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he predictive likelihood is of particular relevance in a Bayesian setting when the purpose is to rank models in a forecast comparison exercise. This paper discusses how the predictive likelihood can be estimated for any subset of the observable variables in linear Gaussian state-space models with Bayesian methods, and proposes to utilize a missing observations consistent Kalman filter in the process of achieving this objective. As an empirical application, we analyze euro area data and compare the density forecast performance of a DSGE model to DSGE-VARs and reduced-form linear Gaussian models.
We use data from the 2009 Internet Survey of the Health and Retirement Study to examine the consumption impact of wealth shocks and unemployment during the Great Recession in the US. We find that many households experienced large capital losses in housing and in their financial portfolios, and that a non-trivial fraction of respondents have lost their job. As a consequence of these shocks, many households reduced substantially their expenditures. We estimate that the marginal propensities to consume with respect to housing and financial wealth are 1 and 3.3 percentage points, respectively. In addition, those who became unemployed reduced spending by 10 percent. We also distinguish the effect of perceived transitory and permanent wealth shocks, splitting the sample between households who think that the stock market is likely to recover in a year’s time, and those who do not. In line with the predictions of standard models of intertemporal choice, we find that the latter group adjusted much more than the former its spending in response to financial wealth shocks.
Using data from the US Health and Retirement Study, we study the causal effect of increased health insurance coverage through Medicare and the associated reduction in health-related background risk on financial risk-taking. Given the onset of Medicare at age 65, we identify our effect of interest using a regression discontinuity approach. We find that getting Medicare coverage induces stockholding for those with at least some college education, but not for their less-educated counterparts. Hence, our results indicate that a reduction in background risk induces financial risk-taking in individuals for whom informational and pecuniary stock market participation costs are relatively low.
Euro area data show a positive connection between sovereign and bank risk, which increases with banks’ and sovereign long run fragility. We build a macro model with banks subject to moral hazard and liquidity risk (sudden deposit withdrawals): banks invest in risky government bonds as a form of capital buffer against liquidity risk. The model can replicate the positive connection between sovereign and bank risk observed in the data. Central bank liquidity policy, through full allotment policy, is successful in stabilizing the spiraling feedback loops between bank and sovereign risk.
Trust in policy makers fluctuates signi
cantly over the cycle and affects the transmission mechanism. Despite this it is absent from the literature. We build a monetary model embedding trust cycles; the latter emerge as an equilibrium phenomenon of a game-theoretic interaction between atomistic agents and the monetary authority. Trust affects agents' stochastic discount factors, namely the price of future risk, and through this it interacts with the monetary transmission mechanism. Using data from the Eurobarometer surveys, we analyze the link between trust and the transmission mechanism of macro and monetary shocks: Empirical results are in line with theoretical ones.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.
We study the effect of weakening creditor rights on distress risk premia via a bankruptcy reform that shifts bargaining power in financial distress toward shareholders. We find that the reform reduces risk factor loadings and returns of distressed stocks. The effect is stronger for firms with lower firm-level shareholder bargaining power. An increase in credit spreads of riskier relative to safer firms, in particular for firms with lower firm-level shareholder bargaining power, confirms a shift in bargaining power from bondholders to shareholders. Out-of-sample tests reveal that a reversal of the reform's effects leads to a reversal of factor loadings and returns.
The recent financial crisis highlighted the limits of the "originate to distribute" model of banking, but its nexus with the macroeconomy remains unexplored. I build a business cycle model with banks engaging in credit risk transfer (CRT) under informational externalities. Markets for CRT provide liquidity insurance to banks, but the emergence of a pooling equilibrium can also impair the banks’ monitoring incentives. In normal times and in face of standard macro shocks the insurance benefits of CRT prevail and the business cycle is stabilized. In face of financial/liquidity shocks the extent of informational asymmetries is larger and the business cycle is amplified. The macro model with CRT can also reproduce well a number of macro and banking statistics over the period of rapid growth of this banks’ business model.
