On the Fragility of Reputation in Financial Markets

Financial Crises are typically associated with a loss of confidence in financial intermediaries. This loss of confidence often manifests itself in a sharp fall in the prices of securities issued by financial intermediaries. We focus on the market for asset-backed securities issued by banks and other financial intermediaries. We argue that adverse selection problems may be important in such markets, in the sense that financial intermediaries have incentives to retain high quality assets and sell low quality assets. We analyze the role of reputational considerations in mitigating such problems. We argue that markets in which reputational considerations play an important role are inherently fragile, in the sense that small fluctuations in fundamentals can lead to large fluctuations in the prices of securities issued by financial intermediaries. We show that if a financial intermediary's reputation for selling high quality securities is not too high, a small change in the probability that it will not be in business in the future can lead to a large decline in the both the volume of and the prices of securities it sells