Banking
My research on banking explores banks’ risk choices and their implications for regulatory policy and financial stability. Key findings indicate that interest-rate derivatives increase banks’ overall risk rather than hedging it, challenging the notion that market power over deposits completely eliminates such risks. As interest rates have generally been declining, this increased risk has actually benefited banks’ performance. The recent turbulence in the banking sector following monetary tightening by central banks corroborates the unhedged interest rate risk in the banking sector. The research also quantitatively examines the complexities of capital requirements, showing that tighter rules stimulate bank lending but shift some activities to less-regulated shadow banks. I also explore the effect of accounting rules that delay the recognition of financial losses on financial stability and quantitatively assess its interaction with capital requirements. This work also has implications on the recent crisis as it shows how accounting rules (such as HTM rules) can contribute to the build-up of fragility in the financial sector. It also allows quantitative assessment of the trade-offs of tighter regulation.
Intermediation in alternative assets
My research on intermediation in alternative assets explores critical policy issues around the increased share of U.S. public pensions’ investment in high-cost alternative assets. I explore issues related to the costs of investing in private capital funds and beliefs that pension funds might have around public equity performance. My research reveals that there is a large dispersion in fees that public pension funds pay for the same private equity investment. I explore reasons for this pattern and find support for non-tangible pension traits such as lack of financial sophistication and negotiation skills. These findings have contributed to a recent SEC policy proposal aimed at enhancing transparency in private equity fee disclosures. Additionally, I scrutinize the motivation behind public pensions’ allocations to private capital funds. I find that these investment choices are largely influenced by public pension fund beliefs that such investments have substantially superior returns relative to public equities.
Corporate Finance
My research in corporate finance develops quantitative models to examine how firms of varying sizes make financing decisions in response to macroeconomic shocks, evolving growth opportunities, and shifts in production technologies. I find that a combination of financial constraints and shocks to both firm-specific and macro-level investment opportunities account for divergent external financing behaviors between small and large firms. Additionally, I explore how sweeping technological changes in production methods influence industry dynamics and firms’ financing strategies. My findings indicate that the increasing prevalence of cash reserves in the corporate sector from 1980s to the early 2000s is linked to a broader transition towards R&D-intensive production technologies, which necessitate higher levels of internal financing and cash holdings. I also find that advancements in big data technology help explain why the corporate sector is increasingly dominated by a few very large firms: when the use of big data disproportionately lowers the cost of capital for large firms, it enables them to grow at the expense of smaller competitors.
Working Papers
Banking
A Q-Theory of Banks
with Saki Bigio and Jeremy Majerovitz and Matias Vieyra (Slides)
Under revision for the Review of Economic Studies
We introduce a dynamic bank theory featuring delayed loss recognition and a regulatory capital constraint, aiming to match the bank leverage dynamics captured by Tobin’s Q. We start from four facts: (1) book and market equity values diverge, especially during crises; (2) Tobin’s Q predicts future bank profitability; (3) neither book nor market leverage constraints are strictly binding for most banks; and (4) bank leverage and Tobin’s Q are mean reverting but highly persistent. We demonstrate that delayed loss accounting rules interact with bank capital requirements, introducing a tradeoff between loan growth and financial fragility. Our welfare analysis implies that accounting rules and capital regulation should optimally be set jointly. This paper emphasizes the need to reconcile regulatory dependence on book values with the market’s emphasis on fundamental values to enhance understanding of banking dynamics and improve regulatory design.
Unstable Inference from Banks’ Stable Net Interest Margins
with Erik Stafford
This paper shows that stable net-interest margins of banks are uninformative about banks’ interest rate exposure. We show that neither deposits nor market power are essential for achieving stable net-interest margins (NIM) in long-short fixed income portfolios. We show that matching interest income and interest expenses sensitivities to market rate movements is a consequence of achieving stable NIM, not necessarily the causal mechanism that allows it. Stable NIM does not imply near zero interest rate risk according to standard risk measures. Common measures of imperfect pass-through of market rates to bank deposit rates commingle two distinct mechanisms: (1) intentional rate setting and (2)mechanical consequence of comparing the changes in the periodic interest earned on positive maturity fixed coupon portfolios to changes in a short-term interest rate. The mechanical maturity consequence dominates the measured imperfect pass-through of market rates on time deposits.
