Revised version of “Fire Sale Bank Recapitalizations”

“Optimal Bank Capitalization in Crowded Markets” with Mike Mariathasan (KU Leuven)
(This version: 08/2017; First version: 09/2015; Sveriges Riksbank Working Paper No. 312)

  • Abstract:

We study banks’ optimal equity buffer in general equilibrium, as well as their ex-post response to under-capitalization. Developing a “pecking order theory” for private recapitalizations, our benchmark model identifies equity issuance as individually and socially optimal, compared to deleveraging, and conditions that invert the individually optimal ranking. Ex-ante, the imperfectly elastic supply of capital, incomplete insurance markets and costly bankruptcies give rise to inefficiently high capital shortfalls and excessive insolvencies. Abstracting from moral hazard and informational asymmetries, we therefore provide a novel rationale for macroprudential capital regulation emerges and a new set of testable implications about banks’ capital structure management.

  • Keywords: bank capital, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency.

New working paper on “The Role of Trust in Online Lending”

“The Role of Trust in Online Lending” with Isaiah Hull (Sveriges Riksbank), Yingjie Qi (Stockholm School of Economics) and Xin Zhang (Sveriges Riksbank)

  • Abstract:

We study the impact of trust on the expansion of online lending in the U.S. over the 2008-2016 period. Using data from the largest platform, we demonstrate that a misconduct-driven decline of trust in traditional banking is associated with a statistically and economically significant increase in online lending at the state level. To the contrary, increased social trust strengthens in-person, bank-based borrowing and informal borrowing, reducing the demand for impersonal online lending. Both of these effects operate primarily through borrowers. We also use a shock that affects only investors to demonstrate that distrust in traditional finance increases participation in online lending.

  • Keywords: financial development, consumer loans, bank misconduct, FinTech.

Revised version of a “A Wake-up Call Theory of Contagion”

“A wake-up call theory or contagion” with Toni Ahnert (Bank of Canada)
(This version: 05/2017; First version: 06/2012)

  • Abstract:

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.

Revised version of Sveriges Riksbank Working Paper Series No. 319

“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)

  • Abstract:

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.

New policy paper on “Revisiting the role of central banks as liquidity providers – old and new challenges”

“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.

  • Abstract:

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.

New paper on online lending and monetary policy; Sveriges Riksbank Working Paper Series No. 319

“Fed Liftoff and Subprime Loan Interest Rates: Evidence from the Peer-to-Peer Lending Market” with Isaiah Hull (Sveriges Riksbank) and Xin Zhang (Sveriges Riksbank) (First version: March 2016)

  • Abstract:

On December 16th of 2015, the Fed initiated “liftoff,” raising the federal funds rate range by 25 basis points and ending a 7-year regime of near-zero rates. We use a unique dataset of 640,000 loan-hour observations to measure the impact of liftoff on interest rates in the peer-to-peer lending segment of the subprime market. We find that the average interest rate dropped by 16.9-22.6 basis points. This holds for 14 and 28 day windows centered around liftoff, and is robust to the inclusion of time dummies and a broad set of loan-level controls. We also find that the spread between high and low credit rating borrowers decreased by 16% and demonstrate that this was not generated by a change in the composition of borrowers along observable dimensions. Furthermore, we find no evidence that either result was driven by a collapse in demand for funds. Our results are consistent with an investor-perceived reduction in default probabilities; and suggest that liftoff provided a strong, positive signal about the future solvency of subprime borrowers, reducing their borrowing cost, even as short term rates increased in other markets.

  • Keywords: peer-to-peer lending, subprime consumer loans, Fed liftoff, monetary policy signaling, default channel, household debt.

New paper on “Fire Sale Bank Recapitalizations”; Sveriges Riksbank Working Paper Series No. 312

“Fire Sale Bank Recapitalizations” with Mike Mariathasan (KU Leuven) (This version: Sept. 2015; First version: Sept. 2015)

  • Abstract:

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.

Revised version of deleveraging paper; Sveriges Riksbank Working Paper Series No. 277

“A detrimental feedback loop: deleveraging and adverse selection” (This version: February 2015; First version: September 2013).

  • Abstract:
Market distress can be the catalyst of a deleveraging wave, as in the 2007/08 financial crisis. This paper demonstrates how market distress and financial sector deleveraging can fuel each other in the presence of adverse selection problems in an opaque asset market segment. At the core of the detrimental feedback loop is investors’ desire to reduce their reliance on the distressed opaque market by decreasing their leverage which in turn amplifies adverse selection in the opaque market segment. In the extreme, trade in the opaque asset market segment breaks down. I find that adverse selection is at the root of two inefficiencies: it distorts both investors’ long-term leverage choices and investors’ short-term liquidity management. I derive implications for central bank policy and highlight the ambiguous role played by transparency. (JEL D82, E58, G01, G20)

Revised version of contagion paper; Sveriges Riksbank Working Paper Series No. 294 – also available as Bank of Canada Working Paper 2015-14

“A wake-up call theory or contagion” with Toni Ahnert (Bank of Canada) (This version: January 2015; First version: June 2012).

  • Abstract:
We propose a novel theory of financial contagion. We study global coordination games of regime change in two regions with an initially uncertain correlation of regional fundamentals. A crisis in region 1 is a wake-up call to investors in region 2 that induces a re-assessment of local fundamentals. Contagion after a wake-up call can occur even if investors learn that fundamentals are uncorrelated and common lender effects or balance sheet linkages are absent. Applicable to currency attacks, bank runs, and debt crises, our theory of contagion is supported by existing evidence and generates a new testable implication for empirical work. (JEL D82, F3, G01)

New publication: Lead article in The B.E. Journal of Economic Analysis & Policy (Advances)

“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.

  • Abstract:

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.