Working Papers and Work in Progress
The number of varieties of financial products that firms can use to raise funds from investors has rapidly expanded over the past decades. And yet, many firms issue only a few standard products, such as common stocks and bonds. This paper studies innovation in financial products using a combination of granular data on security issuance and a model of allocation of financial products to firms in specific sectors. We find three key patterns. First, the differential adoption of products across firms explains most of the observed variation in the amounts of funds raised. Second, firms that adopt new products are more successful in raising funds. Finally, most funds raised from new financial products come from a large number of distinct products that are highly specialized in that only a few firms use them. Our analysis indicates that innovation in financial markets is akin to innovation in consumer markets, which results not just in improvements in the quality of standardized products, but also in increasing varieties in a given market as products become more specialized.
We explore a model in which banks strategically hold interconnected and opaque portfolios, despite increasing the likelihood they are subject to financial crises. In our framework, banks choose their degree of exposure to other banks to influence how investors can use their information. In equilibrium banks choose portfolios which are neither fully opaque, nor fully transparent. However, their portfolios are interconnected beyond what is beneficial for diversification purposes. Banks can create a degree of opacity that decreases welfare, and makes bank crises more likely. Our model is suggestive about the implications of asset securitization, as well as of government bailouts.
We develop a theory of financial innovation in which both market structure and the payoffs of the claims being traded are determined endogenously. Intermediaries use the cash flows of an underlying asset to design securities for investors. Demand for securities arises as investors choose markets then trade using strategies represented by quantity-price schedules. We show that intermediaries create increasingly riskier asset-backed securities when facing deeper markets in which investors trade more competitively. In turn, investors elicit less risky securities when they choose thinner markets, revealing a novel role for market fragmentation in the creation of safer securitie.
Covid-19 vaccine prioritization is key if the initial supply of the vaccine is limited. A consensus is emerging to first prioritize populations facing a high risk of severe illness in high-exposure occupations. The challenge is assigning priorities next among high-risk populations in low-exposure occupations and those that are young and healthy but work in high-exposure occupations. We estimate occupation-based infection risks and use age-based infection fatality rates in a model to assign priorities over populations with different occupations and ages. Among others, we find that 50-year-old food-processing workers and 60-year-old financial advisors are equally prioritized. Our model suggests a vaccine distribution that emphasizes age-based mortality risk more than occupation-based exposure risk. Designating some occupations as essential does not affect the optimal vaccine allocation unless a stay-at-home order is also in effect. Even with vaccines allocated optimally, 7.14% of the employed workforce is still expected to be infected with the virus until the vaccine becomes widely available, provided the vaccine is 50% effective, and assuming a supply of 60mil doses.
We study the determinants of asset market fragmentation in a model with strategic investors that disagree about the value of an asset. Investors' choices determine the market structure. Fragmented markets are supported in equilibrium when disagreement between investors is low. In this case, investors take the same side of the market and are willing to trade in smaller markets with a higher price impact to face less competition when trading against a dealer. The maximum degree of market fragmentation increases as investors' priors are more correlated. Dealers can benefit from fragmentation, but investors are always better off in centralized markets.
The vast majority of regulatory debates about the benefits of centralized trading assume that the set of securities designed by financial intermediaries is immune to the market structure in which trade occurs. In this paper, we consider a regulator who redesigns the market structure for certain financial contracts by introducing an exchange to increase liquidity, understanding that security design is endogenous. For a given market structure, investors would like to trade a less risky security and, for a given security, they would like to trade in a larger market. We show that the security that intermediaries design after the introduction of the exchange is of lower quality, in the sense of a lower expected payoff per unit of standard deviation. This reflects the relative dilution of investor market power, as investors have zero price impact on the exchange and hence less influence on intermediary security design. The issuance of lower quality securities to investors arises even when the introduction of the exchange leads intermediaries to originate better underlying assets. With a large enough exchange, the decline in the quality of the security is so severe that investors can be worse off as a result of the introduction of the exchange. We then consider how origination subsidies could be used by the regulator to counter the negative effects of introducing the exchange on security design.
