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Working Paper
Bank Panics and Scale Economies
A bank panic is an expectation-driven redemption event that results in a self-fulfilling prophecy of losses on demand deposits. From the standpoint of theory in the tradition of Diamond and Dybvig (1983) and Green and Lin (2003), it is surprisingly di cult to generate bank panic equilibria if one allows for a plausible degree of contractual flexibility. A common assumption employed in the standard banking model is that returns are linear in the scale of investment. Instead, we assume the existence of a fixed investment cost, so that a higher risk-adjusted rate of return is available only if investment exceeds a minimum scale requirement. With this simple and empirically-plausible modification to the standard model, we find that bank panic equilibria emerge easily and naturally, even under highly flexible contractual arrangements. While bank panics can be eliminated through an appropriate policy, it is not always desirable to do so. We use our model to examine a number of issues, including the likely effectiveness of recent financial market regulations. Our model also lends some support for the claim that low-interest rate policy induces a ?reach-for-yield? phenomenon resulting in a more panic-prone financial system.
AUTHORS: Andolfatto, David; Nosal, Ed
DATE: 2017-03-29

Working Paper
Fiscal Multipliers and Financial Crises
What type of fiscal policy is most effective during a financial crisis? I study the macroeconomic effects of the US fiscal policy response to the Great Recession, accounting not only for standard tools such as government purchases and transfers but also for financial sector interventions such as bank recapitalizations and credit guarantees. A nonlinear quantitative model calibrated to the US allows me to study the state-dependent effects of different types of fiscal policies. I combine the model with data on the US fiscal policy response to find that the fall in aggregate consumption would have been 50% worse in the absence of that response with a cumulative loss of 9.16%. Transfers and bank recapitalizations yielded the largest fiscal multipliers at the height of the crisis, due to new transmission channels that arise from linkages between household and bank balance sheets.
AUTHORS: Faria-e-Castro, Miguel
DATE: 2018-10-01

Working Paper
Bank runs without sequential service
Banking models in the tradition of Diamond and Dybvig (1983) rely on sequential service to explain belief driven runs. But the run-like phenomena witnessed during the financial crisis of 2007-08 occurred in the wholesale shadow banking sector where sequential service is largely absent. This suggests that something other than sequential service is needed to help explain runs. We show that in the absence of sequential service runs can easily occur whenever bank-funded investments are subject to increasing returns to scale consistent with available evidence. Our framework is used to understand and evaluate recent banking and money market regulations.
AUTHORS: Andolfatto, David; Nosal, Ed
DATE: 2018-07

Working Paper
The (Unintended?) Consequences of the Largest Liquidity Injection Ever
The design of lender-of-last-resort interventions can exacerbate the bank-sovereign nexus. During sovereign crises, central bank provision of long-term liquidity incentivizes banks to purchase high yield eligible collateral securities matching the maturity of the central bank loans. Using unique security level data, we find that the European Central Bank?s 3-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds, equivalent to 10.6% of amounts outstanding, and pledge them to obtain central bank liquidity. The steepening of Eurozone peripheral sovereign yield curves right after the policy announcement is consistent with the equilibrium effects of this ?collateral trade.?
AUTHORS: Crosignani, Matteo; Faria-e-Castro, Miguel; Fonseca, Luis
DATE: 2017-11-01

Working Paper
Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications
Our goal is to elucidate the interaction of banks' screening effort and strategic information production in loan-backed asset markets using a general equilibrium framework. Asset quality is unobserved by investors, but banks may purchase error-prone ratings. The premium paid on highly rated assets emerges as the main determinant of banks' screening effort. The fact that rating strategies reflect banks' private information about asset quality helps keep this premium high. Conventional regulatory policies interfere with this decision margin, thereby reducing signaling value of high ratings and exacerbating the credit misallocation problem. We propose a tax/subsidy scheme that induces efficiency.
AUTHORS: Ramirez, Carlos; Figueroa, Nicolás; Leukhina, Oksana
DATE: 2019-12-05

