We develop a model in which the absolute priority of secured debt leads to conflicts among creditors, but can be optimal nonetheless. The option to use collateral to dilute unsecured debt, even in violation of covenants, loosens financial constraints that could be inefficiently tight. But covenants embed an acceleration option that prevents these constraints from becoming inefficiently loose.
with Giorgia Piacentino, 2021 (forthcoming at the JME)
Bank debt is both a financial security used to raise funds and a kind of money used to facilitate trade. We develop a model based on this dual role of bank debt. It provides a new rationale for why banks do many of the things they do, including why they choose to issue demandable debt, and hence why they are fragile. It gives new perspectives on a number of policies, notably suspension of convertibility and narrow banking.
Non-depository financial intermediaries (“non-banks”) have a higher cost of capital than depositories (“banks”) do, e.g., because they do not benefit from a moneyness premium on deposits or government safety nets. How do they still compete with banks? Non-banks use their high cost of capital as a commitment device not to fund traditional projects, inducing entrepreneurs to innovative efficiently.
Best Paper Award at the 2018 ASU Sonoran Winter Finance Conference
In a dynamic model of board decision making, directors strategically block proposals that benefit other directors. Such deadlock on the board explains CEO entrenchment and strategic inertia. We study how board composition affects deadlock, and find, for example, that board diversity can exacerbate it.
We develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment—there is a collateral overhang.
Using a search model, we find that levered households protected by limited liability suffer from a household-debt-overhang problem that leads them to require high wages to work. Firms respond by posting high wages but few vacancies. The equilibrium level of household debt is inefficiently high due to a household-debt externality.
with Giorgia Piacentino, 2018 (in JET 173)
Delegated asset managers frequently refer to public information, such as credit ratings and benchmark indicies, in the contracts they offer their investors. However, regulators have advised against this. Why do asset managers refer to public information in their contracts? We show that it is a way for asset managers to compete for flows of investor capital, even though it is socially inefficient.
We develop a theory of banking that explains why banks started out as commodities warehouses. 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.
with Eva Micheler, 2018 (in the JFE 127)
Many debt claims, such as bonds, are resaleable, whereas others, such as repos, are not. We develop a model of bank lending in which debt claims are heterogenous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. This causes credit chains to form, creating systemic risk.
How can firms resolve financial distress? Bankruptcy is one way, albeit a costly one. A less costly way is out-of-court restructuring. But hold-out problems can make it infeasible. Do policies that encourage bankruptcy filings, by, e.g., decreasing costs, crowd out restructuring? We find that the answer is no. We study how regulatory interventions can further increase welfare.
We ask how liquidity risk propagates in interbank networks. We show that the answer turns on the maturity of interbank debt. Indebtedness and connectedness are sources of fragility if debt is short term, but of stability if it is long term. The right network of long-term debts implements the optimal allocation of liquidity.
Sovereigns in distress often engage in bond restructuring. Does committing not to restructure one class of bonds benefit that class? Does it spillover to benefit other classes too? Evidence from natural experiments suggests the answers: yes and yes.
Assets pledged as collateral for secured debt cannot be sold unless the debt is paid or otherwise renegotiated. We develop a model of this role of collateralization. We find that debt market frictions (alone) can cause the asset market to fail, causing misallocation.
Interbank debt is money-like, but not a perfect substitute for cash: it can be hard to convert to cash to fund new investments. Hence, interbank lending comes with an opportunity cost that generates positive spreads even absent any credit risk. These spreads enter banks’ collateral constraints, generating a feedback between the opportunity cost in the credit market and the price of collateral in the asset market. This results in instability in the form of multiple equilibria, casting light on repo runs. We provide a new rational for counter-cyclical capital regulation.
I explore how the cyclicality of firms’ output affects their debt capacity. I point out that, in contrast to received theory, procyclical firms can have an advantage in the funding market: because they have more assets in booms, when asset prices are high ex post, they have looser collateral constraints ex ante—assets are useful as collateral only when they are valuable.
with Giorgia Piacentino, 2018 (largely superseded by Systemic Risk in Financial Networks Revisited, above)
Banks hold gross debts without netting them out. Why? These gross debts implement valuable contingent transfers via the option to dilute.