Published Papers

  • Credit Markets, limited commitment and government debt

(with Stephen Williamson)

Review of Economic Studies, 82(3), pp. 963-990, July 2015

(slides - paper)

A dynamic model with credit under limited commitment is constructed, in which limited memory can weaken the effects of punishment for default. This creates an endogenous role for government debt in credit markets. Default can occur in equilibrium, and government debt essentially plays a role as collateral and thus improves borrowers' incentives. The optimal provision of government debt acts to discourage default, whether default occurs in equilibrium or not.
Review of Economic Dynamics, vol. 18(1), pages 21-31, January 2015

(slides - paper)

The events from the 2007-2009 financial crisis have raised concerns that the failure of large financial institutions can lead to destabilizing fire sales of assets. The risk of fire sales is related to exemptions from bankruptcy's automatic stay provision enjoyed by a number of financial contracts, such as repo. An automatic stay prohibits collection actions by creditors against a bankrupt debtor or his property. It prevents a creditor from liquidating collateral of a defaulting debtor since collateral is a lien on the debtor's property. In this paper, we construct a model of repo transactions, and consider the effects of changing the bankruptcy rule regarding the automatic stay on the activity in repo and real investment markets. We find that exempting repos from the automatic stay is beneficial for creditors who that hold the borrowers' collateral. Although the exemption may increase the size of the repo market by enhancing the liquidity of collateral, it can also lead to subsequent damaging fire sales that are associated with reductions in real investment activity. Hence, policy makers face a trade-off between the benefits of investment activity and the benefits of liquid markets for collateral.


(with Laurence Ales, Pricila Maziero, Warren Weber)

Journal of Economic Theory, volume 142, issue 1, 2008, pp. 5-27

Prior to 1863, state-chartered banks in the United States issued notes–dollar-denominated promises to pay specie to the bearer on demand. Although these notes circulated at par locally, they usually were quoted at a discount outside the local area. These discounts varied by both the location of the bank and the location where the discount was being quoted. Further, these discounts were asymmetric across locations, meaning that the discounts quoted in location A on the notes of banks in location B generally differed from the discounts quoted in location B on the notes of banks in location A. Also, discounts generally increased when banks suspended payments on their notes. In this paper we construct a random matching model to qualitatively match these facts about banknote discounts. To attempt to account for locational differences, the model has agents that come from two distinct locations. Each location also has bankers that can issue notes. Banknotes are accepted in exchange because banks are required to produce when a banknote is presented for redemption and their past actions are public information. Overall, the model delivers predictions consistent with the behavior of discounts.

Working Papers

  • Clearing, transparency, and collateral
(with Gaetano Antinolfi and Francesco Carli)

R&R at the Journal of Economic Theory

(slides - paper)

In an environment of Over-The-Counter trading with adverse selection we study traders' incentives to screen their counterparties under different clearing arrangements. When the clearing arrangement is also a choice, traders decide which types of transactions to clear under each arrangement, with significant consequences for transparency and collateral requirements.

The key trade-off is between insurance and the value of information: on one hand risk averse traders want to smooth consumption and on the other hand they want to extract the largest feasible surplus from their counterparties.

Choosing an arrangement that provides insurance, however, may prevent them from taking advantage of the private information they learn about their counterparty. In fact, any arrangement involving risk pooling in equilibrium is inconsistent with any costly screening.

As a result, insurance comes at the cost of losing transparency: when clearing arrangements differ in the degree of risk sharing they implement, then they also differ in the degree of transparency arising in equilibrium. This has significant consequences on the role of collateral.

In environments with limited commitment, collateral plays two roles for risk averse traders: it is a means to discipline incentives and to self-insure at the same time.

When insurance is provided by a clearing arrangement that implements risk sharing, collateral is primarily used to discipline incentives, since risk sharing comes at the cost of less information about the limited commitment of the counterparty.

The opposite is true in the equilibrium with a clearing arrangement that cannot provide risk sharing but gives traders sufficient incentives to screen their counterparties.

