essays on information and financial intermediation

• Princeton University Doctoral Dissertations, 2011-2024

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This thesis investigates the effects of financial frictions such as symmetric information on aspects of financial intermedation process, in particular banks and the securitisation industry. In the first paper, “Contingent capital structure”, I study the optimal financing arrangement of a bank with risk-shifting incentives and private information, in an environment with macroeconomic uncertainty. Leverage mitigates adverse selection problems owing to debt information insensitivity, but leads to excessive risk-taking. I show that the optimal leverage is procyclical, and contingent convertible (CoCo) bonds emerge as part of the implementation of the optimal contingent capital structure. However, the laissez-faire equilibrium entails excessive leverage and risk-taking, due to a bank’s private incentives to minimise market mispricing of its securities. It is socially optimal to impose countercyclical capital requirements. In the second paper, “Counter-cyclical foreclosure for securitisation”, John Chi-fong Kuong and I investigate the optimal forefclosure policy of delinquent mortgages in a model of mortgage-backed securitisation under asymmetric information. We show that it is optimal for a securitiser to commit to an ex-post value-destroying foreclosure policy to reduce the signalling cost. The optimal foreclosure policy, which can be implemented by contracting with a third-party mortgage-servicer, features a excessive foreclosure rate for a mortgage pools of poor quality, implying a counter-cyclical aggregate foreclosure rate and pro-cyclical repossessed property prices. Finally, the third paper, “Bankruptcy-remote securitisation with implicit guarantee”, explores the role of securitisation in the funding of banks under asymmetric information. In a two-period model, I argue that securitisation as an optimal funding source rely on both features. While implicit guarantee mitigates the asymmetric information problem, bankruptcy-remoteness allows a bank to shield its unsecuritised cash flows in a bad state, thereby relaxing its future financing contraint.

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Essays in Financial Intermediation

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Essays on Financial Intermediation and Economic Linkages

My dissertation studies the impact of economic linkages among market participants on equilibrium outcomes such as asset prices and returns as well as investors’ welfare. The first essay—titled “Inter-firm Relationships and Asset Prices”—studies the asset pricing properties that stem from the propagation of shocks within a network economy and the extent to which such a propagation mechanism quantitatively explains asset market phenomena. I show that changes in the propagation of shocks within a network economy are important to understanding variations in asset prices and returns, both in the aggregate and in the cross section. A calibrated model that matches features of customer-supplier networks in the U.S. as well as dynamic features of macroeconomic variables generates a persistent component in expected consumption growth and stochastic consumption volatility similar to the Long-Run Risks Model of Bansal and Yaron (2004). In the cross section, firms that are more central in the network command higher risk premium than firms that are less central. In the time series, firm-level return volatilities exhibit a high degree of comovement. Implicit economic linkages among market participants also arise due to the existence of frictions in financial markets. The second essay—titled “Basket Securities in Segmented Markets”—studies the design and welfare implications of basket securities issued in markets with limited investor participation. Profit-maximizing intermediaries exploit investors’ inability to trade freely across different markets, so they choose which market to specialize in. I show that when there is only one intermediary, the equilibrium may not be constrained efficient. Increasing competition among intermediaries increases the variety of baskets issued, but does not always improve investors’ welfare. Although competition increases the variety of baskets issued, many of these baskets are redundant, in the sense that coordination among intermediaries could improve investors’ risk-sharing opportunities. The equilibrium basket structure depends on institutional features of a market such as depth and gains from trade. The third essay—titled “Imperfect Information Transmission from Banks to Investors: Real Implications” and joint with Nicol´as Figueroa (Universidad Cat´olica de Chile) and Oksana Leukhina (University of Washington)—proposes a general equilibrium model that features characteristics of securitization markets and study the interaction of information transmission in secondary loan markets and screening effort at loan origination. We show that increasing collateral values and asset complexity helps to explain the following pre-2008 crisis observations: (1) lax screening standards, (2) intensified ratings shopping, (3) rating inflation, and (4) the decline in the differential between yields on assets with low and high ratings. Contrary to conventional wisdom, we find that regulatory policies, such as mandatory rating and mandatory rating disclosure, may exacerbate credit misallocation.