We propose a novel approach on how to estimate systemic risk and identify its key determinants. For US financial companies with publicly traded equity options, we extract option-implied value-at-risks and measure the spillover effects between individual company value-at-risks and the option-implied value-at-risk of a financial index. First, we study the spillover effect of increasing company risks on the financial sector. Second, we analyze which companies are mostly affected if the tail risk of the financial sector increases. Key metrics such as size, leverage, market-to-book ratio and earnings have a significant influence on the systemic risk profiles of financial institutions.
We study the effect of weakening creditor rights on distress risk premia via a bankruptcy reform that shifts bargaining power in financial distress toward shareholders. We find that the reform reduces risk factor loadings and returns of distressed stocks. The effect is stronger for firms with lower firm-level shareholder bargaining power. An increase in credit spreads of riskier relative to safer firms, in particular for firms with lower firm-level shareholder bargaining power, confirms a shift in bargaining power from bondholders to shareholders. Out-of-sample tests reveal that a reversal of the reform's effects leads to a reversal of factor loadings and returns.
Does austerity pay off?
(2014)
Policy makers often implement austerity measures when the sustainability of public finances is in doubt and, hence, sovereign yield spreads are high. Is austerity successful in bringing about a reduction in yield spreads? We employ a new panel data set which contains sovereign yield spreads for 31 emerging and advanced economies and estimate the effects of cuts of government consumption on yield spreads and economic activity. The conditions under which austerity takes place are crucial. During times of fiscal stress, spreads rise in response to the spending cuts, at least in the short-run. In contrast, austerity pays off, if conditions are more benign.
One of the leading methods of estimating the structural parameters of DSGE models is the VAR-based impulse response matching estimator. The existing asympotic theory for this estimator does not cover situations in which the number of impulse response parameters exceeds the number of VAR model parameters. Situations in which this order condition is violated arise routinely in applied work. We establish the consistency of the impulse response matching estimator in this situation, we derive its asymptotic distribution, and we show how this distribution can be approximated by bootstrap methods. Our methods of inference remain asymptotically valid when the order condition is satisfied, regardless of whether the usual rank condition for the application of the delta method holds. Our analysis sheds new light on the choice of the weighting matrix and covers both weakly and strongly identified DSGE model parameters. We also show that under our assumptions special care is needed to ensure the asymptotic validity of Bayesian methods of inference. A simulation study suggests that the frequentist and Bayesian point and interval estimators we propose are reasonably accurate in finite samples. We also show that using these methods may affect the substantive conclusions in empirical work.
Robustness, validity, and significance of the ECB's asset quality review and stress test exercise
(2014)
As we are moving toward a eurozone banking union, the European Central Bank (ECB) is going to take over the regulatory oversight of 128 banks in November 2014. To that end, the ECB conducted a comprehensive assessment of these banks, which included an asset quality review (AQR) and a stress test. The fundamental question is how accurately will the financial condition of these banks have been assessed by the ECB when it commences its regulatory oversight? And, can the comprehensive assessment lead to a full repair of banks’ balance sheets so that the ECB takes over financially sound banks and is the necessary regulation in place to facilitate this? Overall, the evidence presented in this paper based on the design of the comprehensive assessment as well as own stress test exercises suggest that the ECB’s assessment might not comprehensively deal with the problems in the financial sector and risks may remain that will pose substantial threats to financial stability in the eurozone.
