Resumen de Essays on banking and financial instability
The global financial crisis that started in 2007 highlights the extremely important role of banks in the economy. In the aftermath of financial crisis, there is a surge in research interest aimed at understanding the relationship between banks and financial instability. What is the role of banks’ attempt to circumvent regulator supervision in the credit cycles? What are the implications of asset encumbrance for financial instability? Do loan sales weaken banks’ special role of information production? The three chapters of the thesis explore these different issues.
While using different modeling frameworks, they have a common emphasis on the bank funding structure.
The first chapter develops a model of financial intermediation in which the dynamic interaction between regulator supervision and banks’ loophole innovation generates credit cycles. It is a joint paper with Tong Xu, a PhD from Emory University. In the model, banks’ leverages are constrained due to a risk-shifting problem. The regulator supervises the banks to ease this moral hazard problem, and its expertise in supervision improves gradually through learning-bydoing.
At the same time, banks can engage in loophole innovation to circumvent supervision, which acts as an endogenous opposing force diminishing the value of the regulator’s accumulated expertise. In equilibrium, banks’ leverage and loophole innovation move together with the regulator’s supervision ability. The model generates pro-cyclical bank leverage and asymmetric credit cycles. We show that a crisis is more likely to occur and the consequences are more severe after a longer boom. In addition, we investigate the welfare implications of a maximum leverage ratio in the environment of loophole innovation.
The second chapter investigates the phenomenon of asset encumbrance. It is a joint paper with Albert Banal-Esta˜nol, Enrique Benito and Dmitry Khametshin. Asset encumbrance refers to the existence of restrictions to a bank’s ability to transfer or realize its assets. Asset encumbrance has recently become a much-discussed subject and policymakers have been actively addressing what some consider to be excessive levels of encumbrance. Despite its importance, the phenomenon remains poorly understood. We provide a simple theoretical model that highlights the implications of asset encumbrance for funding and financial stability. We show that the effect of encumbrance depends on rates of over-collateralization faced by the banks. With low levels of overcollateralization, asset encumbrance is negatively associated with bank credit risks as secured funding minimizes bank’s exposure to liquidity shocks. When overcollateralization levels are high, encumbrance can exacerbate liquidity risks due to structural subordination effect and, hence, can be positively associated with bank credit risk premiums. We use a novel dataset on the levels of asset encumbrance of European banks and provide further empirical evidence supporting the predictions of the model. Our empirical results point to the existence of a negative association between CDS premia and asset encumbrance. Still, certain bank-level variables play a mediating role in this relationship. For banks that have high exposures to the central bank, high leverage ratio, or are located in southern Europe, asset encumbrance is less beneficial and could even be detrimental in absolute terms.
The third chapter re-examines the classical issue of loan sales and banks’ moral hazard by highlighting the role of banks’ bankruptcy risk. In the model, banks finance their loan portfolios by issuing risky debt. Due to limited liability, banks are subject to a risk-shifting problem which leads to the under-provision of screening effort. The bank may sell loans to transfer non-diversifiable credit risk. On the one hand, loan sales reduce banks’ skin in the game, thus diluting their screening incentives. On the other hand, loan sales lower banks’ bankruptcy risk, alleviating the risk-shifting problem. The sign and the magnitude of the effect of loan sales on banks’ moral hazard depend crucially on the relative weights of these two opposing effects. When a bank’s bankruptcy risk is high, the positive risk-shifting reduction effect of loan sales dominates the negative incentive-dilution effect, thus loan sales might curb rather than exacerbate the bank’s moral hazard problem. The results extend to the case in which there is strategic adverse selection of loan sales. I study various extensions of the model.
