| Summary: | <p>This thesis uses information theory to study policy questions in banking, finance, and industrial organization. It consists of four independent papers.</p>
<p>The first paper, “Time Inconsistency in Stress Test Design”, shows that central banks face a time inconsistency problem when publishing bank stress test results. Before a stress test, they want to <em>appear</em> tough as the threat of letting banks fail the stress test incentivizes prudent behaviour. After the stress test, they want to act soft by releasing only partial information in order to reassure financial markets about bank health. The paper characterises an institutional design solution to this commitment problem: a social planner sets the framework within which the central bank communicates. We find that a hurdle rate framework, where all banks are judged to pass or fail relative to a common threshold, is optimal in many settings as it generates intermediate levels of both incentives and reassurance. We show that, in such a hurdle rate framework, stress tests become an informational contagion channel.</p>
<p>The second paper proposes a model of imperfect competition in markets with selection and investigates whether imperfect competition mitigates the inefficiency which, in these markets, arises under perfect competition. Focusing on markets with advantageous selection, such as consumer credit markets, we find that no degree of competition can restore the first best efficient allocation. We discuss policy alternatives.</p>
<p>The third paper shows that, in markets with adverse selection, tying contracts can prevent unravelling and thus have a substantial positive effect on welfare. We illustrate this effect for two insurance markets. When one characteristic (such as life-expectancy) is hidden information and causes agents to have high expected cost for one product (life insurance) but low expected cost for another (pension annuity), then for tying contracts cost differences partially cancel out. This can prevent unravelling.</p>
<p>In the fourth paper, which is joined work, we build on a field experiment, find that some agents increase effort when it becomes more costly, and rationalize this in a signalling model. In the field setting, agents also choose whether to truthfully disclose their effort. The data on this form of strategic communication adds further support to the interpretation that effort choices are driven by signalling motives.</p>
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