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Report
Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting
We consider a model in which banking is characterized by asset substitution moral hazard and managerial underprovision of effort in loan monitoring. The privately optimal bank leverage efficiently balances the benefit of debt in providing the discipline to ensure that the bank monitors its loans against the benefit of equity in attenuating asset-substitution moral hazard. However, when correlated bank failures impose significant social costs, regulators bail out bank creditors. Anticipation of this action generates multiple equilibria, including an equilibrium featuring systemic risk, in ...
Journal Article
So Far, So Good: Government Insurance of Financial Sector Tail Risk
The US government has intervened to provide extraordinary support 16 times from 1970 to 2020 with the goal of preventing or mitigating (or both) the cost of financial instability to the financial sector and the real economy. This article discusses the motivation for such support, reviewing the instances where support was provided, along with one case where it was expected but not provided. The article then discusses the moral hazard and fiscal risks posed by the government's insurance of the tail risk along with ways to reduce the government's risk exposure.
Report
Is size everything?
We examine sources of systemic risk (threshold size, complexity, and interconnectedness) with factors constructed from equity returns of large financial firms, after accounting for standard risk factors. From the factor loadings and factor returns, we estimate the implicit government subsidy for each systemic risk measure, and find that, from 1963 to 2006, only our big-versus-huge threshold size factor, TSIZE, implies a positive implicit subsidy on average. Further, pre-2007 TSIZE-implied subsidies predict the Federal Reserve?s liquidity facility loans and the Treasury?s TARP loans during the ...
Report
The Prudential Toolkit with Shadow Banking
Several countries now require banks or money market funds to impose state-contingent costs on short-term creditors to absorb financial stress. We study these requirements as part of the broader prudential toolkit in a model with five key ingredients: banks may face an aggregate stress state with high withdrawals; a fire-sale externality motivates a mix of non-contingent and state-contingent regulation; banks may use shadow technologies to circumvent regulation; parameters of the shadow technologies may be private information; and bailouts may occur. We characterize the optimal policy for ...