Working Paper
Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications
We study the interaction of information production in loan-backed asset markets and credit allocation in a general equilibrium framework. Originating banks can screen their borrowers, but can inform investors of their asset type only through an error-prone rating technology. The premium paid on highly rated assets emerges as the main determinant of screening effort. Because the rating technology is imperfect, this premium is insufficient to induce the efficient level of screening. However, the fact that banks know their asset quality and produce ratings accordingly helps keep the premium high. Mandatory rating, certified review, and mandatory ratings disclosure policies interfere with this decision margin, thereby reducing informativeness of high ratings, lowering the premium paid on them, and exacerbating the credit misallocation problem. We perform optimal policy analysis.
AUTHORS: Figueroa, Nicolás; Leukhina, Oksana; Ramirez, Carlos
DATE: 2018-09-01

Journal Article
Stability of funding models: an analytical framework
With the recent financial crisis, many financial intermediaries experienced strains created by declining asset values and a loss of funding sources. In reviewing these stress events, one notices that some arrangements appear to have been more stable?that is, better able to withstand shocks to their asset values and/or funding sources?than others. Because the precise determinants of this stability are not well understood, gaining a better grasp of them is a critical task for market participants and policymakers as they try to design more resilient arrangements and improve financial regulation. This article uses a simple analytical framework to illustrate the determinants of a financial intermediary?s ability to survive stress events. An intermediary in the framework faces two types of risk: the value of its assets may decline and/or its short-term creditors may decide not to roll over their debt. The authors measure stability by looking at the combinations of shocks the intermediary can experience while remaining solvent. They study how stability depends on the intermediary?s balance-sheet characteristics, such as its leverage, the maturity structure of its debt, and the liquidity and riskiness of its asset portfolio. They also show how the framework can be applied to examine current policy issues, including liquidity requirements, discount window policy, and different approaches to reforming money market mutual funds.
AUTHORS: McAndrews, James J.; Keister, Todd; Eisenbach, Thomas M.; Yorulmazer, Tanju
DATE: 2014-02

Journal Article
Do \\"Too-Big-to-Fail\\" banks take on more risk?
The notion that some banks are ?too big to fail? builds on the premise that governments will offer support to avoid the adverse consequences of disorderly bank failures. However, this promise of support comes at a cost: Large, complex, or interconnected banks might take on more risk if they expect future rescues. This article studies the effect of potential government support on banks? appetite for risk. Using balance-sheet data for 224 banks in forty-five countries starting in March 2007, the authors find higher levels of impaired loans after an increase in government support. To measure support, they rely on Fitch Ratings? support rating floors (SRFs), a new rating that isolates potential sovereign support from other sources of external support. A one-notch rise in the SRF is found to increase the impaired loan ratio by roughly 0.2?an 8 percent increase for the average bank. The authors obtain similar results when they assess the effect of increased support on net charge-offs and when they narrow their sample to U.S. banks only.
AUTHORS: Santos, Joao A. C.; Afonso, Gara M.; Traina, James
DATE: 2014-12

Journal Article
Bank resolution concepts, trade-offs, and changes in practices
Banks and financial intermediaries perform important roles for the smooth functioning of the economy such as channeling resources from savers to productive projects and providing payment services. Because bank failure can result in significant costs for the economy, an efficient resolution mechanism is needed to mitigate such costs. This article provides a simple framework for analyzing the feasibility and cost of different resolution methods. The analysis shows that while private resolution methods, such as sale to a healthy bank, are preferred options in terms of minimizing costs, they may not be feasible when the distressed institution is large or complex or when its failure occurs during a systemic crisis. Instead, firms and regulators may face second-best solutions, entailing trade-offs between disorderly liquidation and the use of public funds.
AUTHORS: Yorulmazer, Tanju; White, Phoebe
DATE: 2014-12

Journal Article
The Gordon Gekko effect: the role of culture in the financial industry
Culture is a potent force in shaping individual and group behavior, yet it has received scant attention in the context of financial risk management and the 2007-09 financial crisis. This article presents a brief overview of the role of culture as it is seen by psychologists, sociologists, and economists, and then describes a specific framework for analyzing culture in the context of financial practices and institutions. Using this framework, the author addresses three questions: (1) what is culture? (2) does it matter? and (3) can it be changed? He illustrates the utility of this framework by applying it to five concrete situations?the collapse of Long-Term Capital Management, the fall of AIG Financial Products, the use by Lehman Brothers of ?Repo 105,? Socit Gnrale?s rogue trader, and the Securities and Exchange Commission?s handling of the Madoff Ponzi scheme. The article concludes with a proposal to change culture through ?behavioral risk management.?
AUTHORS: Lo, Andrew W.
DATE: 2016-08

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