Essays on Financial Crises and Financial Regulation

Journal of Monetary Economics, 2012

A macroeconomic model with …nancial intermediation is developed in which the intermediaries (banks) can issue outside equity as well as short term debt. This makes bank risk exposure an endogenous choice. The goal is to have a model that can not only capture a crisis when banks are highly vulnerable to risk, but can also account for why banks adopt such a risky balance sheet in the …rst place. We use the model to assess quantitatively how perceptions of fundamental risk and of government credit policy in a crisis a¤ect the vulnerability of the …nancial system ex ante. We also study the e¤ects of macro-prudential policies designed to o¤set the incentives for risk-taking. We thank Philippe Bacchetta and Elu Von Thadden for helpful comments. Gertler and Kiyotaki also wish to acknoweldge the support of the NSF.

Review of International Economics, 2002

The paper develops a new model of private debt financing with an inefficient financial system at its core, where inefficiency is characterized by costly loan monitoring. The model suggests a mechanism that generates the following series of events: a period of low capital inflow despite high rates of economic growth (capital inflow inertia), as observed in the take-off era in the Asian tiger economies; followed by a sudden acceleration of capital inflow (as seen in the 1990s); and then by a crisis, which is defined as a large reduction in the amount of loans intermediated by the financial system (i.e., a large capital outflow or credit crunch). Under certain conditions, financial crisis can occur even when economic fundamentals and market sentiment change only slightly. Unlike most credit rationing models, the results presented here do not hinge on the assumption of asymmetric information. The model also provides guidance about the appropriate policy responses to an imminent crisis.

The paper builds a simple, micro-founded model of exchange rate management, speculative attacks, and exchange rate determination. The country can pick an ambitious peg in an attempt to signal a strong currency and thereby attract foreign capital or boost future re-election prospects. The peg, however, triggers speculative attacks that the country must withstand for the signal to remain credible. Maintaining the peg is costly to a country with an overvalued currency as it must sell the foreign currency at an unfavorable rate. We show that speculative activities can exhibit strategic complementarity or substitutability. We then relate the peg's ambition and the size of the ensuing speculative attack to the market's prior beliefs about the strength of the currency, the ability of foreign speculators to short sell the currency, domestic politics, and the initial debt composition. Finally, the model predicts that pegs and features of original sin emerge concurrently. Country hedging is endogenously incomplete as letting the residents hedge is a clear admission that the currency is overvalued by the market and makes any complementary attempt at exchange rate management futile. Similarly, we show that a peg may make domestic borrowers eager to issue short-term liabilities so as to provide foreign investors with an advantageous exit option. Furthermore, the government does not incentivize firms to lengthen the maturity structure even when it wants to because doing so would again be an open admission of a future depreciation.

2000

1998

In response to severe financial crises in 1997, several Asian governments-backed by bilateral and multilateral lenders-provided enormous amounts of support to ailing domestic banks, and issued sweeping guarantees of private financial liabilities (needing funding of up to 30 percent of GDP). In this paper, we examine how the provision of financial sector bailouts affects private capital markets. At the heart of our analysis is a key commitment problem: to avoid financial collapse during a crisis, governments tend not to allow banks to fail, regardless of previous promises. Our analysis shows that expectations of financial sector support in the event of a systemic crisis can lead to over-borrowing, invested in risky inefficient projects, setting the stage for systemic crisis. Ironically, this outcome is more likely, the stronger the financial position of the government. Thus, without prudential regulation, Asian financial systems were especially prone to crisis.

Macroeconomic Dynamics

We explore the effects of banking regulation on financial stability and macroeconomic dynamics in an agent-based computational model. In particular, we study the minimum level of capital and the lending concentration towards a single counterpart. We show that an overly tight regulation is dangerous because it reduces credit availability. By contrast, overly loose constraints, associated with a high payout ratio, increase financial fragility that, in turn, damage the real economy. Simulation results support the introduction of regulatory rules aimed at assuring an adequate capitalization of banks, such as the Capital Conservation Buffer (Basel III reform).

2013

The first chapter analyzes how default externalities lead to an excessive incidence of systemic private debt crises. An individual defaulting borrower does not internalize that her default leads to a depreciation in the exchange rate because international lenders will sell any seizable assets and flee the country. The exchange rate depreciation in turn reduces the value of non-tradable collateral and induces other borrowers to default, leading to a chain reaction of defaults. The inefficiency of default spillovers can be corrected by strengthening the enforcement of creditor rights, so that private individual borrowers have less incentives to default, reducing

International Economics and Economic Policy, 2010

The recent financial crisis revealed that in a world of large asymmetries of information, of complex financial innovations and incomplete regulatory frameworks "self regulation" obviously does not work. But we have also seen that the governmental stabilisation policies have not worked well either. This paper argues that there have been, at least, two main contributors to the recent financial crisis. The one is supervision and regulation policy, the other is monetary policy. Easy monetary policy designed to ward off perceived risks of deflation in 2002-04 contributed to the boom in the housing market in 2004 and 2005 by keeping interest rates too low for too long. Particularly the US-Fed has played a crucial role by fuelling the assetprice, boom-bust cycle that led to the sub-prime crisis and the following global financial crisis. Moreover, this paper analyses what central banks can do to help avoid a next financial crisis. In particular, the role and limits of supplementary macro-prudential instruments are discussed.

Cambridge Journal of Economics

In the aftermath of the Great Recession, governments have implemented several policy measures to counteract the collapse of the financial sector and the downswing of the real economy. Within a framework of Minsky-Veblen cycles, where relative consumption concerns, a debt-led growth regime and financial sector confidence constitute the main causes of economic fluctuations, we use computer simulations to assess the effectiveness of such measures. We find that the considered policy measures help to mitigate the impact of financial crises, though they do so at the cost of shortening the time between the initial financial crisis and the next. This result is due to an increase in solvency and confidence induced by the policy measures under study, which contribute to an increase in private credit and, thereby, increase effective demand. Our results suggest that without a strengthening of financial regulation any policy intervention remains incomplete.

SSRN Electronic Journal, 2010

In the analysis of the credit crisis of 2007-2010 a clear distinction should be made between (i) the initial shock; (ii) the propagation and amplification of the initial shock to the systemic crisis of the financial markets; and (iii) the transmission of the credit crisis to the real economic sector causing a major cyclical downturn now known as the great recession. This paper argues that banking supervision failed to anticipate and repair the market failure that caused the huge amplification of the relatively small initial shock. As the repair of market failure is the only sound economic argument for regulation, banking supervisors should now focus on the externalities that caused the amplification of the shock and use that knowledge for adequate macro-prudential supervision in the future. Macroeconomic models can be helpful in this search for externalities. The character and timing of future shocks are unpredictable, but contagion in the propagation mechanisms should be mitigated as much as possible.