We study optimal bailout policies amidst banking and sovereign crises. Our model features sovereign borrowing with limited commitment, where domestic banks hold government debt and extend credit to the private sector. Bank capital shocks can trigger banking crises, prompting the government to consider extending guarantees over bank assets. This poses a trade-off: Larger bailouts relax financial frictions and increase output, but increase fiscal needs and default risk (creating a ‘diabolic loop’). Optimal bailouts exhibit clear properties. The fraction of banking losses the bailouts cover is (i) decreasing in government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of banking crises. Even though bailouts mitigate the adverse effects of banking crises, the economy is ex ante better off without bailouts: Having access to bailouts lowers the cost of defaults, which in turn increases the default frequency, and reduces the levels of debt, output, and consumption.
ABSTRACT Why do fire sales occur if many risks are hedgeable? We study a version of Brunnermeier and Sannikov (2014, American Economic Review 104, 379–421) in which all fundamental risks can be hedged frictionlessly. Our analysis shows that fire sales are inherently self‐fulfilling. Fundamental shocks can never cause fire sales, and an efficient, safe equilibrium exists. On the other hand, there exists an equilibrium in which agents coordinate fire sales on nonfundamental shocks. A simple refinement based on vanishingly small perceived fundamental risk eliminates the safe equilibrium and selects the fire‐sale equilibrium as the unique outcome.
ABSTRACT We examine optimal capital requirements in a quantitative general equilibrium model with banks exposed to nondiversifiable borrower default risk. Contrary to standard models of bank default risk, our framework captures the limited upside, but significant downside risk of loan portfolio returns. This helps to reproduce the frequency and severity of twin defaults : simultaneously high firm and bank defaults. Hence, the optimal bank capital requirement, which trades off a lower frequency of twin defaults against restricting credit provision, is higher than under default risk models which underestimate the impact of borrower default on bank solvency.
ABSTRACT The deposit franchise is valuable because banks pay below‐market deposit rates. However, if depositors leave, its value vanishes. This can trigger runs by uninsured depositors, even if banks hold fully liquid assets. Because the franchise value increases with interest rates, runs are more harmful, and hence likelier, when rates are high. Banks can deter runs by shortening asset duration, but this risks insolvency if rates fall. Avoiding both runs and insolvency requires capital covering the potential loss of the uninsured deposit franchise. We estimate deposit franchise values and use them to identify vulnerable banks during the 2023 regional bank crisis.
ABSTRACT We propose a theory of coordination and influence among blockholders. Privately informed activists time their trades in sequence to lower acquisition costs, prompting a strategic use of order flows: leader activists create trading gains for their followers, ultimately influencing their willingness to bear greater value‐enhancing intervention costs. Through this channel, informed trades can exhibit predictability, in sharp contrast with Kyle (1985, Econometrica 53, 1315–1335). We explain how this novel predictability shapes free‐rider problems affecting governance, and how it produces price abnormalities analogous to those documented empirically. We also uncover how private information interdependence can be a key catalyst for the mechanism studied.
ABSTRACT We develop a unified theory of blockholder governance and the voting premium in a setting without takeovers or controlling shareholders. A voting premium emerges when a minority blockholder can influence shareholder composition by accumulating votes and buying shares from dissenting shareholders. Our theory reconciles conflicting empirical findings by showing that standard measures of the voting premium often misrepresent the true value of voting rights, increased conflicts between the blockholder and small shareholders do not necessarily raise the voting premium, and the voting premium can even turn negative when small shareholders free‐ride on the blockholder's trades.
This article introduces the concept of duality in financial networks, which entails the division of losses versus gains. In bankruptcy problems, in which a bankrupt entity divides its non-negative assets among a group of claimants, duality is well understood. Financial networks generalize bankruptcy problems by allowing for multiple agents with individual assets interconnected by mutual claims. We argue that allowing for negative assets is imperative to adequately formulate duality for financial networks. We show that there is a linear relationship between transfer schemes based on claims rules in a financial network and transfer schemes based on the dual of those claims rules in the dual financial network. Moreover, dual financial networks enable us to define dual transfer rules and dual allocation rules. We show that both self-dual transfer rules and self-dual allocation rules have to be based on self-dual claims rules. On the other hand, we demonstrate that transfer rules based on self-dual claims rules need not be self-dual, whereas allocation rules based on self-dual claims rules are always self-dual.
ABSTRACT Green finance—including environmental, social, and governance investing and sustainable finance regulations—is widespread, but can it substitute for carbon pricing in fighting climate change? In a unified model, I show that (i) when carbon prices reflect the social cost of carbon, green finance should not be used; (ii) when carbon prices are too low, green finance can implement the social optimum if each firm's cost of capital can be set to its sustainable discount rate , which increases with the ratio of carbon emissions to firm value. I provide calibrations, analyze stranded assets, and present implementations through subsidies or preferential financing for green firms.