Do Banks have an Edge?
with Erik Stafford (Slides)
Overall, no! We show that the level and time series variation in cash flows for most bank activities are well matched by capital market portfolios with similar interest rate and credit risk to what banks report to hold. Ignoring operating expenses, bank loans earn high returns and transaction deposits pay low interest rates, consistent with these activities having a potential edge. The edge among these activities is insufficient to cover the large operating expenses of banks. A large portion of the aggregate US banking sector closely resembles a tax inefficient passive mutual fund. The residual risks of bank activities, presumably generated by the unique components of the bank business model, generate systematic risks that are uncompensated.
Uniform Rate Setting and the Deposit Channel
with Erik Stafford
Under revision for the Journal of Finance
The deposit channel of monetary policy is neither well identified nor does it aggregate. US banks predominately use uniform deposit rate setting policies, particularly the largest banks. Uniform rate setting ignores local market concentration and therefore, the deposit channel cannot operate in branches belonging to a uniform rate network. Early empirical support for the deposit channel excludes networked branches, representing 85% of all branches. Several reliable relationships in the cross section of banks do not aggregate because of the extreme bank size distribution and the differential behavior of small and large banks.
Banks’ Risk Exposure
with Monika Piazzesi and Martin K. Schneider
Under revision for Econometrica
This paper studies U.S. banks’ exposure to interest rate and credit risk. We exploit the factor structure in interest rates to represent many bank positions in terms of simple factor portfolios. This approach delivers time varying measures of exposure that are comparable across banks as well as 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. We use the approach to document stylized facts about the recent evolution of bank risk taking.
Intermediation in Alternative Assets
The Rise of Alternatives
(joint with Pauline Liang and Emil Siriwardane)
Since the 2000s, U.S. public pensions have rotated heavily out of public equities and into alternative assets like private equity and hedge funds. This behavior is typically attributed to reaching-for-yield incentives created by the secular decline in safe interest rates, like those related to pension underfunding or binding portfolio constraints. We argue that such mechanisms are unlikely to explain the rise of alternatives without a concurrent shift in beliefs. Several facts support the idea that the perceived risk-adjusted return of alternatives has increased over time. Pensions beliefs appear to be shaped by consultants, peers, and experience in the 1990s.
Work in Progress
Banking
Deposit Concentration and Financial Stability?
(joint with Vadim Elenev and Tim Landvoigt)
Determinants of bank performance: evidence from replicating portfolios
(joint with Carlo Altavilla, Lorenzo Burlon, and Franziska Huennekes)
Intermediation in Alternative Assets
What explains fee dispersion in private equity?
(joint with Claudia Robles-Garcia, Emil Siriwardane, and Lulu Wang)
Publications
Banking
Financial Regulation in a Quantitative Model of the Modern Banking System
with Tim Landvoigt (Slides) (Online Appendix) (Code)
WFA Award for the Best Paper on Financial Institutions
The Review of Economic Studies, Volume 89, Issue 4, July 2022, Pages 1748–1784
How does the shadow banking system respond to changes in capital regulation of commercial banks? We propose a quantitative general equilibrium model with regulated and unregulated banks to study the unintended consequences of regulation. Tighter capital requirements for regulated banks cause higher liquidity premia, leading to higher shadow bank leverage and a larger shadow banking sector. At the same time, tighter regulation eliminates implicit subsidies to regulated banks and improves the competitive position of shadow banks, reducing their incentives for risk taking. The net effect is a safer financial system with more shadow banking. Calibrating the model to data on financial institutions in the U.S., the optimal capital requirement is around 16%.
Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model
Journal of Financial Economics, Volume 136, Issue 32, May 2020, Pages 355-378
This paper develops a quantitative dynamic general equilibrium model in which households’ preferences for safe and liquid assets constitute a violation of Modigliani and Miller. I show that the scarcity of these coveted assets created by increased bank capital requirements can reduce overall bank funding costs and increase bank lending. I quantify this mechanism in a two-sector business cycle model featuring a banking sector that provides liquidity and has excessive risk-taking incentives. Under reasonable parametrizations, the marginal benefit of higher capital requirements related to this channel significantly exceeds the marginal cost, indicating that US capital requirements have been sub-optimally low.
