with Eva Micheler (accepted at the JFE)
Many debt claims, such as bonds, are resaleable, whereas others, such as repos, are not. There was a fivefold increase in repo borrowing before the 2008 crisis. Why? Did banks’ dependence on non-resaleable debt precipitate the crisis? In this paper, we develop a model of bank lending with credit frictions. The key feature of the model is that debt claims are heterogenous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. Borrowing via non-resaleable debt has a dark side: it causes credit chains to form, since if a bank makes a loan via non-resaleable debt and needs liquidity, it cannot sell the loan but must borrow via a new contract. These credit chains are a source of systemic risk, since one bank’s default harms not only its creditors but also its creditors’ creditors. Overall, our model suggests that reducing credit market frictions may have an adverse effect on the financial system and may even lead to the failures of financial institutions.
The worst employment slumps tend to follow the largest expansions of household debt. Using a competitive search model, we find that levered households protected by limited liability engage in risk-shifting by searching for jobs with high wages but low employment probabilities. In general equilibrium, firms respond to this household preference distortion and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment. The equilibrium level of household debt is inefficiently high due to a household-debt externality. We analyze the role that a financial regulator can play in mitigating this externality.
with Giorgia Piacentino
We present a banking model in which bank debt circulates in secondary markets, facilitating trade. The key friction is that secondary market trade is decentralized, i.e. bank debt is traded over the counter like banknotes were in the nineteenth century and repos are today. We find that bank debt is susceptible to runs because secondary market liquidity is fragile, and subject to sudden, self-fulfilling dry-ups. When debt fails to circulate it is redeemed on demand in a “money run.” Even though demandable debt exposes banks to costly runs, banks still choose to issue it because it increases their debt capacity: the option to demand increases the price of debt in the secondary market and hence allows banks to borrow more in the primary market—unlike in existing models, demandability and tradeability are complements.
In this paper, we develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that borrowers rely most on collateral when cash flow pledgeability is high, because this is when it is easy to take on new debt, diluting existing creditors. Creditors thus require collateral for protection against being diluted. This causes a collateral rat race that results in all borrowing being collateralized. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment, i.e. there is a collateral overhang. Our results suggest that increasing the supply of collateral can have adverse effects.
We develop a theory of banking that explains why banks started out as commodities warehouses. We show that warehouses become banks because their superior storage technology allows them to enforce the repayment of loans most effectively. Further, interbank markets emerge endogenously to support this enforcement mechanism. Even though warehouses store deposits of real goods, they make loans by writing new “fake” warehouse receipts, rather than by taking deposits out of storage. Our theory helps to explain how modern banks create funding liquidity and why they combine warehousing (custody and deposit-taking), lending, and private money creation within the same institutions. It also casts light on a number of contemporary regulatory policies.
with Giorgia Piacentino
Delegated asset managers frequently refer to credit ratings in the contracts they offer their investors. However, regulators have advised against this. Why? In this paper, we present a model that suggests a new reason that delegated asset managers contract on credit ratings: contracting on ratings is a way for asset managers to compete for flows of investor capital. However, competition among asset mangers triggers a race to the bottom: asset mangers use ratings in their contracts even though it is socially inefficient. This inefficiency is due to a Hirshleifer-type effect by which contracting on ratings prevents risk-sharing.
In this paper, I model a dynamic market economy in which debt contracts are subject to renegotiation. I find that a firm with more cyclical cash flows can borrow more than a firm with less cyclical cash flows, consistent with empirical evidence. The reason is that a firm with cyclical cash flows puts its creditors in a relatively strong bargaining position when debt is renegotiated. In general equilibrium, this leads to a collateral premium for assets that generate cyclical cash flows—they are expensive because they allow firms to borrow against them, scaling up their investments via leverage. Endogenous variation in enforcement frictions generates business cycle fluctuations in both firm-level and aggregate quantities consistent with stylized facts, even in the absence of capital accumulation or technology shocks.
Non-depository financial intermediaries (“non-banks”) have a higher cost of capital than depositories (“banks”) do, because they do not benefit from government safety nets. How do they still compete with banks? In this paper, we develop a search-and-matching model of entrepreneurial finance with endogenous intermediary entry. With only bank finance, entrepreneurs make inefficient project choices, forgoing innovative projects for traditional projects. However, non-banks emerge to mitigate this inefficiency: they use their high cost of capital as a commitment device not to fund traditional projects, inducing entrepreneurs to innovative efficiently. Despite earning high returns, non- banks never take over the entire market, but coexist with banks in equilibrium.