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Institute
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62
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.
61
The implications of delegating fiscal decision making power to sub-national governments has become an area of significant interest over the past two decades, in the expectation that these reforms will lead to better and more efficient provision of public goods and services. The move towards decentralization has, however, not been homogeneously implemented on the revenue and expenditure side: decentralization has materialized more substantially on the latter than on the former, creating "vertical fiscal imbalances". These imbalances measure the extent to which sub-national governments’ expenditures are financed through their own revenues. This mismatch between own revenues and expenditures may have negative consequences for public finances performance, for example by softening the budget constraint of sub-national governments. Using a large sample of countries covering a long time period from the IMF’s Government Finance Statistics Yearbook, this paper is the first to examine the effects of vertical fiscal imbalances on fiscal performance through the accumulation of government debt. Our findings suggest that vertical fiscal imbalances are indeed relevant in explaining government debt accumulation, and call for a degree of caution when promoting fiscal decentralization.
60
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
59
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
58
The Eurozone fiscal crisis has created pressure for institutional harmonization, but skeptics argue that cultural predispositions can prevent convergence in behavior. Our paper derives a robust cultural classification of European countries and utilizes unique data on natives and immigrants to Sweden. Classification based on genetic distance or on Hofstede’s cultural dimensions fails to identify a single ‘southern’ culture but points to a ‘northern’ culture. Significant differences in financial behavior are found across cultural groups, controlling for household characteristics. Financial behavior tends to converge with longer exposure to common institutions, but is slowed down by longer exposure to original institutions.
57
This is a chapter for a forthcoming volume Oxford Handbook of Financial Regulation (Oxford University Press 2014) (eds. Eilís Ferran, Niamh Moloney, and Jennifer Payne). It provides an overview of EU financial regulation from the first banking directive up until its most recent developments in the aftermath of the financial crisis, focusing on the multiple layers of multi-level governance and their characteristic conceptual difficulties. Therefore the paper discusses the need to accommodate cross-border capital flows following from the EU internal market and the resulting regulatory strategies. This includes a brief overview of the principle of home country control and the ensuing Financial Services Action Plan. Dealing with the accommodation of cross-border capital flows and their regulation necessarily require an orchestration of the underlying supervisory structures, which is therefore also discussed. In the aftermath of the financial crisis of 2007-09 an additional aspect of necessary orchestration has emerged, that is the need to control systemic risk. Specific attention is paid to microprudential supervision by the newly established European Supervisory Authorities and macroprudential supervision in the European Banking Union, the latter’s underlying drivers and the accompanying Single Supervisory Mechanism, including the SSM’s institutional framework as well as the consideration of its rationales and the Single Resolution Mechanism closely linked to it.
56
This paper contributes to the ongoing debate on the relationship between austerity measures and economic growth. We propose a general equilibrium model where (i) agents have recursive preferences; (ii) economic growth is endogenously driven by investments in R&D; (iii) the government is committed to a zero-deficit policy and finances public expenditures by means of a combination of labor taxes and R&D taxes. We find that austerity measures that rely on reducing resources available to the R&D sector depress economic growth both in the short- and long-run. High debt EU members are currently implementing austerity measures based on higher taxes and/or lower investments in the R&D sector. This casts some doubts on the real ability of these countries to grow over the next years.
55
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.
54 [v.2]
We investigate the relationship between anchoring and the emergence of bubbles in experimental asset markets. We show that setting a visual anchor at the fundamental value (FV) in the first period only is sufficient to eliminate or to significantly reduce bubbles in laboratory asset markets. If no FV-anchor is set, bubble-crash patterns emerge. Our results indicate that bubbles in laboratory environments are primarily sparked in the first period. If prices are initiated around the FV, they stay close to the FV over the entire trading horizon. Our insights can be related to initial public offerings and the interaction between prices set on pre-opening markets and subsequent intra-day price dynamics.
