Berk's Blog

In a Crisis, Perverse Behavior Often Motivated by Information Asymmetry

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The their book “The Panic of 1907: Lessons Learned from the Market’s Perfect Storm“, Robert Brunner and Sean Carr describe the characteristics of a panic.

A financial system has two vitally important characteristics that can serve as a foundation for a financial crisis. First, the very existence of a system means that trouble can travel. The difficulties of one financial intermediary can spread to others. Second, the complexity of a financial system means that it is difficult for all participants in the financial system to be well-informed – this is called “information asymmetry” and may motivate perverse behavior that can trigger or worsen the financial crisis.

Brunner and Carr go on to explain that this type of information asymmetry played a major role in the panic of 1907. The authors are struck by how little the average depositor – even JP Morgan himself – could know about the hour to hour financial condition of banks,brokerage firms and trust companies.

If you read history, none of these financial panics, runs on leveraged institutions and the like, has been met with a cohesive strategy nor are the regulatory regimes in place at the time capable of handling the unexpected because there is too much asymmetry of information. The credit system is a system based on “trust” – in people, in leaders, in institutions and in regulations. When “confidence” is fragile, leaders have a very difficult time figuring out where the next leak is going to come from.