with Eva Micheler (accepted at the JFE)
Many debt claims, such as bonds, are resaleable, whereas others, such as repos, are not. There was a fivefold increase in repo borrowing before the 2008 crisis. Why? Did banks’ dependence on non-resaleable debt precipitate the crisis? In this paper, we develop a model of bank lending with credit frictions. The key feature of the model is that debt claims are heterogenous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. Borrowing via non-resaleable debt has a dark side: it causes credit chains to form, since if a bank makes a loan via non-resaleable debt and needs liquidity, it cannot sell the loan but must borrow via a new contract. These credit chains are a source of systemic risk, since one bank’s default harms not only its creditors but also its creditors’ creditors. Overall, our model suggests that reducing credit market frictions may have an adverse effect on the financial system and may even lead to the failures of financial institutions.
Since the worst employment slumps follow periods of high household debt and almost all household debt is provided by banks, we theoretically investigate whether bank regulation can play a role in stimulating employment. Using a competitive search model, we find that levered households suffer from a debt overhang problem that distorts their preferences, making them demand high wages. In general equilibrium, firms internalize these preferences and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment. Unemployed households default on their debt. In equilibrium, the level of household debt is inefficiently high due to a household-debt externality—banks fail to internalize the effect that household leverage has on household default probabilities via the vacancy-posting effect. As a result, household debt levels are inefficiently high. Our results suggest that a combination of loan-to-value caps for households and capital requirements for banks can improve efficiency, providing an alternative to monetary policy for labor market intervention.
In this paper, we develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that borrowers rely most on collateral when cash flow pledgeability is high, because this is when it is easy to take on new debt, diluting existing creditors. Creditors thus require collateral for protection against being diluted. This causes a collateral rat race that results in all borrowing being collateralized. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment, i.e. there is a collateral overhang. Our results suggest that increasing the supply of collateral can have adverse effects.
We develop a theory of banking that explains why banks started out as commodities warehouses. We show that warehouses become banks because their superior storage technology allows them to enforce the repayment of loans most effectively. Further, interbank markets emerge endogenously to support this enforcement mechanism. Even though warehouses store deposits of real goods, they make loans by writing new “fake” warehouse receipts, rather than by taking deposits out of storage. Our theory helps to explain how modern banks create funding liquidity and why they combine warehousing (custody and deposit-taking), lending, and private money creation within the same institutions. It also casts light on a number of contemporary regulatory policies.
with Giorgia Piacentino
Delegated asset managers frequently refer to credit ratings in the contracts they offer their investors. However, regulators have advised against this. Why? In this paper, we present a model that suggests a new reason that delegated asset managers contract on credit ratings: contracting on ratings is a way for asset managers to compete for flows of investor capital. However, competition among asset mangers triggers a race to the bottom: asset mangers use ratings in their contracts even though it is socially inefficient. This inefficiency is due to a Hirshleifer-type effect by which contracting on ratings prevents risk-sharing.
In this paper, I model a dynamic market economy in which debt contracts are subject to renegotiation. I find that a firm with more cyclical cash flows can borrow more than a firm with less cyclical cash flows, consistent with empirical evidence. The reason is that a firm with cyclical cash flows puts its creditors in a relatively strong bargaining position when debt is renegotiated. In general equilibrium, this leads to a collateral premium for assets that generate cyclical cash flows—they are expensive because they allow firms to borrow against them, scaling up their investments via leverage. Endogenous variation in enforcement frictions generates business cycle fluctuations in both firm-level and aggregate quantities consistent with stylized facts, even in the absence of capital accumulation or technology shocks.
Why do small intermediaries, such as private equity firms (PEs), exist mainly in competitive credit markets and why do they fund mainly risky, innovative investments? In this paper, we build a general equilibrium search-and-matching model of entrepreneurial finance with endogenous intermediary entry. We show that with only bank finance, entrepreneurs make inefficient project choices in competitive credit markets—they forgo innovative projects in favor of traditional ones. However, private equity firms emerge to mitigate this inefficiency. This is because a PE’s own capital structure works as a commitment device not to fund traditional projects; it thereby disciplines entrepreneurs to invest efficiently in innovative projects. Despite making high returns, PEs never take over the entire market, and PEs and banks coexist in equilibrium. Overall, our findings underscore that intermediation variety and entrepreneurial investment must be examined jointly.