We study consumption-portfolio and asset pricing frameworks with recursive preferences and unspanned risk. We show that in both cases, portfolio choice and asset pricing, the value function of the investor/ representative agent can be characterized by a specific semilinear partial differential equation. To date, the solution to this equation has mostly been approximated by Campbell-Shiller techniques, without addressing general issues of existence and uniqueness. We develop a novel approach that rigorously constructs the solution by a fixed point argument. We prove that under regularity conditions a solution exists and establish a fast and accurate numerical method to solve consumption-portfolio and asset pricing problems with recursive preferences and unspanned risk. Our setting is not restricted to affine asset price dynamics. Numerical examples illustrate our approach.
n a contribution prepared for the Athens Symposium on “Banking Union, Monetary Policy and Economic Growth”, Otmar Issing describes forward guidance by central banks as the culmination of the idea of guiding expectations by pure communication. In practice, he argues, forward guidance has proved a misguided idea. What is presented as state of the art monetary policy is an example of pretence of knowledge. Forward guidance tries to give the impression of a kind of rule-based monetary policy. De facto, however, it is an overambitious discretionary approach which, to be successful, would need much more (or rather better) information than is currently available. In Issing's view, communication must be clear and honest about the limits of monetary policy in a world of uncertainty.
In the wake of the Global Financial Crisis that started in 2007, policymakers were forced to respond quickly and forcefully to a recession caused not by short-term factors, but rather by an over-accumulation of debt by sovereigns, banks, and households: a so-called “balance sheet recession.” Though the nature of the crisis was understood relatively early on, policy prescriptions for how to deal with its consequences have continued to diverge. This paper gives a short overview of the prescriptions, the remaining challenges and key lessons for monetary policy.
In this paper, we propose a novel approach on how to estimate systemic risk and identify its key determinants. For all US financial companies with publicly traded equity options, we extract their option-implied value-at-risks (VaRs) and measure the spillover effects between individual company VaRs and the option-implied VaR of an US financial index. First, we study the spillover effect of increasing company risks on the financial sector. Second, we analyze which companies are most affected if the tail risk of the financial sector increases. We find that key accounting and market valuation metrics such as size, leverage, balance sheet composition, market-to-book ratio and earnings have a significant influence on the systemic risk profile of a financial institution. In contrast to earlier studies, the employed panel vector autoregression (PVAR) estimator allows for a causal interpretation of the results.
This paper makes a conceptual contribution to the effect of monetary policy on financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the beneficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We find that central bank supply of liquidity quite generally increases systemic risk.
Panel Sample Selection ModelsThe empirical evidence currently available in the literature regarding the effects of a country's IMF program participation on its output growth is rather inconclusive. In this paper we propose and estimate a panel data sample selection model featuring state dependence. As in this model the output growth effects of program participation can be conditional on the realization of a state variable (conditional pooling), our framework may reconcile previous empirical evidence based on models without state-dependent effects. We find that the effects of IMF program participation on output growth vary systematically with an index reflecting a country's institutional record, and that output growth effects of program participation are significantly positive only if the program participation is coupled with sufficient improvement of the institutional record.
This paper makes a conceptual contribution to the effect of monetary policy on financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the beneficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We find that central bank supply of liquidity quite generally increases systemic risk.
We explore the sources of household balance sheet adjustment following the collapse of the housing market in 2006. First, we use microdata from the Federal Reserve Board’s Senior Loan Officer Opinion Survey to document that banks cumulatively tightened consumer lending standards more in counties that experienced a house price boom in the mid-2000s than in non-boom counties. We then use the idea that renters, unlike homeowners, did not experience an adverse wealth shock when the housing market collapsed to examine the relative importance of two explanations for the observed deleveraging and the sluggish pickup in consumption after 2008. First, households may have optimally adjusted to lower wealth by reducing their demand for debt and implicitly, their demand for consumption. Alternatively, banks may have been more reluctant to lend in areas with pronounced real estate declines. Our evidence is consistent with the second explanation. Renters with low risk scores, compared to homeowners in the same markets, reduced their levels of nonmortgage debt and credit card debt more in counties where house prices fell more. The contrast suggests that the observed reductions in aggregate borrowing were more driven by cutbacks in the provision of credit than by a demand-based response to lower housing wealth.
We characterize optimal redistribution in a dynastic family model with human capital. We show how a government can improve the trade-off between equality and incentives by changing the amount of observable human capital. We provide an intuitive decomposition for the wedge between human-capital investment in the laissez faire and the social optimum. This wedge differs from the wedge for bequests because human capital carries risk: its returns depend on the non-diversi
able risk of children's ability. Thus, human capital investment is encouraged more than bequests in the social optimum if human capital is a bad hedge for consumption risk.
