2017, Journal of Financial Economics, 126(2), 252–269. [WP Version]
Why does the market discipline that financial intermediaries face seem too weak during booms and too strong during crises? This paper shows in a general equilibrium setting that rollover risk as a disciplining device is effective only if all intermediaries face purely idiosyncratic risk. However, if assets are correlated, a two-sided inefficiency arises: Good aggregate states have intermediaries taking excessive risks, while bad aggregate states suffer from costly fire sales. The driving force behind this inefficiency is an amplifying feedback loop between asset values and market discipline. In equilibrium, financial intermediaries inefficiently amplify both positive and negative aggregate shocks.
with Andrew Haughwout, Beverly Hirtle, Anna Kovner, David Lucca, and Matthew Plosser, 2017, Federal Reserve Bank of New York Economic Policy Review, 23(1), 57–77.
The Federal Reserve is responsible for the prudential supervision of bank holding companies (BHCs) on a consolidated basis. Prudential supervision involves monitoring and oversight to assess whether these firms are engaged in unsafe or unsound practices, as well as ensuring that firms are taking corrective actions to address such practices. Prudential supervision is interlinked with, but distinct from, regulation, which involves the development and promulgation of the rules under which BHCs and other regulated financial intermediaries operate. This paper describes the Federal Reserve’s supervisory approach for large, complex financial companies and how prudential supervisory activities are structured, staffed, and implemented on a day‐to‐day basis at the Federal Reserve Bank of New York as part of the broader supervisory program of the Federal Reserve System. The goal of the paper is to generate insight for those not involved in supervision into what supervisors do and how they do it. Understanding how prudential supervision works is a critical precursor to determining how to measure its impact and effectiveness.
with Martin Schmalz, 2016, Journal of Financial Economics, 121(2), 414–426. [WP Version]
We model an ‘anxious’ agent as one who is more risk averse with respect to imminent risks than with respect to distant risks. Based on a utility function that captures individual subjects’ behavior in experiments, we provide a tractable theory relaxing the restriction of constant risk aversion across horizons and show that it generates rich implications. We first apply the model to insurance markets and explain the high premia for short-horizon insurance. Then, we show that costly delegated portfolio management, investment advice, and withdrawal fees emerge as endogenous features and strategies to cope with dynamic inconsistency in intratemporal risk–return tradeoffs.
with Dong Choi and Tanju Yorulmazer, 2016, American Economic Review (Papers and Proceedings), 106(5), 490–495.
We analyze the effects and interactions of monetary policy tools that differ in terms of their timing and their targeting. In a model with heterogeneous agents, more productive agents endogenously expose themselves to higher interim liquidity risk by borrowing and investing more. Two inefficiencies impair the transmission of monetary policy: an investment- and a hoarding inefficiency. Heterogeneous agents respond disparately to ex-ante, conventional and ex-post, unconventional monetary policy. However, we show that the two policies are equivalent due to the endogeneity of hoarding. In contrast, targeted interventions such as discount-window lending can alleviate both inefficiencies at the same time.
with Todd Keister, James McAndrews and Tanju Yorulmazer, 2014, Federal Reserve Bank of New York Economic Policy Review, 20(1), 29–49.
We use a simple analytical framework to illustrate the determinants of a financial intermediary’s ability to survive stress events. An intermediary in our framework faces two types of risk: the value of its assets may decline and/or its short-term creditors may decide not to roll over their debt. We measure its stability by looking at what combinations of shocks it can experience while remaining solvent. We study how stability depends on the intermediary’s balance-sheet characteristics such as its leverage, the maturity structure of its debt, and the liquidity and riskiness of its asset portfolio. We also show how our framework can be applied to study current policy issues, including liquidity requirements, discount window policy, and different approaches to reforming money market mutual funds.
with Markus Brunnermeier and Yuliy Sannikov, 2013, in Advances in Economics and Econometrics, Tenth World Congress of the Econometric Society, ed. by D. Acemoglu, M. Arellano and E. Dekel, Cambridge University Press.
This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification effects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate downturns. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained efficient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.