  • Voluntary Reserve Targets

(with Garth Baughman)

(slides - paper)

This paper updates the standard workhorse model of banks' reserve management to include frictions inherent to the market for federal funds. We apply the model to study monetary policy implementation through an operating regime involving voluntary reserve targeting.
We argue that voluntary reserve targeting provides advantages relative to standard operating regimes.
When reserves are abundant, as is the case following the unconventional policies adopted during the recent financial crisis, standard reserve requirements may lead to a collapse in interbank trade.
We show that, no matter the relative abundance of reserves, voluntary reserve targets encourage market activity and support the central bank's control over interest rates.
Various comparative statics are considered, including the impact of routine and non-routine liquidity injections by the central bank on market outcomes.
We introduce non-depository institutions into the model and show that the central bank can control the federal funds rate without recourse to non-standard facilities such as reverse repos.

  • Dealers' insurance, market structure and liquidity

    (with Cyril Monnet)
    (slides - paper)

    Dealers intermediate transactions between buyers and sellers in many markets, especially financial markets where many contracts are over-the-counter (OTC). Contracts are negotiated bilaterally and subject their users to the risk of counterparty default. Since the late 1990s, some derivatives negotiated OTC, began to be cleared and settled through central counterparties (CCPs), however, many market participants still prefer bilateral clearing. Why, then, in certain markets and for certain transactions CCPs are not used? This is the first question that this paper answers. In the wake of the recent financial crisis, policy makers developed an elevated interest in CCP clearing and settlement solutions for OTC derivatives, culminated in mandatory central clearing for all standardized OTC derivatives. In essence, clearing via CCPs reallocates the risk of loss arising from non-performance in derivatives transactions. This reallocation, however, may affect the behavior of market participants and the structure of the market. This is the second question that this paper answers: it studies the effect that the provision of counterparty risk insurance to dealers has on market liquidity and market structure. We interpret our insurance mechanism as the introduction of a central counterparty. Contrary to most papers in the literature, we analyze how insurance will impact the trading behavior of incumbents dealers as well as the effect on dealers' entry. We find that more counterparty risk shifts trading toward more efficient dealers, who are the incumbents: so these dealers would reject the introduction of an insurance as it allows more (and relatively inefficient) dealers to enter the market, thus lowering their market power. As a result, insurance implies a decrease in the bid-ask spread. This feature of the equilibrium shows a trade off for end users: they benefit from the reduction of the bid-ask spread, but they lose from facing on average less efficient dealers. Therefore, whether the overall welfare generated by the industry increases with the insurance or not, depends on which of the two effects dominates.

This paper combines the idea that securities should be information insensitive in order to be liquid, with the idea that an infrastructure which performs clearing of trades, and offers additional services to the counterparties, facilitates securities to be liquid.

In a recent paper, Gorton et al. argue that securities that serve as a transaction medium should be the least information-sensitive, and derive sufficient conditions for such security to be debt.
Also, a few recent papers (Acharya and Bisin, Duffie and Zhu and Koeppl and Monnet among others) emphasize the role of a Central Counterparty (CCP) in internalizing externalities that stem from the opacity of over-the-counter (OTC) transactions, therefore achieving the efficient level of trade, and the role of a CCP in providing the participants with insurance and cost effective clearing services.

This paper develops a framework very similar to Gorton et al., modified to analyze some of the functions that a CCP performs. It shows that for any type of security, regardless of whether it is debt or equity, clearing transactions through a CCP reduces the extent to which securities are information-sensitive. Two functions of a CCP are key: multilateral netting and the existence of a default fund. By reducing the exposure of each counterparty to one another (or to the CCP), both netting and the default fund reduce the incentives of traders to acquire information about the payoffs of the security they are trading.

A role of CCPs that has been identified by policy makers as fostering liquidity and stability of OTC transactions, is to perform margin calls to adjust the available collateral posted for each participant's net position, following the marking to market of securities. In this framework, however, the perception that margin calls foster liquidity is incorrect: traders have even more incentives to acquire information about the securities' payoff so that fewer transactions, which would be welfare improving, are carried out.

  • Banking panics and deflation in dynamic general equilibrium

    (slides - paper)

This paper develops a framework to study the interaction between banking, price dynamics, and monetary policy. Deposit contracts are written in nominal terms: if prices unexpectedly fall, the real value of banks' existing obligations increases. Banks default, a panic precipitates and economic activity declines. If banks default, aggregate demand for cash increases because financial intermediation provided by banks disappears. With the stock of money supply unchanged, the price level drops, thereby providing incentives for banks to default.
Active monetary policy prevents banks from failing and output from falling. Deposit insurance can achieve the same goal but amplifies business cycle fluctuations by inducing moral hazard.