ABSTRACT An investor receives utility bursts from realizing gains and losses at the individual stock level and dynamically allocates his mental budget between risky and risk‐free assets at the trading account level. Using savings, he reduces his stockholdings and is more willing to realize losses. Using leverage, he increases his stockholdings beyond his mental budget and is more reluctant to realize losses. While leverage strengthens the disposition effect, introducing leverage constraints mitigates it. Our model predicts that investors with stocks in deep losses sell them either immediately or after stocks rebound a little.
ABSTRACT We study aversion to model ambiguity and misspecification in dynamic portfolio choice. Risk‐averse investors (relative risk aversion γ > 1) fear return persistence, while risk‐tolerant investors (0 < γ < 1) fear mean reversion, when confronting model misspecification concerns of identically and independently distributed (IID) returns. The intuition is that risk‐averse investors, who want to hedge intertemporally, endogenously fear return persistence, which precludes hedging. A log investor is myopic and unaffected by model misspecification, therefore only worrying about model ambiguity. Our model can generate belief scarring, nonparticipation in equity markets, and extrapolative return expectations. Extending beyond IID returns, we study model misspecification for a mean‐reverting Sharpe ratio.
ABSTRACT Borrowers' use of cashless payments improves their access to capital from FinTech lenders and predicts a lower probability of default. These relationships are stronger for cashless technologies providing more precise information, and for outflows. Cashless payment usage complements other signals of borrower quality. We rationalize these empirical findings using a framework in which borrowers signal their lower likelihood of diverting cash flows through payment technology choice, and screening accuracy is further strengthened by informational complementarities. The informational synergy we uncover provides a rationale for the joint rise of cashless payments and FinTech lending, as well as for open banking.
We analyze risk-taking behaviors of financial institutions linked through cross-shareholding relationships. We endogenize risk exposure accounting for default risk by modeling Value-at-Risk-based risk-management – that is targeted default probabilities – in the presence of extreme risk on asset return. We relate risk-taking behaviors to a centrality measure that captures the propagation of losses within the network, and show that network integration increases risk-taking levels and expected return. However, we show that network integration also results in larger expected shortfall, indicating greater exposure to losses for creditors. We explore the impact of the cross-shareholding network on the implementation of regulation, particularly through capital requirements, and identify key institutions, those with the highest influence on aggregate investments in risky assets.
In this paper, we explore the issue of manipulability in the setting of financial systems by considering two weak forms of immunity: merging-proofness and splitting-proofness. Not surprisingly, splitting-proofness conflicts with basic requirements such as the priority of debt over equity and the limited liability of equity. Remarkably, we provide a comprehensive characterization of the class of bankruptcy rules that gives rise to financial rules that satisfy merging-proofness.
ABSTRACT We show that incorporating defined benefit pension funds in an incomplete markets asset pricing model improves its ability to match the historical equity premium and riskless rate and has important risk‐sharing implications. We document the importance of the pension fund's size and asset demands, and a new risk channel arising from fluctuations in the fund's returns. We use our calibrated model to study the implications of a shift to an economy with defined contribution plans. The new steady state is characterized by a higher riskless rate and a lower equity premium. Consumption volatility increases for retirees but decreases for workers.
We characterize how managers can curb manipulation by signaling information via stock repurchases in an environment with costly short selling and feedback effects from trading to firms’ access to capital. Without repurchases, manipulation coexists with informed trading at low shorting costs, reducing price informativeness and firm investment. Manipulation becomes less profitable as shorting costs increase, making prices more informative and boosting investment if speculators are less informed. Incentives to manipulate cease to exist at moderate short selling costs, but making shorting more costly reduces price informativeness and firm investment. Our model shows how contracts that precommit funding and condition future investment on stock prices can induce managers to eliminate manipulation through stock repurchases, facilitating optimal investment policies. An important policy implication is that when stock repurchases are allowed and shorting costs are low, short selling bans will typically reduce investment efficiency.
We develop an economic model of a decentralized exchange with concentrated liquidity (e.g., Uniswap v3 and v4), with a particular focus on the economics of liquidity provision. We demonstrate that providing liquidity for a risky/risk-free asset pool is comparable to investing in a covered call, except that the call option therein is sold at intrinsic rather than market value. Hence, when providing liquidity, liquidity providers forgo the time premium of the call option in exchange for fees, and thus equilibrium liquidity provision decreases in the time premium. Finally, we provide an expression for equilibrium liquidity provision that is useful for empirical work.
We develop a model of political cycles driven by time-varying risk aversion. Agents choose to work in the public or private sector and to vote Democratic or Republican. In equilibrium, when risk aversion is high, agents elect Democrats—the party promising more redistribution. The model predicts higher average stock market returns under Democratic presidencies, explaining the well-known “presidential puzzle.” The model can also explain why economic growth has been faster under Democratic presidencies.
In the data, Democratic voters are more risk averse, and risk aversion declines during Democratic presidencies. Public workers vote Democratic, while entrepreneurs vote Republican, as the model predicts.