Capital markets,financial intermediaries,and liquidity supply

We study a dynamic economy endowed with a sequence of overlapping generations of consumers and production processes, and where productive assets are illiquid and consumption preferences are subject to uninsurable demand for liquidity. We characterize the steady states that can be achieved with alternative financial systems. We show that infinitely lived financial intermediaries offering a liability with age-dependent restrictions may implement a social optimum with full insurance. If, instead, they offer anonymous, unrestricted contracts, then only second-best consumption allocations with partial insurance obtain. We also examine the consumption allocations available when agents can trade shares in competitive stock markets. While allowing for trade across generations may or may not improve upon generational autarky, we show that this competitive equilibrium is not a social optimum, and is dominated by a system of infinitely lived, unrestricted intermediaries.     

Dynamic credit relationships in general equilibrium

We construct a general equilibrium model with private information in which borrowers and lenders enter into long-term dynamic credit relationships. Each new generation of ex ante identical individuals is divided in equilibrium into workers and entrepreneurs. Workers save through financial intermediaries in the form of interest-bearing deposits and supply labor to entrepreneurs in a competitive labor market. Entrepreneurs borrow from financial intermediaries to finance projects which produce privately observed sequences of random returns. Each financial intermediary holds deposits from a large number of workers and operates a portfolio of dynamic contracts with different credit positions. We calibrate the model to the U.S. economy and find that dynamic contracting is very effective at mitigating the effects of private information. Moreover, restricting borrowers and lenders to use static (one-period) contracts with a costly monitoring technology has adverse effects both on the level of aggregate economic activity and on individual welfare unless monitoring costs are very small. Finally, the optimal provision of intertemporal incentives leads to increasing consumption inequality over time within generational cohorts as in U.S. data.     

Customers and investors: A framework for understanding the evolution of financial institutions

Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary's credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary's credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets.     

Household Debt and Income Inequality, 1963–2003

I construct an economy with heterogeneous agents that mimics the time-series behavior of the earnings distribution in the United States from 1963 to 2003. Agents face aggregate and idiosyncratic shocks and accumulate real and financial assets. I estimate the shocks that drive the model using data on income inequality, aggregate income, and measures of financial liberalization. I show how the model economy can replicate two empirical facts: the trend and cyclical behavior of household debt and the diverging patterns in consumption and wealth inequality over time. While business cycle fluctuations can account for the short-run changes in household debt, its prolonged rise of the 1980s and the 1990s can be quantitatively explained only by the concurrent increase in income inequality.     

Financial integration and business cycles in a small open economy

The purpose of this study is to examine a dynamic, stochastic, general equilibrium framework with financial and informational frictions and foreign borrowing in the case of money growth and technology shocks for a small open economy and to analyze the implications of varying degrees of financial integration for aggregate fluctuations and propagation mechanisms in the economy. The existence of informational asymmetries among the agents in the model necessitates financial intermediation in the economy. Moreover, there is uncertainty involved in the production process which leads to collateralized borrowing by firms and, therefore, has to be taken into account in the design of the loan contracts between firms and financial intermediaries. It is shown that increasing financial integration amplifies the effect of a positive, temporary monetary shock on output, consumption, investment, labor demand and loans; whereas it has barely any implication for the impact of a positive, temporary technology shock on the economy.     

Financial covenants in the markets for public and private debt

The public debt contracts surveyed in Whittred and Zimmer (1986) and Stokes and Tay (1988) were issued between 1962 and 1985, and there has been significant macroeconomic, institutional and regulatory change since that time. We analyse a sample of 36 recently issued Australian public debt contracts and document a considerable change in the ‘package’ of financial covenants used in public debt contracts. The covenant package is now less restrictive and the types of covenants used are more heterogenous. We also survey a sample of 41 recent Australian private debt contracts. These contracts contain a greater number, variety and, collectively, more restrictive set of financial covenants than those public debt contracts we survey, supporting theory which suggests that covenant restrictive and renegotiation–flexible contracts are more suited to borrowers contracting with financial intermediaries in private debt markets. We also note differences in accounting rules associated with financial covenants used in these private debt contracts.     

