Runs versus Lemons: Information Disclosure, Fiscal Capacity and Financial Stability∗

We study how a government should optimally disclose information about banks’ assets during a financial crisis. The government can also use its resources to stop runs and unfreeze credit markets. Disclosure improves welfare by reducing adverse selection, but it can also create runs on weak banks. A credible fiscal backstop mitigates these risks and allows the government to pursue efficient but risky strategies. A strong fiscal position makes it possible to provide a candid assessment of financial health while providing guarantees to banks that are run on. A weak fiscal position can make it optimal not to reveal too much information. We argue that our theory provides an explanation for the different choices that countries make in response to financial crises. JEL: E5, E6, G1, G2. We thank Willie Fuchs, Harald Uhlig, Wei Xiong, as well as participants in seminars at MIT, NYU, NYU Stern, NBER Summer Institute and the Wharton Conference on Liquidity and Financial Crises.