54
We investigate the relationship between anchoring and the emergence of bubbles in experimental asset markets. We show that setting a visual anchor at the fundamental value (FV) in the first period only is sufficient to eliminate or to significantly reduce bubbles in laboratory asset markets. If no FV-anchor is set, bubble-crash patterns emerge. Our results indicate that bubbles in laboratory environments are primarily sparked in the first period. If prices are initiated around the FV, they stay close to the FV over the entire trading horizon. Our insights can be related to initial public offerings and the interaction between prices set on pre-opening markets and subsequent intra-day price dynamics.
53
he observed hump-shaped life-cycle pattern in individuals' consumption cannot be explained by the classical consumption-savings model. We explicitly solve a model with utility of both consumption and leisure and with educational decisions affecting future wages. We show optimal consumption is hump shaped and determine the peak age. The hump results from consumption and leisure being substitutes and from the implicit price of leisure being decreasing over time; more leisure means less education, which lowers future wages, and the present value of foregone wages decreases with age. Consumption is hump shaped whether the wage is hump shaped or increasing over life.
52
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.
51
We study self- and cross-excitation of shocks in the Eurozone sovereign CDS market. We adopt a multivariate setting with credit default intensities driven by mutually exciting jump processes, to capture the salient features observed in the data, in particular, the clustering of high default probabilities both in time (over days) and in space (across countries). The feedback between jump events and the intensity of these jumps is the key element of the model. We derive closed-form formulae for CDS prices, and estimate the model by matching theoretical prices to their empirical counterparts. We find evidence of self-excitation and asymmetric cross-excitation. Using impulse-response analysis, we assess the impact of shocks and a potential policy intervention not just on a single country under scrutiny but also, through the effect on cross-excitation risk which generates systemic sovereign risk, on other interconnected countries.
50
Exit strategies
(2014)
We study alternative scenarios for exiting the post-crisis fiscal and monetary accommodation using a macromodel where banks choose their capital structure and are subject to runs. Under a Taylor rule, the post-crisis interest rate hits the zero lower bound (ZLB) and remains there for several years. In that condition, pre-announced and fast fiscal consolidations dominate - based on output and inflation performance and bank stability - alternative strategies incorporating various degrees of gradualism and surprise. We also examine an alternative monetary strategy in which the interest rate does not reach the ZLB; the benefits from fiscal consolidation persist, but are more nuanced.
49
We study the behavioral underpinnings of adopting cash versus electronic payments in retail transactions. A novel theoretical and experimental framework is developed to primarily assess the impact of sellers’ service fees and buyers’ rewards from using electronic payments. Buyers and sellers face a coordination problem, independently choosing a payment method before trading. In the experiment, sellers readily adopt electronic payments but buyers do not. Eliminating service fees or introducing rewards significantly boosts the adoption of electronic payments. Hence, buyers’ incentives play a pivotal role in the diffusion of electronic payments but monetary incentives cannot fully explain their adoption choices. Findings from this experiment complement empirical findings based on surveys and field data.
48
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.
47
This paper explores consequences of consumer education on prices and welfare in retail financial markets when some consumers are naive about shrouded add-on prices and firms try to exploit it. Allowing for different information and pricing strategies we show that education is unlikely to push firms to disclose prices towards all consumers, which would be socially efficient. Instead, price discrimination emerges as a new equilibrium. Further, due to a feedback on prices, education that is good for consumers who become sophisticated may be bad for consumers who stay naive and even for the group of all consumers as a whole
46
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.
45
Banks can deal with their liquidity risk by holding liquid assets (self-insurance), by participating in interbank markets (coinsurance), or by using flexible financing instruments, such as bank capital (risk-sharing). We use a simple model to show that undiversifiable liquidity risk, i.e. the liquidity risk that banks are unable to coinsure on interbank markets, represents an important risk factor affecting their capital structures. Banks facing higher undiversifiable liquidity risk hold more capital. We posit that empirically banks that are more exposed to undiversifiable liquidity risk are less active on interbank markets. Therefore, we test for the existence of a negative relationship between bank capital and interbank market activity and find support in a large sample of U.S. commercial banks.
44
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.
43
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.
42
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.
41
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.
