“Systematic bailout guarantees and tacit coordination” with Claudio Calcagno and Mark Le Quement, The B.E. Journal of Economic Analysis & Policy (Advances), Volume 15, Issue 1, Pages 1-36, December 2014. – Lead article –
Both the academic literature and the policy debate on systematic bailout guarantees and Government subsidies have ignored an important effect: in industries where firms may go out of business due to idiosyncratic shocks, Governments may increase the likelihood of (tacit) coordination if they set up schemes that rescue failing firms. In a repeated-game setting, we show that a systematic bailout regime increases the expected profits from coordination and simultaneously raises the probability that competitors will remain in business and will thus be able to ’punish’ firms that deviate from coordinated behaviour. These effects make tacit coordination easier to sustain and have a detrimental impact on welfare. While the key insight holds across any industry, we study this question with an application to the banking sector, in light of the recent financial crisis and the extensive use of bailout schemes.
- Keywords: competition policy, systematic bailout guarantees, collusion, banking, State aid.
- A recent version is available as Sveriges Riksbank Working Paper No. 289 and a previous version was published under the title “State aid and tacit collusion”, EUI Working Paper (ECO 2009/36).
“Monetary Normalizations and Consumer Credit: Evidence from Fed Liftoff and Online Lending” with Isaiah Hull (Sveriges Riksbank) and Xin Zhang (Sveriges Riksbank)
(This version: 05/2017; First version: 03/2016; Sveriges Riksbank Working Paper No. 319)
On December 16th of 2015, the Fed initiated “liftoff,” a critical step in the monetary normalization process. We use a unique panel dataset of 640,000 loan-hour observations to measure the impact of liftoff on interest rates, demand, and supply in the online primary market for uncollateralized consumer credit. We find that credit supply increased, reducing the spread by 16% and lowering the average interest rate by 16.9-22.6 basis points. Our findings are consistent with an investor-perceived reduction in default probabilities; and suggest that liftoff provided a strong, positive signal about the future solvency of borrowers.
- Keywords: monetary normalization, monetary policy signaling, consumer loans, credit risk.
We develop a general equilibrium model of banks’ capital structure, featuring heterogeneous portfolio risk and an imperfectly elastic supply of bank equity stemming from financial market segmentation. In our model, equity is costly and serves as a buffer against costly bankruptcy. Banks are ex-ante identical, but may need to recapitalize by selling equity claims after their portfolio risk becomes public knowledge. When the need to issue outside equity arises simultaneously in a large number of banks, the market for equity becomes crowded. Reminiscent of asset fire sales, banks do not fully internalize the effect of their individual equity issuance on the endogenous cost of equity and their future ability to recapitalize. As a result, they are under- capitalized in equilibrium, and the incidence of insolvency is inefficiently high. This constrained inefficiency provides a new rationale for macroprudential capital regulation that arises despite the absence of deposit insurance and moral hazard; it also has implications for the regulation of payout policies and the design of bank stress testing.
- Keywords: macroprudential policy, capital regulation, capital structure, financial market segmentation, incomplete markets, constrained inefficiency.
We offer a theory of contagion based on the information choice of investors after observing a financial crisis elsewhere. We study global coordination games of regime change in two regions with an unobserved common macro shock as the only link between regions. A crisis in the first region is a wake-up call to investors in the second region. It induces them to reassess the regional fundamental and acquire information about the macro shock. Contagion can even occur after investors learn that regions are unrelated (zero macro shock). Our results rationalize empirical evidence about contagious bank runs and currency crises after wake-up calls. We also derive new implications and discuss how these can be tested. (JEL D82, F3, G01)
- Keywords: wake-up call, information choice, financial crises, contagion, global games, regime change, fundamental re-assessment.
- A previous version was published under the title “A wake-up call: information contagion and strategic uncertainty”, Sveriges Riksbank Working Paper No. 282, 2013.
“A detrimental feedback loop: deleveraging and adverse selection”
(This version: 08/2015; First version: 09/2013)
Market distress can lead to a deleveraging wave, as in the 2007/08 financial crisis. This paper demonstrates how market distress and deleveraging can fuel each other in the presence of adverse selection in opaque asset markets. A detrimental feedback loop emerges: investors reduce their reliance on opaque markets by decreasing their leverage which in turn amplifies adverse selection. In the extreme, trade breaks down. Asymmetric information together with incomplete markets is at the root of two inefficiencies: investors’ leverage choices are distorted and investors’ liquidity management exhibits under-investment in cash. I discuss policy implications and the ambiguous role of transparency.
- Keywords: Endogenous borrowing constraints, financial crisis, liquidity, fire sales, opacity, private information, central bank policy.
Published as “A detrimental feedback loop: deleveraging and adverse selection”, Sveriges Riksbank Working Paper No. 277, 2013.
“A Model of Liquidity Provision with Adverse Selection”
(This version: 12/2012; First version: 12/2010)
This paper analyzes a model of liquidity provision where liquidity risk is shared in two distinct spot markets. One of them is a market for asset sales prone to an adverse selection problem and the other is a collateralized credit market, which is not subject to an adverse selection problem. I find that the increased availability of collateralized credit (ex-post) may make the adverse selection problem in the asset market more severe. As a result, the relationship between the completeness of markets and equilibrium welfare, as well as efficiency, is non-monotone. Furthermore, I generate a financial crisis by introducing an aggregate liquidity or solvency shock, which amplifies the adverse selection problem, leading to a market failure. A central bank can address this market failure by using existing market institutions to re-allocate liquidity in the economy. Interestingly, the central bank has to be willing and able to incur a loss.
- Keywords: liquidity, asymmetric information, open market operations.
“Revisiting the role of central banks as liquidity providers – old and new challenges” with Johan Molin (Sveriges Riksbank), The Sveriges Riksbank Economic Review 2016:2, September 2016.
This article offers a review of the role of central banks as providers of public liquidity. Against the backdrop of the global financial crisis of 2007-2009, we discuss various challenges for public liquidity provision and the effectiveness of central bank lending facilities. These challenges help us identify potential gaps in existing mechanisms and frameworks governing liquidity assistance. We discuss how the available liquidity policy tool kit can be used to deal with the challenges. Furthermore, we highlight modifications to existing central bank facilities during and after the global financial crisis. We point at trade-offs faced by policy makers and describe potential pitfalls for public liquidity providers. Lastly, we attempt to look ahead and outline some specific challenges posed by more recent structural, regulatory, and technological developments in the financial system.
- Keywords: central bank liquidity assistance, liquidity provision, liquidity policy, Great Financial Crisis.
I was a member of the Committee on the Global Financial System (CGFS) Working Group on Policy Challenges and Open Issues in Liquidity Assistance, which produced a report on “Designing frameworks for central bank liquidity assistance: addressing new challenges”, CGFS Papers No 58, April 2017.
Work in progress
- On crowdfunding
- On communication and transparency
- On liquidity policy
- “The banker in a prisoner’s dilemma” with Emanuele Tarantino (University of Bologna)
- “Heterogeneous Firms, Innovation, and the Business Cycle” with Cristiana Benedetti Fasil (EUI)
Disclaimer: This is my private homepage. The views expressed are my own and do not reflect the official views of Sveriges Riksbank.