New bank resolution mechanisms: is it the end of the bailout era?

We study the effectiveness of three common bank resolution mechanisms: bailouts, bank sales, and ‘bad banks’. We first apply the financial fragility model of Goodhart et al. (2005, 2006a) to analyze the impact of these resolution mechanisms on bank behavior. We then use a novel bank-level database on 39 countries that used these resolution mechanisms during 1992-2017 and analyze the relationship between the mechanisms applied and subsequent bank performance. We find that the effectiveness of resolution mechanisms depends crucially on the timing and severity of crises. While mergers can deliver good results at the beginning of a crisis, this is less likely at later stages of a crisis. In the event of severe crises, mechanisms aimed at restructuring bank balance sheets are most likely to deliver positive results. We find no support for bank bailouts as an optimal strategy. A calibration exercise shows that the effectiveness of resolution mechanisms to mitigate systemic risk declines with the severity of crises

Interbank borrowing and lending between financially constrained banks

Some stylized facts about transactions among banks are not easily reconciled with coinsurance of short-term liquidity risks. In our model, interbank markets play a different role. We argue that lending to another bank can reduce a bank’s overall portfolio risk through diversification. If insolvency is costly, this diversification improves the interbank lender's funding liquidity, boosting credit supply to nonbanks. However, diversification comes at an endogenous cost that depends on bank-specific factors of interbank borrower and lender. The model provides a framework for understanding the importance of interbank lending for aggregate credit supply and the stability of banking systems. The model’s predictions are consistent with evidence documented in the literature that other theories cannot consistently explain

Default and determinacy under quantitative easing

We show that the path of inflation under quantitative easing policies that target interest rates, is determinate in the presence of default. We achieve this through different payoff profiles that a collateralised defaultable bond achieves in different states of nature with distinct default outcomes. In the model, heterogeneous households trade this bond and other shorter maturity risk-free bonds to maximize their intertemporal utility of consumption and labour. The differentiated payoffs of the collateralised bond, in an equilibrium with active default, span the full state space giving determinacy of prices and inflation as an outcome. This, implies that quantitative easing as implemented by the ECB in the recent years, can control the stochastic path of inflation

How investment opportunities affect optimal capital structure

The topic of optimal capital structure1 has been well-studied since 1958, when the original Modigliani- Miller theorem2 appeared. Since then, a great many articles have addressed the question of how companies choose their target leverage from both theoretical and empirical perspectives. Much of this research has focused on the merits and limitations of the so-called “trade-off theory” of capital structure, which describes companies as weighing the tax and control benefits of more debt against the increasing costs of financial distress and bankruptcy. But as a number of the articles in this issue have noted, companies appear to make much less use of debt than the trade-off theory would seem to recommend.</p

Support for small businesses amid COVID-19

How should the government support small and medium-sized enterprises amid a pandemic crisis while balancing the trade-off between short-run stabilization and long-run allocative efficiency? We develop a two-sector equilibrium model featuring small businesses with private information on their likely future success and a screening contract. Businesses in the sector adversely affected by a pandemic can apply for government loans to stay afloat. A pro-allocation government sets a harsh default sanction to deter entrepreneurs with poorer projects, thereby improving long-run productivity at the cost of persistent unemployment, whereas a pro-stabilization government sets a lenient default sanction. Interest rate effective lower bound leads to involuntary unemployment in the other open sector and shifts the optimal default sanction to a lenient stance. The rise in firm markups exerts the opposite effect. A high creative destruction wedge polarizes the government’s hawkish and dovish stances, and optimal default sanction is more lenient, exacerbating resource misallocation. The model illuminates how credit guarantees might be structured in future crises

Debt overhang and monetary policy in Czech Republic

We investigate the consequences of excessive international debt overhang as they relate to both debtor and creditor countries. In particular, we assess the impact of monetary policy on financial stability and how it can be used to smooth borrowers, as well as creditors, consumption over the business cycle. Based on [Goodhart, Peiris and Tsomocos, 2018], we establish that an independent countercyclical monetary policy, that contracts liquidity whenever debt grows whereas it expands it when default rises, reduces volatility of consumption. In effect, monetary policy provides an extra degree of freedom to the policymaker. We implement our approach to the Czech and Eurozone area economies during the 1990s. In our model, we introduce endogenous default ά la [Shubik and Wilson, 1977], whereby debtors incur a welfare cost in renegotiating their contractual debt obligations that is commensurate to the level of default. However, this cost depends explicitly on the business cycle and it should be countercyclical. Hence, contractionary monetary policy reduces the volume of trade and efficiency, thus increasing default. This occurs as the default cost increases the associated default accelerator channel engenders higher default rates. On the other hand, lower interest rates increase trade efficiency and, consequently, reduce the amplitude of the business cycle and benefit financial stability. In sum, the appropriate design of monetary policy complements financial stability policy. The modelling of endogenous default allows us to study the interaction of monetary and macroprudential policy