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• Dissertation
• Tepper School of Business

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• Doctor of Philosophy (PhD)

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Essays on Financial Intermediation and International Finance

• Beltran Saavedra, Paula Andrea
• Advisor(s): Weill, Pierre-Olivier ;
• Atkeson, Andrew G

This dissertation consists of three chapters on financial intermediation and international finance that contribute to our understanding and identification of the transmission of aggregate shocks in imperfect financial markets. The first chapter studies the effect of an aggregate funding supply shock in a lending network in times of distress in a quantitative framework for the money market funds industry in the U.S. The second chapter identifies the effect of cross-border banking flows on macroeconomic and financial outcomes for emerging economies. The third chapter studies the identification of the impact of foreign exchange interventions under a limited risk-bearing capacity of financial intermediaries.

The first chapter studies the implications of network frictions for the allocative efficiency of funding provision of the U.S. Money Markets Funds Industry. I build a tractable model of financial intermediation that features an incomplete network of counterparties and bilateral bargaining within a network. I use the quantitative model to assess the effect of a large supply shock of funding in the money market funds industry. I provide an identification framework to estimate the model's parameters and discipline the model using portfolio data of the money market funds industry. I assess a counterfactual taking as primitives the drop in assets under management at the onset of the COVID-19 pandemic and show that the model can account for price dispersion and funding allocation observed in the data.

The second chapter assesses the effect of capital flows in emerging countries. We focus on the impact of cross-border banking flows and leverage the size distribution at the bilateral level to construct an instrument for capital inflows. We build a granular instrumental variable to identify the effects on macroeconomic and financial conditions for 22 emerging countries. Cross-border bank credit causes higher domestic activity in EMEs and looser financial conditions. We also show that the effect is heterogeneous across different levels of capital inflow controls.

The third chapter studies the effects of foreign exchange intervention. We estimate the causal effect of foreign exchange intervention. Theoretically, the impact of foreign exchange intervention depends on the imperfect asset substitution that relates to the limited risk-bearing capacity of financial intermediaries. To identify the risk-bearing capacity, we use the variation from information free flows of passive investors around rebalancing dates. These flows are plausibly exogenous with respect to domestic conditions and act as a shock to the risk held by financial intermediaries. We show that information-free flows have effects on UIP and CIP deviations. Our preliminary estimates show that the required foreign exchange intervention to achieve a 10% foreign exchange depreciation in one week is between $0.02-$5.06 billion dollars.

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ESSAYS ON FINANCIAL INTERMEDIATION

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This dissertation explores the relationship between financial intermediaries and the macroeconomy, both internationally and domestically. The dissertation is composed of two chapters, which study the role of financial sectors in international finance and the US economy, respectively.

In the first chapter, I build a two-country two-goods open economy model with asymmetric financial development levels to jointly match two puzzling observations during the 2008 global financial crisis (GFC): (1) the real consumption growth declined more in foreign countries than in the US although the crisis broke out in the US; (2) the US dollar appreciated against foreign currencies despite the sharp net foreign asset position (NFA) deterioration in the US. The key innovation is to introduce a milder financial constraint in the US within an international context. In tranquil times, the US holds more risky assets due to its more advanced financial market and consequently is more exposed to risks. When a crisis unfolds, the US financial intermediaries suffer heavier capital losses and are forced to liquidate risky asset holdings to deleverage. This deleveraging process leads to a capital retrenchment in the US, which will smooth the US consumption, raise the relative demand of US goods, push up the domestic price index, and lead to a US dollar appreciation. Meanwhile, the NFA deterioration in the US is mainly due to the valuation effect rather than the transaction effect. I show that the valuation effect does not affect the contemporaneous relative consumption between countries, a fact that has been overlooked in the literature. I then verify the model predictions in the data covering major countries from 2003 to 2018. The empirical evidence echoes the theoretical predictions: (1) The US financial sector net worth plunged more than its foreign counterparts and there was a large capital retrenchment in the US during the GFC. (2) The US capital retrenchment had a significant negative impact on foreign countries’ consumption and currency value.

