Timothy Geithner's memoir of the financial crisis of 2007–08—Stress Test: Reflections on Financial Crises—is an important historical document offering details of how policies were formed and implemented during the crisis, showing the political constraints, and offering lessons for future crises. Walter Bagehot's classic rule for fighting crises— that the central bank should lend against good collateral at a high rate—is passive and incomplete. Geithner argues for the use of overwhelming force to reestablish confidence. Also, although the Federal Reserve's new crisis lending programs needed to be anonymous so as not to reveal weak banks' identities—“stigma”—the stress tests during the crisis did reveal information that may have been useful in reestablishing confidence.

The credit crisis was sparked by a shock to fundamentals, housing prices failed to rise, which led to a collapse of trust in credit markets. In particular, the repurchase agreement market in the U.S., estimated to be about $12 trillion, larger than the total assets in the U.S. banking system ($10 trillion), became very illiquid during the crisis due to the fear of counterparty default, leaving lenders with illiquid bonds that they did not want, believing that they could not be sold. As a result, there was an increase in repo haircuts (the initial margin), causing massive deleveraging. I investigate this indirectly, by looking at the breakdown in the arbitrage foundation of the ABX.HE indices during the panic. The ABX.HE indices of subprime mortgage-backed securities are derivatives linked to the underlying subprime bonds. Introduced in 2006, the indices aggregated and revealed information about the value of the subprime mortgage-backed securities and allowed parties to buy protection against declines in subprime value via credit derivatives written on the index or tranches of the index. When the ABX prices plummeted, the arbitrage relationships linking the credit derivatives linked to the index and the underlying bonds broke down because liquidity evaporated in the repo market. This breakdown allows a glimpse of the information problems that led to illiquidity in the repo markets, and the extent of the demand for protection against subprime risk.

Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms that have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds to the formation of a "reputation," a valuable asset that provides an incentive for firms not to choose risky projects. The second hypothesis is that prior to the establishment of a reputation, new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838-60). The presence of a reputation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for the notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period because of technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre-Civil War system of private money issuance by banks was not plagued by problems of overissuance ("wildcat banking").

Short-term collateralized debt, private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output. Financial fragility is endogenous; it builds up over time as information about counterparties decays. A crisis occurs when a ( possibly small) shock causes agents to suddenly have incentives to produce information, leading to a decline in output. A social planner would produce more information than private agents but would not always want to eliminate fragility.

In the 1980s, U.S. banks became systematically less profitable and riskier as nonbank competition eroded the profitability of banks' traditional activities. Bank failures rose exponentially during this decade. The leading explanation for the persistence of these trends centers on fixed-rate deposit insurance: the insurance gives bank equityholders an incentive to take on risk when the value of bank charters falls. We propose and test an alternative explanation based on corporate control considerations. We show that managerial entrenchment played a more important role than did the moral hazard associated with deposit insurance in explaining the recent behavior of the banking industry.

A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; and (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices, because informed traders do not act on their information until the event date is sufficiently close. We also show that limited horizons can arise because of the cost‐carry associated with holding an arbitrage portfolio over an extended period of time.

All economists should be conversant with “what happened?” during the financial crisis of 2007–09. We select and summarize sixteen documents, including academic papers and reports from regulatory and international agencies. This reading list covers the key facts and mechanisms in the build-up of risk, the panics in short-term-debt markets, the policy reactions, and the real effects of the financial crisis.

In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most 'informationally efficient' prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Agency problems in firms are prevalent because of a scarcity of wealthy principals with corporate governance ability, whom we call “restructuring specialists.” We investigate how this scarce resource, “agency cost-free capital,” is allocated. We show that the restructuring specialists may acquire blocks only in those states of the worls in which they can increase firm value the most, which corresponds to a takeover. Firms with dispersed ownership and firms with a financial intermediary as a blockholder can coexist, although they are otherwise identical. The moderl can explain differences in corporate ownership structures and restructuring mechanisms across economies.