After the Global Financial Crisis a controversial rush to fiscal austerity followed in many countries. Yet research on the effects of austerity on macroeconomic aggregates was and still is unsettled, mired by the difficulty of identifying multipliers from observational data. This paper reconciles seemingly disparate estimates of multipliers within a unified and state-contingent framework. We achieve identification of causal effects with new propensity-score based methods for time series data. Using this novel approach, we show that austerity is always a drag on growth, and especially so in depressed economies: a one percent of GDP fiscal consolidation translates into 4 percent lower real GDP after five years when implemented in the slump rather than the boom. We illustrate our findings with a counterfactual evaluation of the impact of the U.K. government’s shift to austerity policies in 2010 on subsequent growth.
In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.
Riley (1979)'s reactive equilibrium concept addresses problems of equilibrium existence in competitive markets with adverse selection. The game-theoretic interpretation of the reactive equilibrium concept in Engers and Fernandez (1987) yields the Rothschild-Stiglitz (1976)/Riley (1979) allocation as an equilibrium allocation, however multiplicity of equilibrium emerges. In this note we imbed the reactive equilibrium's logic in a dynamic market context with active consumers. We show that the Riley/Rothschild-Stiglitz contracts constitute the unique equilibrium allocation in any pure strategy subgame perfect Nash equilibrium.
This paper contrasts the recent European initiatives on regulating corporate groups with alternative approaches to the phenomenon. In doing so it pays particular regard to the German codified law on corporate groups as the polar opposite to the piecemeal approach favored by E.U. legislation.
It finds that the European Commission’s proposal to submit (significant) related party transactions to enhanced transparency, outside fairness review, and ex ante shareholder approval is both flawed in its design and based on contestable assumptions on informed voting of institutional investors. In particular, the contemplated exemption for transactions with wholly owned subsidiaries allows controlling shareholders to circumvent the rule extensively. Moreover, vesting voting rights with (institutional) investors will not lead to the informed assessment that is hoped for, because these investors will rationally abstain from active monitoring and rely on proxy advisory firms instead whose competency to analyze non-routine significant related party transactions is questionable.
The paper further delineates that the proposed recognition of an overriding interest of the group requires strong counterbalances to adequately protect minority shareholders and creditors. Hence, if the Commission choses to go down this route it might end up with a comprehensive regulation that is akin to the unpopular Ninth Company Law Directive in spirit, though not in content. The latter prediction is corroborated by the pertinent parts of the proposal for a European Model Company Act.
In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium.
This essay reviews a cornerstone of the European Banking Union project, the resolution of systemically important banks. The focus is on the inherent conflict between a possible intervention by resolution authorities, conditional on a crisis situation, and effective prevention prior to a crisis. Moreover, the paper discusses the rules for bail-in debt and conversion rules for different layers of debt. Finally, some organizational requirements to achieve effective resolution results will be analyzed.
On November 8, 2013, several members of the British House of Lords’ Subcommittee A conducted a hearing at the ECB in Frankfurt, Germany, on “Genuine Economic and Monetary Union and its Implications for the UK”. Professors Otmar Issing and Jan Pieter Krahnen were called as expert witnesses.
The testimony began with a general discussion on the elements considered necessary for a functioning internal market. Do economic union and monetary union require a fiscal union or even a political union, beyond the elements of the banking union currently being prepared? In this context, also the critique of the German current account surplus and the international expectations that Germany stimulate internal demand to support growth in crisis countries, were discussed.
With regard to the monetary union, the members of the subcommittee asked for an assessment of how European nations and the banking industry would have fared in the banking crisis that followed the Lehman collapse, had there not been a common currency. Given the important role that the ECB has played in the course of the crisis management, the members further asked for an evaluation of the OMT-program of the ECB and also if the monetary union is in need of common debt instruments, in order to provide the ECB with the possibility of buying EU liabilities, comparable to the Fed buying US Treasury bonds. Finally, the dual role of the ECB for monetary policy and banking supervision was an issue touched on by several questions.