40 [Ver. juni 2015]
This paper studies the life cycle consumption-investment-insurance problem of a family. The wage earner faces the risk of a health shock that significantly increases his probability of dying. The family can buy long-term life insurance that can only be revised at significant costs, which makes insurance decisions sticky. Furthermore, a revision is only possible as long as the insured person is healthy. A second important feature of our model is that the labor income of the wage earner is unspanned. We document that the combination of unspanned labor income and the stickiness of insurance decisions reduces the long-term insurance demand significantly. This is because an income shock induces the need to reduce the insurance coverage, since premia become less affordable. Since such a reduction is costly and families anticipate these potential costs, they buy less protection at all ages. In particular, young families stay away from long-term life insurance markets altogether. Our results are robust to adding short-term life insurance, annuities and health insurance.
40
This paper studies the life cycle consumption-investment-insurance problem of a family. The wage earner faces the risk of a health shock that significantly increases his probability of dying. The family can buy term life insurance with realistic features. In particular, the available contracts are long term so that decisions are sticky and can only be revised at significant costs. Furthermore, a revision is only possible as long as the insured person is healthy. A second important and realistic feature of our model is that the labor income of
the wage earner is unspanned. We document that the combination of unspanned labor income and the stickiness of insurance decisions reduces the insurance demand significantly. This is because an income shock induces the need to reduce the insurance coverage, since premia become less affordable. Since such a reduction is costly and families anticipate these potential costs, they buy less protection at all ages. In particular, young families stay away from life insurance markets altogether.
39
Banks' financial distress, lending supply and consumption expenditure : [version december 2013]
(2014)
The paper employs a unique identification strategy that links survey data on household consumption expenditure to bank level data in order to estimate the effects of bank financial distress on consumer credit and consumption expenditures. Specifically, we show that households whose banks were more exposed to funding shocks report significantly lower levels of non-mortgage liabilities compared to a matched sample of households. The reduced access to credit, however, does not result in lower levels of consumption. Instead, we show that households compensate by drawing down liquid assets. Only households without the ability to draw on liquid assets reduce consumption. The results are consistent with consumption smoothing in the face of a temporary adverse lending supply shock. The results contrast with recent evidence on the real effects of finance on firms' investment, where even temporary adverse credit supply shocks are associated with significant real effects.
38
This paper tests whether an increase in insured deposits causes banks to become more risky. We use variation introduced by the U.S. Emergency Economic Stabilization Act in October 2008, which increased the deposit insurance coverage from $100,000 to $250,000 per depositor and bank. For some banks, the amount of insured deposits increased significantly; for others, it was a minor change. Our analysis shows that the more affected banks increase their investments in risky commercial real estate loans and become more risky relative to unaffected banks following the change. This effect is most distinct for affected banks that are low capitalized.
37
We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability.
36
We show that market discipline, defined as the extent to which firm specific risk characteristics are reflected in market prices, eroded during the recent financial crisis in 2008. We design a novel test of changes in market discipline based on the relation between firm specific risk characteristics and debt-to-equity hedge ratios. We find that market discipline already weakened after the rescue of Bear Stearns before disappearing almost entirely after the failure of Lehman Brothers. The effect is stronger for investment banks and large financial institutions, while there is no comparable effect for non-financial firms.
35
Advances in technology and several regulatory initiatives have led to the emergence of a competitive but fragmented equity trading landscape in the US and Europe. While these changes have brought about several benefits like reduced transaction costs, regulators and market participants have also raised concerns about the potential adverse effects associated with increased execution complexity and the impact on market quality of new types of venues like dark pools. In this article we review the theoretical and empirical literature examining the economic arguments and motivations underlying market fragmentation, as well as the resulting implications for investors' welfare. We start with the literature that views exchanges as natural monopolies due to presence of network externalities, and then examine studies which challenge this view by focusing on trader heterogeneity and other aspects of the microstructure of equity markets.