In standard Walrasian macro-finance models, pecuniary externalities such as fire sales lead to overinvestment in illiquid assets or underprovision of liquidity. We investigate whether imperfect competition (Cournot) improves welfare through internalizing the externality and find that this is far from guaranteed. In a standard model of liquidity shocks, when liquidity is sufficiently scarce, Cournot competition leads to even less liquidity than the Walrasian equilibrium. In a standard model of productivity shocks, the Cournot equilibrium overcorrects for the fire-sale externality and holds less capital than socially efficient. Implications for welfare and regulation therefore depend highly on the nature of the shocks and the competitiveness of the industry considered.
We address two fundamental critiques of established asset pricing models: that they (1) require a controversial degree of preference for early resolution of uncertainty; and (2) do not match the term structures of risk premia observed in the data. Inspired by experimental evidence, we construct preferences in which risk aversion decreases with the temporal horizon. The resulting model implies term structures of risk premia consistent with the evidence, including time-variations and reversals in the slope, without imposing a particular preference for early or late resolutions of uncertainty or compromising on the ability to match standard moments in the returns distributions.
We study bank supervision by combining a theoretical model of asymmetric information and a novel dataset on work hours of Federal Reserve supervisors. We highlight the trade-offs between the benefits and costs of supervision and use the model to interpret the relation between supervisory efforts and bank characteristics observed in the data. More supervisory hours are spent on larger, more complex, and riskier banks. However, hours increase less than proportionally with bank size, suggesting technological scale economies in supervision. We provide evidence of constraints on supervisory resources, documenting reallocation of hours at times of stress and in the post-2008 period. Using variation implied by this resource reallocation, we find evidence that supervision lowers risk.
with Marianne Andries, Martin Schmalz and Yichuan Wang.
We estimate the term structure of the price of variance risk (PVR), which helps distinguish between competing asset-pricing theories. First, we measure the PVR as proportional to the Sharpe ratio of short-term holding returns of delta-neutral index straddles; second, we estimate the PVR in a Heston (1993) stochastic-volatility model. In both cases, the estimation is performed separately for different maturities. We find the PVR is negative and decreases in absolute value with maturity; it is more negative and its term structure is steeper when volatility is high. These findings are inconsistent with calibrations of established asset-pricing models that assume constant risk aversion across maturities.
We build a general equilibrium model with maturity transformation that impedes monetary policy transmission. In equilibrium, productive agents choose higher leverage, exposing themselves to greater liquidity risk, which limits their responsiveness to interest rate changes. A reduction in the interest rate then leads to a deterioration in aggregate investment quality, which blunts the monetary stimulus and decreases liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.
We provide a model that rationalizes variation in confidence in the time-series and the cross-section. Combining horizon-dependent risk aversion (“anxiety”) and selective memory, we show that overly precise beliefs (“overconfidence”) can arise in the equilibrium of a Bayesian agent’s intra-personal game. In the time-series, overconfidence is more prevalent when actual risk levels are high, while underconfidence occurs when risks are low. As more confident agents take more risk, fluctuations in confidence amplify boom-bust cycles. More anxious agents’ beliefs fluctuate more, leading them to buy in booms and sell in crashes.
with Fernando Duarte. R&R at the Review of Financial Studies.
We construct a new systemic risk measure that quantifies vulnerability to fire-sale spillovers using detailed repo market data for broker-dealers and regulatory balance sheet data for U.S. bank holding companies. For broker-dealers, vulnerabilities in the repo market are driven by flight-to-quality episodes, when liquidity and leverage can change rapidly. We estimate that an exogenous 1 percent decline in the price of all assets financed with repos leads to losses due to fire sale spillovers of 8 percent of total broker-dealer equity on average and over 12 percent during the financial crisis. For bank holding companies, vulnerabilities to fire sales are equally sizable but build up slowly over time. Our measure signals build-up of systemic risk starting in the early 2000s, ahead of many other measures. Our measure also predicts low quantiles of macroeconomic outcomes above and beyond other existing measures, especially at longer horizons.