Intermediation in Alternative Assets
Fee Variation in Private Equity (joint with Emil Siriwardane)
Journal of Finance (Internet Appendix), 2024
Data: An Empirical Guide to Investor-Level Private Equity Data from Preqin
We study how investment fees vary within private-capital funds. Net-of-fee return clustering suggests that most funds have two tiers of fees, and we decompose differences across tie into both management and performance-based fees. Managers of venture capital funds and those in high demand are less likely to use multiple fee schedules. Some investors consistently pay lower fees relative to others within their funds. Investor size, experience, and past performance explain some but not all of this effect, suggesting that unobserved traits like negotiation skill or bargaining power materially impact the fees that investors pay to access private markets.
Corporate Finance
Big Data in Finance and the Growth of Large Firms
with Maryam Farboodi and Laura Veldkamp
Journal of Monetary Economics. Volume 97, 2018, pp. 71-87
Two modern economic trends are the increase in firm size and advances in information technology. We explore the hypothesis that big data disproportionately benefits big firms. Because they have more economic activity and a longer firm history, large firms have produced more data. As processor speed rises, abundant data attracts more financial analysis. Data analysis improves investors’ forecasts and reduces equity uncertainty, reducing the firm’s cost of capital. When investors can process more data, large firm investment costs fall by more, enabling large firms to grow larger.
Firm Financing Over the Business Cycle
with Juliana Salomao
The Review of Financial Studies, Volume 32, Issue 4, 1 April 2019, Pages 1235–1274
Lead Article
We study the investment and financing policies of public U.S. firms. Large firms substitute between debt- and equity financing over the business cycle whereas small firms’ financing policy for debt and equity is pro-cyclical. This paper proposes a novel mechanism that explains these cyclical patterns in a quantitative heterogeneous firm industry model with endogenous firm dynamics. We find that cross-sectional differences in investment policies and therefore funding needs as well as exposure to financial frictions are key to understand how firms’ financing policies respond to macroeconomic shocks. Financial frictions cause firms to be larger with lower valuations and less investments.
Firm Selection and Corporate Cash Holdings
with Berardino Palazzo
Journal of Financial Economics, Volume 139, Issue 3, March 2021, Pages 697-718
Editor’s Choice
Among stock market entrants, more firms over time are R&D–intensive with initially lower profitability but higher growth potential. This sample-selection effect determines the secular trend in U.S. public firms’ cash holdings. A stylized firm industry model allows us to analyze two competing changes to the selection mechanism: a change in industry composition and a shift toward less profitable R&D–firms. The latter is key to generating higher cash ratios at IPO, necessary for the secular increase, whereas the former mechanism amplifies this effect. The data confirm the prominent role played by selection, and corroborate the model’s predictions.
Book Chapters
Banking
A New Approach to Measuring Banks’ Risk Exposure
Chapter in “Leveraged: The New Economics of Debt and Financial Fragility” (2022), edited by Moritz Schularick, the University of Chicago Press, (p. 165-180)
How can we measure banks’ risk exposure? I argue that the portfolio mimicking approach combines both market data and bank accounting data in a useful way to make progress on this question. The resulting risk measures are transparent and illuminate recently overlooked risk exposures such as interest rate risk.
Remapping the Flow of Funds
with Monika Piazzesi and Martin K. Schneider
Chapter in NBER book Risk Topography: Systemic Risk and Macro Modeling (2014),
Markus Brunnermeier and Arvind Krishnamurthy, editors (p. 57-64)
The Flow of Funds Accounts are a crucial data source on credit market positions in the U.S. economy. In particular, they combine regulatory data from various sources to produce a consistent set of flow and stock tables in major credit market instruments by sector. The events of the last five years have underscored the importance of positions data to guide economic analysis. Viewing positions as payment streams typically requires more information than book value or fair value. However, much of this information is already contained in the data sets from which the Flow of Funds accounts are constructed. This chapter first 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, and derives some concrete alternatives for data collection.
Comment: Government Guarantees and the Valuation of American Banks
by Andrew G. Atkeson, Adrien d’Avernas, Andrea Eisfeldt, Pierre-Olivier Weill.
Prepared for the NBER Macroeconomics Annual 2018, volume 33, Martin Eichenbaum and Jonathan A. Parker, editors