34
We analyze the equilibrium in a two-tree (sector) economy with two regimes. The output of each tree is driven by a jump-diffusion process, and a downward jump in one sector of the economy can (but need not) trigger a shift to a regime where the likelihood of future jumps is generally higher. Furthermore, the true regime is unobservable, so that the representative Epstein-Zin investor has to extract the probability of being in a certain regime from the data. These two channels help us to match the stylized facts of countercyclical and excessive return volatilities and correlations between sectors. Moreover, the model reproduces the predictability of stock returns in the data without generating consumption growth predictability. The uncertainty about the state also reduces the slope of the term structure of equity. We document that heterogeneity between the two sectors with respect to shock propagation risk can lead to highly persistent aggregate price-dividend ratios. Finally, the possibility of jumps in one sector triggering higher overall jump probabilities boosts jump risk premia while uncertainty about the regime is the reason for sizeable diffusive risk premia.
33
We present a thought-provoking study of two monetary models: the cash-in-advance and the Lagos and Wright (2005) models. We report that the different approach to modeling money — reduced-form vs. explicit role — neither induces theoretical nor quantitative differences in results. Given conformity of preferences, technologies and shocks, both models reduce to one difference equation. The equations do not coincide only if price distortions are differentially imposed across models. To illustrate, when cash prices are equally distorted in both models equally large welfare costs of inflation are obtained in each model. Our insight is that if results differ, then this is due to differential assumptions about the pricing mechanism that governs cash transactions, not the explicit microfoundation of money.
32
Monetary theorists have advanced an intriguing notion: we exchange money to make up for a lack of enforcement, when it is difficult to monitor and sanction opportunistic behaviors. We demonstrate that, in fact, monetary equilibrium cannot generally be sustained when monitoring and punishment limitations preclude enforcement — external or not. Simply put, monetary systems cannot operate independently of institutions — formal or informal — designed to monitor behaviors and sanction undesirable ones. This fundamental result is derived by integrating monetary theory with the theory of repeated games, studying monetary equilibrium as the outcome of a matching game with private monitoring.
31
In the aftermath of the financial crisis, the ECB has experienced an unprecedented deterioration in the level of trust. This raises the question as to what factors determine trust in central banking. We use a unique cross-country dataset which includes a rich set of socio-economic characteristics and supplement it with variables meant to reflect a country’s macroeconomic condition. We find that besides individual socio-economic characteristics, macroeconomic conditions play a crucial role in the trust-building process. Our results suggest that agents are boundedly rational in the trust-building process and that current ECB market operations may even be beneficial for trust in the ECB in the long-run.
30
We examine whether the robustifying nature of Taylor rule cross-checking under model uncertainty carries over to the case of parameter uncertainty. Adjusting monetary policy based on this kind of cross-checking can improve the outcome for the monetary authority. This, however, crucially depends on the relative welfare weight that is attached to the output gap and also the degree of monetary policy commitment. We find that Taylor rule cross-checking is on average able to improve losses when the monetary authority only moderately cares about output stabilization and when policy is set in a discretionary way.
29
The analyses of intersectoral linkages of Leontief (1941) and Hirschman (1958) provide a natural way to study the transmission of risk among interconnected banks and to measure their systemic importance. In this paper we show how classic input-output analysis can be applied to banking and how to derive six indicators that capture different aspects of systemic importance, using a simple numerical example for illustration. We also discuss the relationship with other approaches, most notably network centrality measures, both formally and by means of a simulated network.
28
This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.
27
This paper analyzes the evolving architecture for the prudential supervision of banks in the euro area. It is primarily concerned with the likely effectiveness of the SSM as a regime that intends to bolster financial stability in the steady state.
By using insights from the political economy of bureaucracy it finds that the SSM is overly focused on sharp tools to discipline captured national supervisors and thus under-incentives their top-level personnel to voluntarily contribute to rigid supervision. The success of the SSM in this regard will hinge on establishing a common supervisory culture that provides positive incentives for national supervisors. In this regard, the internal decision making structure of the ECB in supervisory matters provides some integrative elements. Yet, the complex procedures also impede swift decision making and do not solve the problem adequately. Ultimately, a careful design and animation of the ECB-defined supervisory framework and the development of inter-agency career opportunities will be critical.