“ca” indicates presentation by coauthor
Jackson Hole Finance Conference; Adam Smith Workshop (ca); Banco de España–CEMFI Conference on Financial Stability (ca); Society for Economic Dynamics; Western Finance Association; Chicago-Minnesota Theory Conference; Workshop on Measurement and Control of Systemic Risks in the Financial Sector; University of Mannheim; Deutsche Bundesbank; Frankfurt School of Finance & Management; European Central Bank.
American Economic Association Meeting (ca); American Finance Association Meeting (ca); NY Fed Conference on Supervising Large & Complex Financial Institutions; Global Games Conference at ISU; Rutgers University; Brandeis Summer Workshop; Research in Behavioral Finance Conference (self & ca); Wharton Conference on Liquidity and Financial Crises; International Banking Conference at Bocconi (ca); University of British Columbia.
European Winter Finance Conference (ca); University of Amsterdam; Financial Intermediation Research Society (ca); Mitsui Finance Symposium (self & ca); Society for Economic Dynamics (ca); Econometric Society World Congress (self & ca); European Economic Association (ca); European Finance Association (ca); Trinity of Stability Conference at Princeton; Cass Business School; German Economists Abroad Meeting.
European Winter Finance Conference; NYU Stern; ECB; University of Amsterdam; Hong Kong University of Science and Technology; Financial Intermediation Research Society; Western Finance Association; Society for Economic Dynamics; Isaac Newton Institute; NBER Asset Pricing Workshop (ca).
American Finance Association Meeting in San Diego (ca); Finance Down Under in Melbourne (ca); Macroeconomic Financial Modeling and Macroeconomic Fragility Conference in Cambridge, MA (ca).
People & Money Symposium at DePaul University; Academy of Behavioral Finance & Economics Meeting in New York.
Whitebox Doctoral Conference at Yale University (ca); Behavioral Finance Conference at the University of Miami.
EconCon at Princeton University.
Malherbe and McMahon, “Financial Sector Origins of Economic Growth Delusions,” Oxford Financial Intermediation Theory Conference, 2017.
De Roure, “Fire Buys of Central Bank Collateral Assets,” Yale Program on Financial Stability, 2017.
Zeng, “A Dynamic Theory of Mutual Fund Runs and Liquidity Management,” Oxford Financial Intermediation Theory Conference, 2016.
Lorenzoni and Werning, “Slow Moving Debt Crises,” Global Games in Ames, 2016.
Silva, “Strategic Complementarity in Banks’ Funding Liquidity Choices and Financial Stability,” Network Models and Stress Testing for Financial Stability Monitoring and Macroprudential Policy Design and Implementation, Banco de Mexico, 2015.
Citci and Inci, “Career Concerns and Bayesian Overconfidence of Managers,” European Finance Association, Cambridge, 2013.
Bordalo, Gennaioli, and Shleifer, “Salience and Consumer Choice,” Econometric Society, San Diego, 2013.
Monnet and Sanches, “Private Money and Banking Regulation,” System Committee Meeting on Financial Structure and Regulation, Chicago Fed, 2012.
Abbassi and Fecht, “Liquidity of Financial Markets and the Demand for Reserves,” European Finance Association, Copenhagen, 2012.
Sun and Widdicks, “Why Do Employees Like to Be Paid with Options? A Multi-period Prospect Theory Approach,” European Finance Association, Copenhagen, 2012.
Martin and Taddei, “International Capital Flows and Credit Market Imperfections: A Tale of Two Frictions,” Mitsui Finance Symposium, Michigan Ross, 2012.
AEJ Macroeconomics; American Economic Review; Econometrica; Economics Letters; European Economic Review; Journal of Economic Literature; Journal of Economic Dynamics and Control; Journal of Economic Theory; Journal of Empirical Finance; Journal of Finance; Journal of Financial Intermediation; Journal of Mathematical Economics; Journal of Money, Credit, and Banking; Management Science; Review of Corporate Finance Studies; Review of Finance; Review of Financial Studies.
Program Committee Member:
Western Finance Association Annual Meeting, 2013–2018; European Finance Association Annual Meeting, 2015–2016; Oxford Financial Intermediation Theory Conference (OxFIT), 2018.
New York Fed Money and Payments Workshop, 2012; New York Fed Workshop on the Risks of Wholesale Funding, 2014.