Does competition aggravate moral hazard? A Multi-Principal-Agent experiment

We conduct an experiment to determine whether market structure affects financial intermediary behavior. The intermediaries (Agents) are perfectly informed regarding project types and can recommend that their clients (Principals) either proceed or discontinue a project. Intermediaries earn revenues only when they recommend proceeding with the transaction. Thus, our design captures some of the incentives faced by financial advisers in commercial banks, where compensation depends on sales performance, and also by money-managers, whose income depends on the size of their portfolios. We find that a monopolist intermediary protects the interest of clients better than when intermediaries compete. Our results are robust to a significant fee increase and provide additional evidence on the impact of market structure on individual incentives and equilibrium outcomes.     

On the pricing of intermediated risks: Theory and application to catastrophe reinsurance

We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be “high” in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price.     

Monitoring and Structure of Debt Contracts

This paper presents a theory of optimal debt structure when the moral hazard problem is severe. The main idea is that the optimal debt contract delegates monitoring to a single senior lender and that seniority allows the monitoring senior lender to appropriate the full return from his monitoring activities. The theory explains (i) why debt contracts are prioritized, (ii) why short-term debt is senior to long-term debt, and (iii) why financial intermediaries usually hold short-term senior debt whereas long-term junior debt is widely held. Another implication of the theory is that covenant and maturity structures will be set to conform to the seniority structure.     

Optimal incentives and securitization of defaultable assets

We study optimal securitization in the presence of an initial moral hazard. A financial intermediary creates and then sells to outside investors defaultable assets, whose default risk is determined by the unobservable costly effort exerted by the intermediary. We calculate the optimal contract for any given effort level and show the natural emergence of extreme punishment for defaults, under which investors stop paying the intermediary after the first default. With securitization contracts optimally designed, we find securitization improves the intermediary's screening incentives. Furthermore, the equilibrium effort level and the surplus converge to their first best levels with sufficiently many assets.     

Corporate Insurance as a Necessary Form of Consultant–Investigator Contract

Existing literature argues that corporate insurance is purchased because the insurance company produces risk management information for publicly held corporations. In this article, we address a fundamental question as to why other financial intermediaries cannot perform the same information production function as the insurance company. We argue that when the risk manager of the firm performs multiple tasks and needs consulting and investigation services from an outside agent for efficient risk management, the optimal contract with the agent has to be in the form of an insurance contract. Other types of contracts, such as flat-fee contracts, cannot be optimal. Therefore, the insurance company is ideally suited to provides these services.     

Collateral,rehypothecation, and efficiency

This paper studies rehypothecation, a practice in which financial institutions re-pledge collateral pledged to them by their clients. Rehypothecation enhances provision of funding liquidity to the economy, but it also incurs deadweight cost by misallocating the asset among the agents when counterparties fail. We examine the possibility of a conflict between the intermediary and its borrower on rehypothecation arrangements. The direction of this conflict depends on haircuts of the contract between them: if the contract involves over-collateralization, there tends to be an excessive use of rehypothecation, and if the contract involves under-collateralization, there tends to be an insufficient use of rehypothecation. This offers an empirical prediction of a link between the size of haircut in collateralized financial contracts, borrower information, and the likelihood of rehypothecation.     

Banks as Tax Planning Intermediaries

We provide the first large‐scale empirical evidence of banks functioning as tax planning intermediaries. We posit that some banks specialize in assisting corporate clients with tax planning. In this role, banks make use of their centrality in financial relationships; access to private information; and ability to structure, execute, and participate in tax planning transactions for clients. We measure bank‐client relationships using loan contracts and measure client tax planning using either the cash effective tax rate or the unrecognized tax benefit balance. Using a difference‐in‐differences design, we find that firms experience meaningful tax reductions when they begin a relationship with a bank whose existing clients engage in above‐median tax planning. The effects of pairing with such tax intermediary banks are concentrated in relationships with larger or longer maturity loans, clients with foreign income or greater credit risk, and when the bank is an industry specialist or has above‐median investment banking activities. Finally, we find that potential clients are more likely to choose tax intermediary banks than nontax intermediary banks, suggesting that tax intermediary banks benefit by attracting new business. Collectively, our results suggest that some banks act as tax planning intermediaries, a role beyond the traditional one of financial intermediary.     