The ECB will become a de facto standard setter that competes with the EBA. A likely standoff in the EBA’s Board of Supervisors will lead to a growing gap in regulatory integration between SSM-participants and other EU Member States.
Joining the SSM as a non-euro area Member State is unattractive because the cur-rent legal framework grants no voting rights in the ECB’s ultimate decision making body. It also does not supply a credible commitment opportunity for Member States who seek to bond to high quality supervision.
26
In this paper we provide new evidence that corporate financing decisions are associated with managerial incentives to report high equity earnings. Managers rely most heavily on debt to finance their asset growth when their future earnings prospects are poor, when they are under pressure due to past declines in earnings, negative past stock returns, and excessively optimistic analyst earnings forecasts, and when the earnings yield is high relative to bond yields so that from an accounting perspective equity is ‘expensive’. Managers of high debt issuing firms are more likely to be newly appointed and also more likely to be replaced in subsequent years. Abnormal returns on portfolios formed on the basis of asset growth and debt issuance are strongly positively associated with the contemporaneous changes in returns on assets and on equity as well as with earnings surprises. This may account for the finding that debt issuance forecasts negative abnormal returns, since debt issuance also forecasts negative changes in returns on assets and on equity and negative earnings surprises. Different mechanisms appear to be at work for firms that retire debt.
25
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.
24
This study investigates the transition from being a listed company with a dispersed ownership structure to being a privately held company with a concentrated ownership structure. We consider a sample of private equity backed portfolio companies to evaluate the consequences of the corporate governance changes on operational performance. Our analysis shows significant positive abnormal growth in several performance ratios for the private period of our sample companies relative to comparable public companies. These performance differences come from the increase in ownership concentration after the leveraged buyout transaction.
23
We are able to shed light on the black box of restructuring tools private equity investors use to improve the operational performance of their portfolio companies. By building on previous work considering performance evaluation of PE backed companies, we analyze whether private equity improves operating efficiency and which of the typical restructuring tools are the main performance drivers. Using a set of over 300 international leveraged buyout transactions of the last thirty years, we find that while there is vast improvement in operational efficiency, these gains vary considerably. Our top performing transactions are subject to strong equity incentives, frequent asset restructuring and tight control by the investor. Furthermore, investors’ experience has a positive influence while financial leverage has no influence on operational performance.
22
The paper looks at the determinants of fiscal adjustments as reflected in the primary surplus of countries. Our conjecture is that governments will usually find it more attractive to pursue fiscal adjustments in a situation of relatively high growth, but based on a simple stylized model of government behavior the expectation is that mainly high trust governments will be in a position to defer consolidation to years with higher growth. Overall, our analysis of a panel of European countries provides support for this expectation. The difference in fiscal policies depending on government trust levels may help explaining why better governed countries have been found to have less severe business cycles. It suggests that trust and credibility play an important role not only in monetary policy, but also in fiscal policy.
21
Homestead exemptions to personal bankruptcy allow households to retain their home equity up to a limit determined at the state level. Households that may experience bankruptcy thus have an incentive to bias their portfolios towards home equity. Using US household data for the period 1996 to 2006, we find that household demand for real estate is relatively high if the marginal investment in home equity is covered by the exemption. The home equity bias is more pronounced for younger households that face more financial uncertainty and therefore have a higher ex ante probability of bankruptcy.
20
In this paper, we develop a state-dependent sensitivity value-at-risk (SDSVaR) approach that enables us to quantify the direction, size, and duration of risk spillovers among financial institutions as a function of the state of financial markets (tranquil, normal, and volatile). Within a system of quantile regressions for four sets of major financial institutions (commercial banks, investment banks, hedge funds, and insurance companies) we show that while small during normal times, equivalent shocks lead to considerable spillover effects in volatile market periods. Commercial banks and, especially, hedge funds appear to play a major role in the transmission of shocks to other financial institutions. Using daily data, we can trace out the spillover effects over time in a set of impulse response functions and find that they reach their peak after 10 to 15 days.
