Banking Systems, Risk and Financial Markets

‘Bank Capital Structure, Fire Sales, and the Social Value of Deposits,’ Gale, D. (with T. Yorulmazer), 2017.

We describe a model in which bank deposits yield liquidity services and therefore earn a lower rate of return than bank equity. In this sense, deposits are a cheaper source of funding than equity. The bank’s equilibrium capital structure is determined by a trade off between the funding advantages of deposits and the risk of costly default. Default is costly because banks assets are sold in fire sales, which transfer value to the purchasers. This transfer is a private cost for the owners of failed banks, but not a deadweight loss for society. As a result, deposits are under-used and banks’ funding costs receive a subsidy from depositors. This subsidy eventually causes banks to grow too large and accumulate too many assets.

‘Equilibrium Theory of Banks’ Capital Structure’ Gale, D. (with P. Gottardi), 2017.

We develop a general equilibrium theory of the capital structures of banks and firms. The liquidity services of bank deposits make deposits a “cheaper” source of funding than equity. Banks pass on part of this funding advantage in the form of lower interest rates to firms that borrow from them. Firms and banks choose their capital structures to balance the funding of debt against the risk of costly default. Firm equity is a substitute for bank equity. An increase in a firm’s equity makes the firm’s debt less risky and that in turn reduces the risk of the bank’s portfolio. Firms have a comparative advantage in providing a buffer against systemic shocks, whereas banks have a comparative advantage in providing a buffer against idiosyncratic shocks.

‘Dynamic Bank Capital Regulation in Equilibrium’ Gale, D. (with A. Gamba, and M. Lucchetta), 2017.

We study optimal bank regulation in an economy with aggregate uncertainty. Bank liabilities are used as “money” and hence earn lower returns than equity. In laissez faire equilibrium, banks maximize market value, trading off the funding advantage of debt against the risk of costly default. The capital structure is not socially optimal because external costs of distress are not internalized by the banks. The constrained efficient allocation is characterized as the solution to a planner’s problem. Efficient regulation is procyclical, but countercyclical relative to laissez faire. We show that simple leverage constraints can get the decentralized economy close to the constrained efficient outcome.

‘On Interest Rate Policy and Asset Bubbles’ Gale, D. (with F. Allen, and G. Barlevy), 2017.

In a provocative paper, Gali (2014), showed that a policymaker who raises interest rates to rein in a potential bubble will only make a bubble bigger if one exists. This poses a challenge to advocates of lean-against-the-wind policies that call for raising interest rates to mitigate potential bubbles. In this paper, we argue there are situations in which the lean-against-the wind view is justified. First, we argue GalÌís framework abstracts from the possibility that a policymaker who raises rates will crowd out resources that would have otherwise been spent on the bubble. Once we modify Galiís model to allow for this possibility, policymakers can intervene in ways that raise interest rates and dampen bubbles. However, there is no reason policymakers should intervene to dampen the bubble in this case, since the bubble that arises in Gali’s setup is not one that society would be better o§ without. We then further modify Gali’s model to generate the type of credit-driven bubbles that alarm policymakers, and argue
there may be justification for intervention in that case.

‘How Should Bank Liquidity be Regulated?’ Gale, D. (with F. Allen), 2017.

Before the crisis, bank regulation relied to a large extent on capital regulation. Liquidity
regulation was not widely used. The liquidity problems during the crisis led to calls for liquidity regulation. As a result, the Basel III accord introduced global liquidity standards. An important issue in the construction of such liquidity regulations is the exact nature of the problem they are trying to solve. What is the market failure they are designed to correct? Why is the provision of liquidity that the market provides insufficient? This paper considers the literature analyzing liquidity regulation. There is no wide agreement on the rationale for liquidity regulation.

‘Financial Contagion Revisited’ Gale, D. (with F. Allen), 2017.

‘Equilibrium Corporate Finance and Intermediation,’ Bisin, A. (with P. Gottardi, and G. Clementi), 2017.

This paper analyzes a class of competitive economies with production, incomplete financial markets, and agency frictions. Since markets are incomplete, firms choose their capital structure – and, to some extent, their investment – to satisfy investors’ hedging needs. This class of economies generates interesting implications for investment in physical capital, leverage, corporate bond spreads, as well as excess equity returns. Even though markets are incomplete, we show that an objective function of the firm is generally defined such that shareholders always unanimously support firms’ choices. Furthermore, with no agency frictions competitive equilibria are constrained efficient.

‘Windfall Gains and Stock Market Participation,’ Cesarini, D. (with J.S Briggs, E. Lindqvist, and R. Östling), 2015.

We estimate the causal effect of wealth on stock market participation using administrative data on Swedish lottery players. A $150,000 windfall gain increases stock ownership probability among pre-lottery non-participants by 12 percentage points, while pre-lottery stock holders are unaffected. The effect is immediate, seemingly permanent and heterogeneous in intuitive ways. Standard lifecycle models predict wealth effects far too large to match our causal estimates under common calibrations. Additional analyses suggest a limited role for explanations such as procrastination or real-estate investment. Overall, results suggest that “nonstandard” beliefs or preferences contribute to the nonparticipation of households across many demographic groups.

‘Sovereign Debt, Domestic Banks, and the Provision of Public Liquidity,’ Perez, D., 2015.