Money is more than memory
(2014)
Impersonal exchange is the hallmark of an advanced society. One key institution for impersonal exchange is money, which economic theory considers just a primitive arrangement for monitoring past conduct in society. If so, then a public record of past actions — or memory — supersedes the function performed by money. This intriguing theoretical postulate remains untested. In an experiment, we show that the suggested functional equality between money and memory does not translate into an empirical equivalence. Monetary systems perform a richer set of functions than just revealing past behaviors, which proves to be crucial in promoting large-scale cooperation.
Although oil price shocks have long been viewed as one of the leading candidates for explaining U.S. recessions, surprisingly little is known about the extent to which oil price shocks explain recessions. We provide the first formal analysis of this question with special attention to the possible role of net oil price increases in amplifying the transmission of oil price shocks. We quantify the conditional recessionary effect of oil price shocks in the net oil price increase model for all episodes of net oil price increases since the mid-1970s. Compared to the linear model, the cumulative effect of oil price shocks over course of the next two years is much larger in the net oil price increase model. For example, oil price shocks explain a 3% cumulative reduction in U.S. real GDP in the late 1970s and early 1980s and a 5% cumulative reduction during the financial crisis. An obvious concern is that some of these estimates are an artifact of net oil price increases being correlated with other variables that explain recessions. We show that the explanatory power of oil price shocks largely persists even after augmenting the nonlinear model with a measure of credit supply conditions, of the monetary policy stance and of consumer confidence. There is evidence, however, that the conditional fit of the net oil price increase model is worse on average than the fit of the corresponding linear model, suggesting much smaller cumulative effects of oil price shocks for these episodes of at most 1%.
This paper explains why the collection of panel (reinterview) data on a comprehensive measure of household expenditures is of great value both for measuring budget shares (the core mission of a Consumer Expenditure survey) and for the most important research and public policy uses to which CE data can be applied, including construction of spending-based measures of poverty and inequality and estimating the effects of fiscal policy.
The Great Recession confirmed a bedrock principle of modern consumption theory: It is impossible to explain aggregate spending behavior without knowledge of the underlying microeconomic distribution of circumstances and choices across households. National accounting frameworks therefore need to be augmented by “bottom up” measures that both (a) capture the microeconomic heterogeneity (in expenditures, income, assets, debt, and beliefs) in the population and (b) sum up to statistics that have a recognizable relationship to the aggregate totals that are already reasonably well measured.
Austerity
(2014)
We shed light on the function, properties and optimal size of austerity using the standard sovereign model augmented to include incomplete information about credit risk. Austerity is defined as the shortfall of consumption from the level desired by a country and supported by its repayment capacity. We find that austerity serves as a tool for securing a more favorable loan package; that it is associated with over-investment even when investment does not create collateral; and that low risk borrowers may favor more to less severe austerity. These findings imply that the amount of fresh funds obtained by a sovereign is not a reliable measure of austerity suffered; and that austerity may actually be associated with higher growth. Our analysis accommodates costly signalling for gaining credibility and also assigns a novel role to spending multipliers in the determination of optimal austerity.
This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis allows to capture individual behavior across various levels of ambiguity, ranging from low to high. Attitudes towards risk and attitudes towards ambiguity are disentangled, providing pure measures of ambiguity aversion. Ambiguity aversion is captured in several ways, i.e. as a discount factor net of a risk premium, and as an estimated parameter in a generalized utility function. We find that ambiguity aversion varies across individuals, and with the level of ambiguity, being most prominent for intermediate levels. Around one third of subjects show no aversion, one third show maximum aversion, and one third show intermediate levels of ambiguity aversion, while there is almost no ambiguity seeking. While most theoretical work on ambiguity builds on maxmin expected utility, our results provide evidence that MEU does not adequately capture individual attitudes towards ambiguity for the majority of individuals. Instead, our results support models that allow for intermediate levels of ambiguity aversion. Moreover, we find risk aversion to be statistically unrelated to ambiguity aversion on average. Taken together, the results support the view that ambiguity is an important and distinct argument in decision making under uncertainty.