Dynamic Insurance Contracts and Adverse Selection

We take a dynamic perspective on insurance markets under adverse selection and study a dynamic version of the Rothschild and Stiglitz model. We investigate the nature of dynamic insurance contracts by considering both conditional and unconditional dynamic contracts. An unconditional dynamic contract has insurance companies offering contracts where the terms of the contract depend on time, but not on the occurrence of past accidents. Conditional dynamic contracts make the actual contract also depend on individual past performance (such as in car insurances). We show that dynamic insurance contracts yield a welfare improvement only if they are conditional on past performance. With conditional contracts, the first‐best can be approximated if the contract lasts long. Moreover, this is true for any fraction of low‐risk agents in the population.     

The ownership of ratings

We identify the optimal contract between a rating agency and a firm and the circumstances under which simple ownership contracts implement this optimal solution. We assume that the decision to obtain a rating is endogenous and the price of a rating is a strategic variable. Clients hiding their ratings can be an equilibrium only if they are ex ante uncertain of their quality and if the hiring decision is not observable. For some distribution functions, a competitive rating market is necessary for this result to obtain. In this context, competition between rating intermediaries will lead to less information in equilibrium.     

A note on managing deposit flows with cash and futures market decisions

As deposit market become less regulated, financial intermediaries must focus more of their attention on the explicit pricing of deposit accounts. An implication of pricing deposits is that the intermediary faces a random source of funds when future deposit supplies are unknown. This note shows that financial futures contracts can be used to hedge the risk of deposit withdrawals, allowing the financial firm to set lower deposit rates than it would without futures trading. A model of risk averse banking behavior is constructed to determine the relationship between hedging deposit withdrawals and setting deposit rates. Using the certificate of deposit futures contract to hedge demand and savings deposit withdrawals, an empirical application of the model reveals that the possible gains in profitability from setting deposit rates and hedging withdrawals are small but statistically significant.     

Mortgage risks,debt literacy and financial advice

A limited understanding of mortgage contracts and the risks involved may have contributed to the outbreak of the 2007–2008 financial crisis. We developed a special questionnaire relating mortgage loan decisions to financial knowledge and financial advice. Our results demonstrate that homeowners appear to be well aware of mortgage risks. Large loans relative to home value are perceived as riskier, as are loans with large mortgage payments relative to income and loans linked to investment vehicles. Homeowners with riskier mortgages indicated that they could encounter financial problems should house prices or their income decline. Homeowners with relatively low debt literacy are more likely to take out traditional mortgages with principal repayments over the maturity of the loan. Riskier mortgages are more prevalent among homeowners with a better understanding of loan contracts. Financially less sophisticated homeowners consulting mortgage brokers, too, hold riskier mortgages.     

Variety expansion,preference shocks,and financial intermediaries

We investigate the effect of lifetime uncertainty on economic growth by incorporating preference shocks into a variety-expansion model and comparing financial autarky and financial intermediaries. In this economy, long-term investment facilitates the promotion of R&D investment and the creation of new differentiated goods. Our results suggest that when risk aversion is high, an increase in number of differentiated goods slows down R&D investment through a decrease in the price index. Further, if the risk of early withdrawal and the liquidation cost of long-term investment are high, financial intermediaries have significant effects on the growth of variety.     

Liquidity Provision and Financial Stability

When financial intermediaries' key characteristic is provision of liquidity through their liabilities, with financial frictions, the financial sector in the aggregate is likely to overaccumulate equity, thus decreasing liquidity provision and household welfare. Aggregate household welfare is therefore decreasing in the level of aggregate intermediary equity even though the individual value of intermediaries is increasing in equity, which is why intermediaries overaccumulate equity. Subsidizing intermediary dividends can improve welfare by encouraging earlier payout and decreasing aggregate equity in the financial sector. This policy increases the likelihood that intermediaries provide more liquidity and improves the stability of the economy, even though asset prices fall.     

Interaction between economic and financial development

This paper presents a model of financial and economic development which assumes the consumption of real resources by the financial sector. Financial development occurs endogenously as the economy reaches a critical threshold of economic development. Compared to financial autarky, financial intermediaries allocate savings, net of their costs of operation, to more productive investments. Whenever the technology financed by intermediaries is more capital-intensive than that operated in financial autarky, the growth effect of financial development is ambiguous. As a result, financial development may be unsustainable. However, when financial development is sustainable, the credit market becomes more competitive and more efficient over time, and this could eventually contribute to economic growth. Nonetheless, given monopolistic competition in the financial sector, the level of entry into the credit market is generally inefficient. For instance, with diminishing returns to specialisation, entrants might be too few at the early stages of economic development and too many later on.