Arms Race We propose a model in which firms involved in trading securities overinvest in financial exper-tise. 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 informa-tion, which improves their bargaining position, even though the information has the potential to create 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 assets 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 informa-tion 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. Persistence in the volatility process can produce contractions and expansions resembling employment cycles for financial experts.