Europe's debt crisis casts doubt on the effectiveness of fiscal austerity in highly-integrated economies. Closed-economy models overestimate its effectiveness, because they underestimate tax-base elasticities and ignore cross-country tax externalities. In contrast, we study tax responses to debt shocks in a two-country model with endogenous utilization that captures those externalities and matches the capital-tax-base elasticity. Quantitative results show that unilateral capital tax hikes cannot restore fiscal solvency in Europe, and have large negative (positive) effects at "home" ("abroad"). Restoring solvency via either Nash competition or Cooperation reduces (increases) capital (labor) taxes significantly, and leaves countries with larger debt shocks preferring autarky.
Advertising arbitrage
(2014)
Speculators often advertise arbitrage opportunities in order to persuade other investors and thus accelerate the correction of mispricing. We show that in order to minimize the risk and the cost of arbitrage an investor who identifies several mispriced assets optimally advertises only one of them, and overweights it in his portfolio; a risk-neutral arbitrageur invests only in this asset. The choice of the asset to be advertised depends not only on mispricing but also on its "advertisability" and accuracy of future news about it. When several arbitrageurs identify the same arbitrage opportunities, their decisions are strategic complements: they invest in the same asset and advertise it. Then, multiple equilibria may arise, some of which inefficient: arbitrageurs may correct small mispricings while failing to eliminate large ones. Finally, prices react more strongly to the ads of arbitrageurs with a successful track record, and reputation-building induces high-skill arbitrageurs to advertise more than others.
In this paper we investigate the implications of providing loan officers with a compensation structure that rewards loan volume and penalizes poor performance versus a fixed wage unrelated to performance. We study detailed transaction information for more than 45,000 loans issued by 240 loan officers of a large commercial bank in Europe. We examine the three main activities that loan officers perform: monitoring, originating, and screening. We find that when the performance of their portfolio deteriorates, loan officers increase their effort to monitor existing borrowers, reduce loan origination, and approve a higher fraction of loan applications. These loans, however, are of above-average quality. Consistent with the theoretical literature on multitasking in incomplete contracts, we show that loan officers neglect activities that are not directly rewarded under the contract, but are in the interest of the bank. In addition, while the response by loan officers constitutes a rational response to a time allocation problem, their reaction to incentives appears myopic in other dimensions.
SAFE Newsletter : 2014, Q4
(2014)
SAFE Newsletter : 2014, Q3
(2014)
Emotions-at-risk: an experimental investigation into emotions, option prices and risk perception
(2014)
This paper experimentally investigates how emotions are associated with option prices and risk perception. Using a binary lottery, we find evidence that the emotion ‘surprise’ plays a significant role in the negative correlation between lottery returns and estimates of the price of a put option. Our findings shed new light on various existing theories on emotions and affect. We find gratitude, admiration, and joy to be positively associated with risk perception, although the affect heuristic predicts a negative association. In contrast with the predictions of the appraisal tendency framework (ATF), we document a negative correlation between option price and surprise for lottery winners. Finally, the results show that the option price is not associated with risk perception as commonly used in psychology.
I analyze a critical illness insurance in a consumption-investment model over the life cycle. I solve a model with stochastic mortality risk and health shock risk numerically. These shocks are interpreted as critical illness and can negatively affect the expected remaining lifetime, the health expenses, and the income. In order to hedge the health expense effect of a shock, the agent has the possibility to contract a critical illness insurance. My results highlight that the critical illness insurance is strongly desired by the agents. With an insurance profit of 20%, nearly all agents contract the insurance in the working stage of the life cycle and more than 50% of the agents contract the insurance during retirement. With an insurance profit of 200%, still nearly all working agents contract the insurance, whereas there is little demand in the retirement stage.