"Trading and Information Diffusion in Over-the-Counter Markets" (with Peter Kondor).
Econometrica, vol. 86, 1727-1769, 2018.
Corrigendum (with Peter Kondor and with Yilin Wang), vol. 88, 2221-2228, 2020.
[Abstract] [Paper] [Link to article] [MATLAB code][Online Appendices]
We propose a model of trade in OTC markets in which each dealer with private information can engage in bilateral transactions with other dealers, determined by her links in a network. Each dealer's strategy is represented as a quantity-price schedule. We analyze the effect of trade decentralization and adverse selection on information diffusion, expected profits, trading costs and welfare. Information diffusion through prices is not affected by dealers' strategic trading motives, and there is an informational externality constraining the informativeness of prices. Trade decentralization can both increase or decrease welfare. The main determinant of a dealer's trading cost is the centrality of her counterparties. Central dealers tend to learn more, trade more at lower costs and earn higher expected profit.
We provide a theory of trading through intermediaries in OTC markets. The role of intermediaries is to sustain trade, when trade is beneficial. In our model, traders are connected through a network. Agents observe their neighbors' actions, and can trade with their counterparty in a given period through a path of intermediaries in the network. However, agents can renege on their obligations. We show that trading through a network is essential to support trade, when agents infrequently meet the same counteparty in the market. However, intermediaries must receive fees to have the incentive to implement trades. Concentrated intermediation, as represented by a star network, is both a constrained efficient and a stable structure, when agents incur linking costs. Moreover, the center agent in a star can receive higher fees as well.
Modern banking systems are highly interconnected. Despite their various benefits, linkages between banks carry the risk of contagion. In this paper we investigate whether banks can commit ex-ante to mutually insure each other, when there is contagion risk in the financial system. Banks can share the risk through bilateral agreements, and we model their decisions as a network formation game. A financial network that allows losses to be shared among various counterparties emerges endogenously. We show that in an equilibrium network the degree of systemic risk, defined as the probability that contagion occurs conditional on one bank failing, is significantly reduced. In certain equilibria, contagion does not occur.
We develop a model in which asset commonality and short-term debt of banks interact to generate excessive systemic risk. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an unclustered structure, defaults are more dispersed. Portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short-term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered asset structures. In contrast, when bank debt is long-term, welfare is the same under both asset structures.
"Global Stochastic Properties of Dynamic Models and their Approximations" (with Casper de Vries).
Journal of Economic Dynamics and Control, vol. 34, 817-824, 2010.
[Abstract] [Paper] [Link to article]
The dynamic properties of micro based stochastic macro models are often analyzed through a linearization around the associated deterministic steady state. Recent literature has investigated the error made by such a deterministic approximation. Complementary to this literature we investigate how the linearization affects the stochastic properties of the original model. We consider a simple real business cycle model with noisy learning by doing. The solution has a stationary distribution that exhibits moment failure and has an unbounded support. The linear approximation, however, yields a stationary distribution with possibly a bounded support and all moments finite.
"Innovation for Innovators: The Financing of Intangibles" (with Matias Marzani and Sara Moreira).
American Economic Association: Papers & Proceedings, vol. 113, 268-73, 2023.
[Abstract] [Paper] [Link to article]
This paper examines the characteristics of firms that adopt new financial products and their performance. We build a novel firm-level panel dataset and document a positive association between intangible capital and the adoption of new products. We also find that access to external financing through new types of securities is associated with size growth and further investments into intangibles. These findings have important implications for understanding the role that financial innovation can play in meeting the financing needs of firms that rely heavily on intangible capital.
Financial crises have occurred for many centuries. They are often preceded by a credit boom and a rise in real estate and other asset prices as in the current crisis. They are also often associated with severe disruption in the real economy. This paper surveys the theoretical and empirical literature on crises. The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle. Modeling crises as a global game allows the two to be unified. With all the liquidity problems in interbank markets that have occurred during the current crisis, there is a growing literature on this topic. Perhaps the most serious market failure associated with crises is contagion and there are many papers on this important topic. The relationship between asset price bubbles, particularly in real estate, and crises is discussed at length.
Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.