Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model (pdf) (Job Market Paper)
This paper presents a quantitative dynamic general equilibrium model for the purpose of determining the optimal capital requirement for banks. Banks play two roles in this model: They contribute to the production of a final good and they provide liquidity in the form of bank debt, which households value. Banks also benefit from an implicit bailout guarantee from the government, which motivates them to take on excessive risk. I quantify this model using data from the national income and product accounts as well as the Federal Deposit Insurance Corporation and find that the dynamics of the model are consistent with business cycle facts. Higher capital requirements lower risk-taking and increase consumption, but they also reduce the supply of bank debt. The reduction in bank debt leads to a lower interest rate on bank debt through a general equilibrium effect. This reduces the overall funding costs of banks and allows them to grow larger, which increases the capital stock and, consequently, production as well as consumption. The optimal capital requirement weighs the reduction in economic volatility and the increase in consumption against the reduction in liquidity. Welfare is maximized at 14% equity as a share of risk-weighted assets.
Banks' Risk Exposure (pdf) (joint with Monika Piazzesi and Martin Schneider)
This paper studies the interest rate and default risk exposure of US banks. We exploit the factor structure in interest rates to represent many bank positions as portfolios in a small number of bonds. This approach makes exposures comparable across banks and across the business segments of an individual bank. We also propose a strategy to estimate exposure due to interest rate derivatives from regulatory data on notional and fair values together with the history of interest rates.
Remapping the Flow of Funds (joint with Monika Piazzesi and Martin Schneider) (2012),
Chapter in NBER book Risk Topography: Systemic Risk and Macro Modeling, Markus K. Brunnermeier and Arvind Krishnamurthy, editors
This article argues that quantitative analysis of credit market positions would benefit tremendously if the additional information about the structure of payment streams were more readily available. Most available data on credit market positions, such as the Flow of Funds Accounts report accounting measures such as book value or fair value. In contrast, most economic analysis views asset positions as random payment streams that are valued by state prices. The latter view typically requires additional information, in particular the maturity or next repricing date of the instrument, the promised interest rate, call or prepayment provisions, and the credit rating of the borrower.
Firm Financing over the Business Cycle (pdf) (joint with Juliana Salomao)
Firm financing is the link between financial markets and the real economy. In this paper, we investigate how firm financing depends on the state of the economy. Using Compustat data, we look at the external financing decisions of firms over the business cycle. We find that firm financing is cyclical, but that the cyclicality depends on size. Whereas large firms seem to substitute between debt and equity financing over the business cycle, small firms are unable to do so, increasing financing in good times and reducing it in bad. More importantly, small firms make extensive use of equity financing which is generally more expensive. In this paper, we propose a mechanism that explains these empirical facts in a heterogeneous firm optimization model. Our mechanism is based on two main features: (1) small firms are growing and therefore need more funds and (2) cost of debt financing is higher for more leveraged firms. These features imply that small firms’ funding needs cannot be satisfied by debt alone - especially not in booms when growth opportunities and therefore funding needs are higher. For this reason they turn to equity. The model accounts for the cyclical patterns we see in the data.