19
This paper empirically examines the role of soft information in the competitive interaction between relationship and transaction banks. Soft information can be interpreted as a private signal about the quality of a firm that is observable to a relationship bank, but not to a transaction bank. We show that borrowers self-select to relationship banks depending on whether their privately observed soft information is positive or negative. Competition affects the investment in learning the private signal from firms by relationship banks and transaction banks asymmetrically. Relationship banks invest more; transaction banks invest less in soft information, exacerbating the selection effect. Finally, we show that firms where soft information was important in the lending decision were no more likely to default compared to firms where only financial information was used.
18
The paper uses fiscal reaction functions for a panel of euro-area countries to investigate whether euro membership has reduced the responsiveness of countries to shocks in the level of inherited debt compared to the period prior to succession to the euro. While we find some evidence for such a loss in prudence, the results are not robust to changes in the specification, such as an exclusion of Greece from the panel. This suggests that the current debt problems may result to a large extent from preexisting debt levels prior to entry or from a larger need for fiscal prudence in a common currency, while an adverse change in the fiscal reaction functions for most countries does not apply.
17
16
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on results from the true model. We apply our method to a calibrated affine model and fine that relative wealth equivalent losses are below 1.16% if the jump size is stochastic and below 1% if the jump size is constant and γ ≥ 5. We perform robustness checks for various levels of risk-aversion, expected jump size, and jump intensity.
16 [Version 2015]
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on quantities known only in the true model. We apply our method to a calibrated affine model. Our findings are threefold: Jumps matter more, i.e. our approximation is less accurate, if (i) the expected jump size or (ii) the jump intensity is large. Fixing the average impact of jumps, we find that (iii) rare, but severe jumps matter more than frequent, but small jumps.
15
We show that the optimal consumption of an individual over the life cycle can have the hump shape (inverted U-shape) observed empirically if the preferences of the individual exhibit internal habit formation. In the absence of habit formation, an impatient individual would prefer a decreasing consumption path over life. However, because of habit formation, a high initial consumption would lead to high required consumption in the future. To cover the future required consumption, wealth is set aside, but the necessary amount decreases with age which allows consumption to increase in the early part of life. At some age, the impatience outweighs the habit concerns so that consumption starts to decrease. We derive the optimal consumption strategy in closed form, deduce sufficient conditions for the presence of a consumption hump, and characterize the age at which the hump occurs. Numerical examples illustrate our findings. We show that our model calibrates well to U.S. consumption data from the Consumer Expenditure Survey.
14
The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model.
13
This paper investigates risk-taking in the liquid portfolios held by a large panel of Swedish twins. We document that the portfolio share invested in risky assets is an increasing and concave function of financial wealth, leading to different risk sensitivities across investors. Human capital, which we estimate directly from individual labor income, also drives risk-taking positively, while internal habit and expenditure commitments tend to reduce it. Our micro findings lend strong support to decreasing relative risk aversion and habit formation preferences. Furthermore, heterogeneous risk sensitivities across investors help reconcile individual preferences with representative-agent models.
12
We develop a dynamic network model whose links are governed by banks' optmizing decisions and by an endogenous tâtonnement market adjustment. Banks in our model can default and engage in firesales: risk is transmitted through direct and cascading counterparty defaults as well as through indirect pecuniary externalities triggered by firesales. We use the model to assess the evolution of the network configuration under various prudential policy regimes, to measure banks' contribution to systemic risk (through Shapley values) in response to shocks and to analyze the effects of systemic risk charges. We complement the analysis by introducing the possibility of central bank liquidity provision.
11
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
11 [neue Version]
There has been a considerable debate about whether disaster models can rationalize the equity premium puzzle. This is because empirically disasters are not single extreme events, but long-lasting periods in which moderate negative consumption growth realizations cluster. Our paper proposes a novel way to explain this stylized fact. By allowing for consumption drops that can spark an economic crisis, we introduce a new economic channel that combines long-run and short-run risk. First, we document that our model can match consumption data of several countries. Second, it generates a large equity risk premium even if consumption drops are of moderate size.
