Herd Behavior, Bank Runs and Information Disclosure

I develop a dynamic model of bank runs that allows me to study important phenomena such as the role of information externalities and herd behavior of depositors as a source of bank runs. I show that eliminating bank runs completely, even they can be generated by herd behavior of depositors, has costs. Furthermore, a deposit contract that allows for runs can achieve higher levels of depositor welfare than a contract that completely eliminates them. Since early liquidation of bank's assets is costly, a central bank that acts as a lender of last resort alleviates some of the costs associated with bank runs. Yet it cannot prevent runs on healthy banks in the absence of perfect information about the bank's asset quality. In those cases, a deposit contract, even with liquidity support from the central bank, cannot achieve the first-best efficient outcome. As a policy measure, any efforts to give market discipline a stronger role in achieving financial stability should be accompanied by transparency and disclosure of information on banks’ soundness and management of the crisis.

Herd Behavior, Bank Runs and Information Disclosure

I develop a dynamic model of bank runs that allows me to study important phenomena such as the role of information externalities and herd behavior of depositors as a source of bank runs. I show that eliminating bank runs completely, even they can be generated by herd behavior of depositors, has costs. Furthermore, a deposit contract that allows for runs can achieve higher levels of depositor welfare than a contract that completely eliminates them. Since early liquidation of bank's assets is costly, a central bank that acts as a lender of last resort alleviates some of the costs associated with bank runs. Yet it cannot prevent runs on healthy banks in the absence of perfect information about the bank's asset quality. In those cases, a deposit contract, even with liquidity support from the central bank, cannot achieve the first-best efficient outcome. As a policy measure, any efforts to give market discipline a stronger role in achieving financial stability should be accompanied by transparency and disclosure of information on banks’ soundness and management of the crisis

Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking

We study liquidity transfers between banks through the interbank borrowing and asset sale markets when(i)surplus banks providing liquidity have market power, ii)there are frictions in the lending market due to moral hazard, and(iii)assets are bank-specific. We show that when the outside options of needy banks are weak, surplus banks may strategically under-provide lending, thereby inducing inefficient sales of bank-specific assets. A central bank can ameliorate this inefficiency by standing ready to lend to needy banks, provided it has greater information about banks(e.g.,through supervision) compared to outside markets, or is prepared to extend potentially loss-making loans. The public provision of liquidity to banks, in fact its mere credibility, can thus improve the private allocation of liquidity among banks. This rationale for central banking funds support in historical episodes preceding the modern era of central banking and has implications for recent debates on the supervisory and lender-of-last-resort roles of central banks

Herd Behavior, Bank Runs and Information Disclosure

I develop a dynamic model of bank runs that allows me to study important phenomena such as the role of information externalities and herd behavior of depositors as a source of bank runs. I show that eliminating bank runs completely, even they can be generated by herd behavior of depositors, has costs. Furthermore, a deposit contract that allows for runs can achieve higher levels of depositor welfare than a contract that completely eliminates them. Since early liquidation of bank's assets is costly, a central bank that acts as a lender of last resort alleviates some of the costs associated with bank runs. Yet it cannot prevent runs on healthy banks in the absence of perfect information about the bank's asset quality. In those cases, a deposit contract, even with liquidity support from the central bank, cannot achieve the first-best efficient outcome. As a policy measure, any efforts to give market discipline a stronger role in achieving financial stability should be accompanied by transparency and disclosure of information on banks’ soundness and management of the crisis

Rollover Risk and Market Freezes

The sub-prime crisis of 2007 and 2008 has been characterized by a sudden freeze in the market for short-term, secured borrowing. We present a model that can explain a sudden collapse in the amount that can be borrowed against assets with little credit risk. The borrowing in this model takes the form of asset-backed commercial paper that has to be rolled over several times before the underlying assets mature and their true value is revealed. In the event of default, the creditors (holders of commercial paper) can seize the collateral. We assume that there is a small cost of liquidating the assets. The debt capacity of the assets (the maximum amount that can be borrowed using the assets as collateral) depends on how information about the quality of the asset is revealed. In one scenario, there is a constant probability that "bad news" is revealed each period and, in the absence of bad news, the value of the assets is high. We call this the "optimistic" scenario because, in the absence of bad news, the expected value of the assets is increasing over time. By contrast, in another scenario, there is a constant probability that "good news" is revealed each period and, in the absence of good news, the value of the assets is low. We call this the "pessimistic" scenario because, in the absence of good news, the expected value of the assets is decreasing over time. In the optimistic scenario, the debt capacity of the assets is equal to the fundamental value (the expected NPV), whereas in the pessimistic scenario, the debt capacity is below the fundamental value and is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions

Fire-Sale FDI

Financial crises are often accompanied by an outflow of foreign portfolio investment and an inflow of foreign direct investment(FDI). We provide an agency-theoretic framework that explains this phenomenon. We show that during crises, agency problems affecting domestic firms are exacerbated, and, in turn, external financing constrained. Transfer of control in the form of direct ownership of failedfirms' assets by alternate users can circumvent agency problems, but during crises, efficient owners (e.g.other domestic firms) face similar financing constraints. The result is a transfer of ownership to foreignfirms, including inefficient ones, at fire-sale prices. Suchre-sale FDI is associated with a flipping of acquired firms back to domestic owners once the crisis abates. These features of re-sale FDI find empirical support

Crisis Resolution and Bank Liquidity

What is the effect of financial crises and the irresolution on banks' choice of liquidity? When banks have relative expertise in employing risky assets, the market for these assets clears only atre-sale prices following a large number of bank failures. The gains from acquiring assets atre-sale prices make it attractive for banks to hold liquid assets. The resulting choice of bank liquidity is counter-cyclical, inefficiently low during economic booms but excessively high during crises. We present evidence consistent with these predictions. While interventions to resolve banking crises may be desirable ex post, they affect bank liquidity in subtle ways: liquidity support to failed banks or unconditional support to surviving banks reduces incentives to hold liquidity, whereas support to surviving banks conditional on their liquid asset holdings has the opposite effect

Fire Sales, Foreign Entry and Bank Liquidity

Bank liquidity is a crucial determinant of the severity of banking crises. We consider the effect of fire sales and foreign entry during crises on banks' ex-ante choice of liquid asset holdings. In a setting with limited pledgeability of risky cash flows and differential expertise between banks and outsiders in employing banking assets, the market for assets clears only at fire-sale prices following the onset of a crisis - and outsiders may enter the market if prices fall sufficiently low. While fire sales make it attractive for banks to hold liquid assets, foreign entry reduces this incentive. We show that in this setting, bank liquidity is counter-cyclical whereas bank capital measured as bank profits is pro-cyclical. We derive conditions under which privately optimal levels of bank liquidity are higher or lower than benchmark levels that maximize total output of the banking sector. We present and discuss evidence on bank liquidity that is consistent with model predictions

Contagion Effects of the Silicon Valley Bank Run

This paper analyzes the contagion effects associated with the failure of Silicon Valley Bank (SVB) and identifies bank-specific vulnerabilities contributing to the subsequent declines in banks' stock returns. We find that uninsured deposits, unrealized losses in held-to-maturity securities, bank size, and cash holdings had a significant impact, while better-quality assets or holdings of liquid securities did not help mitigate the negative spillovers. Interestingly, banks whose stocks performed worse post SVB also had lower returns in the previous year following Federal Reserve interest rate hikes. The stock market partially anticipated risks associated with uninsured deposit reliance, but did not price in unrealized losses due to interest rate hikes nor risks linked to bank size. While mid-sized banks experienced particular stress immediately after the SVB failure, over time negative spillovers became widespread except for the largest banks