Abstract: We develop a tractable rational expectations model that allow for general portfolio constraints. We apply our methodology to study a model where constraints arise due to endogenous margin requirements. We argue that margin requirements affect and are affected by informational efficiency, leading to a novel amplification mechanism. A drop in investors' wealth tightens constraints and reduces their incentive to acquire information, which lowers price informativeness. Moreover, financiers who use information in prices to assess the risk of financing a trade face more uncertainty and set tighter margins, which further tightens constraints. This information spiral implies that risk premium, conditional volatility and Sharpe ratios rise disproportionately as investors' wealth drops. Our model uncovers a new, information-based rationale why the wealth of investors is important.
Revise and resubmit , Review of Financial Studies
Winner of Deutsche Bank Prize in Financial Risk Management and Regulation 2014
Abstract: This paper shows that collateralised short-term debt, although privately optimal for reducing borrowers' moral hazard, can cause fragility (multiple equilibria) when the collateral market is illiquid. A new form of coordination failure between borrowers' ex ante margin and risk-taking decisions engenders a systemic run in the collateralised debt market: large changes in credit rationing, margins, repo spreads, etc. The model also captures the large (small) cross-sectional differences between safe and risky collateral in bad (good) times. Finally, I show that asset price guarantees could improve welfare and promote stability but repealing repo contracts' ``automatic stay'' exemption might do the opposite.
Abstract: Banks as informed intermediaries have information about their borrowers to make efficient liquidation versus restructuring decisions for distressed loans, but their information also creates an adverse selection problem when they seek financing from uninformed investors. We demonstrate that a bank with high-quality loans faces incentives to distort its resolution policy in order to improve allocative efficiency and to signal information about loan quality, with the direction of the distortion depending on whether the security issued to uninformed investors is concave or convex. We find that the bank's equilibrium resolution policy is biased towards liquidation when it optimally designs and sells a debt (concave) security to raise financing. Regulations aimed at promoting ex post efficient liquidation may increase banks' financing costs and discourage their screening effort, thereby reducing welfare.
Dealers' leverage and asset liquidity (with Max Bruche)