This paper develops a theory of banking that is rooted in the evolution of banks from warehouses of commodities and precious goods, which occurred even before the invention of coinage or fiat money. The theory helps to explain why modern banks offer warehousing (custodial and deposit-taking) services within the same institutions that provides lending services and how banks create funding liquidity by creating private money. In our model, the warehouse endogenously becomes a bank because its superior storage technology–the raison d’etre for its existence in the first place–allows it to enforce loan repayment most effectively. The warehouse makes loans by issuing “fake” warehouse receipts—those not backed by actual deposits–rather than by lending out deposited goods. The model provides a rationale for banks that take deposits, make loans, and have circulating liabilities, even in an environment without risk or asymmetric information. Our analysis provides new perspectives on narrow banking, liquidity ratios and reserves requirements, capital regulation, and monetary policy.
with Eva Micheler
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.
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.
In this paper, I present a general equilibrium model with limited enforcement to explore how the cyclicality of firms’ output affects corporate borrowing, asset prices, and social welfare. I show the following three main results. First, firms with more procyclical output have higher debt capacities than firms with less procyclical output. Second, assets with more procyclical output trade at a premium over assets with less procyclical output. This is due to a collateral premium that replaces the insurance premium in models based on risk aversion. Third, a social planner should tax firms with less procyclical output to subsidize firms with more procyclical output. This policy increases welfare even though it amplifies the business cycle. Each of these results reflects the ability for procyclicality to mitigate two pervasive enforcement fictions—capital diversion and renegotiation. The results contrast with the established conclusions of the theory literature, but are consistent with empirical findings about corporate leverage and asset prices.
with Giorgia Piacentino
We propose a model of delegated investment with a public signal that suggests that (i) contracts do not have to refer to the public signal in order to overcome incentive problems; (ii) contracts include references to the public signal not to address incentive problems, but rather to help agents compete; and, in contrast to the contracting literature, (iii) decreasing the precision of the public signal leads to Pareto improvements. We apply this framework to a problem of delegated portfolio choice in which contracts make references to credit ratings. Our model suggests that wider rating categories make everyone better off.