In the second chapter, I identify a series of credit supply shocks in the US since the 1970s using sign restriction VAR and apply the identified shock to firm-level data using the panel local projection method. I document two main findings. First, the identified credit supply shock has a significant and persistent impact on firm investment. One unit of a credit supply shock (0.39% movement of credit volume) induces over 1% movement of firm investment on average at the peak. Different from monetary policy shocks, the credit supply shock has medium- and long-term effects on real variables. Second, the heterogeneous responses of firm investment to the credit supply shock conditional on firm default risk are state-dependent. Firms with lower default risk will increase investment more relative to average firms during credit expansions, and contract investment less during credit contractions. Low default risk firms have consistently lower borrowing costs and better access to external financing over credit cycles. This state-dependence of heterogeneous effects also holds for firms that are large, mature, and less volatile. The second finding has important implications for both empirical and theoretical studies in the future. On the empirical side, it suggests a possibility of misspecification when assuming the effects of firm characteristics on firm activity to exogenous shocks are invariant in expansionary and contractionary phases. This paper highlights that the effects of firm characteristics on firm investment to credit supply shocks have flipped signs and commensurate magnitudes during credit expansions and contractions. On the theoretical side, the evidence is consistent with the insights of financial friction literature arguing that financially constrained firms will be more negatively impacted during credit contractions. Nevertheless, it also suggests that this effect is nonlinear and state-dependent, i.e., financial frictions will amplify the effects of negative shocks, but dampen the effects of positive shocks. A future model featuring credit cycles and heterogeneous financial frictions should take this observation into account.

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Essays in Financial Intermediation and Credit Risk

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2022 Theses Doctoral

Essays on Banking and Financial Intermediation

De Souza Netto, Felipe Anderson

This dissertation combines micro-level data and partial equilibrium models to understand how financial policies affect non-financial firms, with a particular focus on the role played by banks in such transmission. In the first chapter we study a large-scale intervention in the Brazilian banking sector characterized by a sudden increase in the supply of credit provided by commercial government banks. Theoretically, the effect of this type of policy is ambiguous: while it can increase the total amount of credit in the economy, it can also increase misallocation if government banks finance riskier firms with unproductive projects. We leverage credit registry data to document a series of empirical facts and test if the intervention alleviated inefficient underprovision of credit. We find that while the intervention led to a reduction in interest rates and to an increase in total credit from both government and private banks, government banks faced a significant increase in defaults. Loans to ex-ante indebted firms explain this increase in default for government banks. Moreover, neither the increase in total credit nor the reduction in interest rates had any observable effects on output or employment. Our results suggest that the intervention increased credit misallocation, and that adverse selection did not play a significant role in the allocation of credit in Brazil. In the second chapter, we assess the role of banks in the Paycheck Protection Program (PPP), a large and unprecedented small-business support program instituted as a response to the COVID-19 crisis in the United States. In 2020, the PPP administered more than $525 billion in loans and grants to small businesses through the banking system. First, we provide empirical evidence of heterogeneity in the allocation of PPP loans. Firms that were larger and less affected by the COVID-19 crisis received loans earlier, even in a within-bank analysis. Second, we develop a model of PPP allocation through banks that is consistent with the data. We show that research designs based on bank or regional shocks in PPP disbursement, common in the empirical literature, cannot directly identify the overall effect of the program. Bank targeting implies that these designs can, at best, recover the effect of the PPP on a set of firms that is endogenous, changes over time, and is systematically different from the overall set of firms that ultimately receive PPP loans. We propose and implement a model-based method to estimate the overall effect of the program and find that the PPP saved 7.5 million jobs. In the third chapter we further explore the Paycheck Protection Program (PPP) by asking what is the optimal allocation of funds across firms and the distortions caused by allocating these funds through banks. We show that it can be optimal to allocate funds to the least or most affected firms depending on the underlying distribution of the shock that firms face, the firms' financial position, and the total budget available for the program. In the model, as in the data, banks distort the allocation toward firms with more pre-pandemic debt and those less affected by the COVID-19 crisis. We characterize how this misallocation depends on the degree of asymmetric information between banks and the government. In an empirical application of our model, we estimate the PPP's effectiveness and compare it with alternative policies. A policy targeted at the smallest firms could have increased the program's effectiveness significantly.

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• Banks and banking
• COVID-19 (Disease)--Economic aspects

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