This paper explores two mechanisms through which a sovereign default can disrupt the domestic economy via its banking system. First, a default creates a negative balance sheet effect on banks, which prevents the flow of resources to productive investments. Second, default undermines internal liquidity as banks replace government securities with less productive investments. A quantitative analysis of the model shows that these mechanisms generate a deep and persistent fall in output post-default, which accounts for the government’s commitment necessary to explain observed levels of external public debt. The model is used to study policies that address the government’s lack of commitment.

‘Global Banks and Systemic Debt Crises,’ Perez, D. (with P. Ottonello, J. Morelli), 2019.

We study the role of global financial intermediaries in international lending. We construct a model of the world economy, where heterogeneous borrowers issue risky securities purchased by financial intermediaries. Aggregate shocks transmit internationally through financial intermediaries’ net worth. The strength of this transmission is governed by the degree of frictions intermediaries face financing their risky investments. We provide direct empirical evidence on this mechanism showing that, around Lehman Brothers’ collapse, emerging-market bonds held by more-distressed global banks experienced larger price contractions. A quantitative analysis of the model shows that global financial intermediaries play a relevant role driving borrowing-cost and consumption fluctuations in emerging-market economies, both during debt crises and in regular business cycles. The portfolio of financial intermediaries and the distribution of bond holdings in the world economy are key to determine aggregate dynamics.

‘Structured Uncertainty and Model Misspecification∗,’ Sargent, T. (with L.P. Hansen), 2019.

An ambiguity averse decision maker evaluates plans under a restricted family of structured models and unstructured alternatives that are statistically close to them. Structured models include parametric models in which parameter values vary over time in ways that the decision maker cannot describe probabilistically. Because he suspects that all parametric models are misspecified, the decision maker also evaluates plans under alternative probability distributions with much less structure.

‘A Case for Incomplete Markets,’ Cogley, T. and T. Sargent (with L.E. Blume, D.A. Easley, and V. Tsyrennikov), 2015.

We propose a new welfare criterion that allows us to rank alternative financial market structures in the presence of belief heterogeneity. We analyze economies with complete and incomplete financial markets and/or restricted trading possibilities in the form of borrowing limits or transaction costs. We describe circumstances under which variousrestrictions on financial markets are desirable according to our welfare criterion.

‘On Money as a medium of exchange in near-cashless credit economies,’ Lagos, R. (with S. Zhang), 2019.

We study the transmission of monetary policy in credit economies where money serves as a medium of exchange. We find that—in contrast to current conventional wisdom in policy-oriented research in monetary economics—the role of money in transactions can be a powerful conduit to asset prices and ultimately, aggregate consumption, investment, output, and welfare. Theoretically, we show that the cashless limit of the monetary equilibrium (as the cash-and-credit economy converges to a pure-credit economy) need not correspond to the equilibrium of the nonmonetary pure-credit economy. Quantitatively, we find that the magnitudes of the responses of prices and allocations to monetary policy in the monetary economy are sizeable—even in the cashless limit. Hence, as tools to assess the effects of monetary policy, monetary models without money are generically poor approximations—even to idealized highly developed credit economies that are able to accommodate a large volume of transactions with arbitrarily small aggregate real money balances.

‘An Empirical Study of Trade Dynamics in the Fed Funds Market,’ Lagos, R. (with G. Afonso), 2014.

We use minute-by-minute daily transaction-level payments data to document the cross-sectional and time-series behavior of the estimated prices and quantities negotiated by commercial banks in the fed funds market. We study the frequency and volume of trade, the size distribution of loans, the distribution of bilateral fed funds rates, and the intraday dynamics of the reserve balances held by commercial banks. We find evidence of the importance of the liquidity provision achieved by commercial banks that act as de facto intermediaries of fed funds.

‘Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises,’ Lagos, R. (with S. Zhang), 2015.

We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset’s marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds—an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.

‘Turnover Liquidity and the Transmission of Monetary Policy,’ Lagos, R. (with S. Zhang), 2018.

We study the severity of liquidity constraints in the U.S. housing market using a life-cycle model with uninsurable idiosyncratic risks in which houses are illiquid, but agents have the option to extract home equity by refinancing their long-term mortgages. The model implies that three quarters of homeowners are liquidity constrained and willing to pay an average of 5 cents to extract an additional dollar of liquidity from their home. Most homeowners value liquidity for precautionary reasons, anticipating the possibility of income declines and the need to make mortgage payments in future periods. Mortgage assistance policies structured as credit lines to homeowners who experience a shortfall in income greatly reduce the severity of liquidity constraints.

‘Stress Tests and Bank Portfolio Choice,’ Williams, B., 2017.

How informative should bank stress tests be? I use Bayesian persuasion to formalize stress tests and show that regulators can reduce the likelihood of a bank run by performing tests which are only partially informative. Optimal stress tests give just enough failing grades to keep passing grades credible enough to avoid runs. The worse the state of the banking system, the more stringent stress tests must be to prevent runs. I find that optimal stress tests, by reducing the probability of runs, reduce the optimal level of banks’ liquidity cushions. I also examine the impact of anticipated stress tests on banks’ ex ante incentive to invest in risky versus safe assets.