I numerically solve realistically calibrated life cycle consumption-investment problems in continuous time featuring stochastic mortality risk driven by jumps, unspanned labor income as well as short-sale and liquidity constraints and a simple insurance. I compare models with deterministic and stochastic hazard rate of death to a model without mortality risk. Mortality risk has only minor effects on the optimal controls early in the life cycle but it becomes crucial in later years. A diffusive component in the hazard rate of death has no significant impact, whereas a jump component is desired by the agent and influences optimal controls and wealth evolution. The insurance is used to ensure optimal bequest such that there is no accidental bequest. In the absence of the insurance, the biggest part of bequest is accidental.
SAFE Newsletter : 2014, Q2
(2014)
Efforts to control bank risk address the wrong problem in the wrong way. They presume that the financial crisis was caused by CEOs who failed to supervise risk-taking employees. The responses focus on executive pay, believing that executives will bring non-executives into line—using incentives to manage risk-taking—once their own pay is regulated. What they overlook is the effect on non-executive pay of the competition for talent. Even if executive pay is regulated, and executives act in the bank’s best interests, they will still be trapped into providing incentives that encourage risk-taking by non-executives due to the negative externality that arises from that competition. Greater risk-taking can increase short-term profits and, in turn, the amount a non-executive receives, potentially at the expense of long-term bank value. Non-executives, therefore, have an incentive to incur significant risk upfront so long as they can depart for a new employer before any losses materialize. The result is an upward spiral in compensation—reducing an executive’s ability to set non-executive pay and the ability of any one bank to adjust compensation to reflect risk-taking and long-term outcomes. New regulation must address the tension between compensation and competition. Regulators should take account of the effect of competition on market-wide levels of pay, including by non-banks who compete for talent. The ability of non-executives to jump from a bank employer to another financial firm should also be limited. In addition, banks should be required to include a long-term equity component in non-executive pay, with subsequent employers being restricted from compensating a new employee for any losses she incurs related to her prior work.
SAFE Newsletter : 2014, Q1
(2014)
How much additional tax revenue can the government generate by increasing labor income taxes? In this paper we provide a quantitative answer to this question, and study the importance of the progressivity of the tax schedule for the ability of the government to generate tax revenues. We develop a rich overlapping generations model featuring an explicit family structure, extensive and intensive margins of labor supply, endogenous accumulation of labor market experience as well as standard intertemporal consumption-savings choices in the presence of uninsurable idiosyncratic labor productivity risk. We calibrate the model to US macro, micro and tax data and characterize the labor income tax Laffer curve under the current choice of the progressivity of the labor income tax code as well as when varying progressivity. We find that more progressive labor income taxes significantly reduce tax revenues. For the US, converting to a flat tax code raises the peak of the Laffer curve by 6%, whereas converting to a tax system with progressivity similar to Denmark would lower the peak by 7%. We also show that, relative to a representative agent economy tax revenues are less sensitive to the progressivity of the tax code in our economy. This finding is due to the fact that labor supply of two earner households is less elastic (along the intensive margin) and the endogenous accumulation of labor market experience makes labor supply of females less elastic (around the extensive margin) to changes in tax progressivity.
This paper investigates the impact of news media sentiment on financial market returns and volatility in the long-term. We hypothesize that the way the media formulate and present news to the public produces different perceptions and, thus, incurs different investor behavior. To analyze such framing effects we distinguish between optimistic and pessimistic news frames. We construct a monthly media sentiment indicator by taking the ratio of the number of newspaper articles that contain predetermined negative words to the number of newspaper articles that contain predetermined positive words in the headline and/or the lead paragraph. Our results indicate that pessimistic news media sentiment is positively related to global market volatility and negatively related to global market returns 12 to 24 months in advance. We show that our media sentiment indicator reflects very well the financial market crises and pricing bubbles over the past 20 years.