10
This paper presents a theory that explains why it is beneficial for banks to engage in circular lending activities on the interbank market. Using a simple network structure, it shows that if there is a non-zero bailout probability, banks can significantly increase the expected repayment of uninsured creditors by entering into cyclical liabilities on the interbank market before investing in loan portfolios. Therefore, banks are better able to attract funds from uninsured creditors. Our results show that implicit government guarantees incentivize banks to have large interbank exposures, to be highly interconnected, and to invest in highly correlated, risky portfolios. This can serve as an explanation for the observed high interconnectedness between banks and their investment behavior in the run-up to the subprime mortgage crisis.
9
Basel III and CEO compensation in banks: pay structures as a regulatory signal : [March 6, 2013]
(2013)
This paper proposes a new regulatory approach that implements capital requirements contingent on managerial compensation. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea of the proposed regulation is to utilize the compensation scheme to drive a wedge between the interests of top management and shareholders to counteract shareholder risk-shifting incentives. The decisive advantage of this approach compared to existing regulation is that the regulator does not need to be able to properly measure the bank investment risk, which has been shown to be a difficult task during the 2008-2009 financial crisis.
8
We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel - monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and tends to concentrate on the bank funding side. Then, to rationalize this evidence we build a macro model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.
7
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 incentive problems and liquidity risk (in the form of liquidity based banks’ runs) which provides a link between endogenous bank capital and macro and policy risk. Our banks also invest in risky government bonds used as capital buffer to self-insure 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.
6
This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. However, the significance mainly comes from R&D firms, which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we also document that only idiosyncratic volatility (ivol) has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting according to the size of idiosyncratic volatility, we only find a significant ivol anomaly for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To simultaneously control for several explanatory variables, we also run panel regressions of portfolio alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses.
5
We study whether prices of traded options contain information about future extreme market events. Our option-implied conditional expectation of market loss due to tail events, or tail loss measure, predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-specific tail loss measure predicts individual expected returns and magnitude of realized stock-specific crashes in the cross-section of stocks. An investor that cares about the left tail of her wealth distribution benefits from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index.
4
We test whether investor mood affects trading with data on all stock market transactions in Finland, utilizing variation in daylight and local weather. We find some evidence that environmental mood variables (local weather, length of day, daylight saving and lunar phase) affect investors’ direction of trade and volume. The effect magnitudes are roughly comparable to those of classical seasonals, such as the Monday effect. The statistical significance of the mood variables is weak in many cases, however. Only very little of the day-to-day variation in trading is collectively explained by all mood variables and calendar effects, but lower frequency variation seems connected to holiday seasons.
3
We use unique data from financial advisers’ professional exam scores and combine it with other variables to create an index of financial sophistication. Using this index to explain long-term stock return expectations, we find that more sophisticated financial advisers tend to have lower return expectations. A one standard deviation increase in the sophistication index reduces expected returns by 1.1 percentage points. The effect is stronger for emerging market stocks (2.3 percentage points). The sophistication effect contributes 60% to the model fit, while employer fixed effects combined contribute less than 30%. These results help understand the formation of potentially excessively optimistic expectations.
2
A natural experiment in which customer-owned mutual companies converted to publicly listed firms created a plausibly exogenous shock to the stock market participation status of tens of thousands of people. We find the shock changed the way people vote in the affected areas, with a 10% increase in share-ownership rate being followed by a 1.3%–3.1% increase in right-of-center vote share. The institutional details and additional tests suggest that wealth, liquidity, and tax-related incentives cannot fully explain the results. A plausible explanation is that the associated increase in the salience of stock ownership causes a shift in voters’ attention.
1
Debt-induced crises, including the subprime, are usually attributed exclusively to supply-side factors. We uncover an additional factor contributing to debt culture, namely social influences emanating from the perceived average income of peers. Using unique information from a representative household survey of the Dutch population that circumvents the need to define the social circle, we consider collateralized, consumer, and informal loans. We find robust social effects on borrowing – especially among those who consider themselves poorer than their peers – and on indebtedness, suggesting a link to financial distress. We check the robustness of our results using several approaches to rule out spurious associations and handle correlated effects.