On ESG Investing: Heterogeneous Preferences, Information, and Asset Prices (with Itay Goldstein, Alexandr Kopytov and Haotian Xiang)
Academic blog: Principles for Responsible Investment (PRI)
We study how environmental, social and governance (ESG) investing reshapes information aggregation by prices. We develop a rational expectations equilibrium model in which traditional and green investors are informed about financial and ESG risks but have different preferences over them. Because of the preference heterogeneity, traditional and green investors trade in the opposite directions based on the same information. We show that the equilibrium price may not be uniquely determined. An increase in the fraction of green investors and an improvement in the ESG information quality can reduce price informativeness about financial payoff and raise the cost of capital.
Synchronicity and Fragility (with Itay Goldstein, Alexandr Kopytov and Haotian Xiang), R&R at Journal of Financial Economics
Earlier versions of the paper circulated under the title “Bank Heterogeneity and Financial Stability”
Covered in Think Advisor
We show that the correlation across financial institutions is a major force that increases their overall fragility. Our model features a financial system with financial institutions individually prone to runs and interconnected through fire sales. Strategic complementarities within and across financial institutions amplify each other, and this causes the correlation in their risks to be a key factor driving the fragility of each individual financial institution and the system as a whole. We provide new policy prescriptions to alleviate financial fragility that act through the reduction in synchronicity across financial institutions. They include reducing asset commonality and improving bank-specific disclosure. We show that secondary market liquidity injections, frequently used in recent years, have a significant stabilizing effect through synchronicity reduction on top of their direct effect.
Capital Flows in the Financial System and Supply of Credit, R&R at Journal of Finance
Runner-up for the Best Theory Paper on the Academic Job market in Finance 2019
This paper develops a model to study how capital flows in the financial system affect banks’ coordination problem in the credit supply process. The economy is susceptible to self-fulfilling credit freezes: banks abstain from lending when they fear that other banks will withhold lending, and the resultant credit contraction impedes economic growth. Capital flows across banks can alleviate the problem by enabling optimistic banks to borrow from pessimistic banks and extend more credit to the real economy. However, the equilibrium interest rate reveals public information about economic fundamentals and banks’ aggregate willingness to lend, increasing the fragility of the credit market. As a result, the economy can get stuck in an equilibrium where both interbank capital flows and the real credit supply freeze and they reinforce each other through a vicious feedback loop. Regulations addressing counterparty risks can help to maintain active capital flows in the financial system and stabilize the real credit market.
Intervention with Screening in Panic-Based Runs (with Junyuan Zou), forthcoming in Journal of Finance
Winner of Best Graduate Paper of Lisbon Meetings 2017
Policymakers frequently use guarantees to reduce panic-based runs in the financial system. We analyze a binary-action coordination game under the global games framework and propose a novel intervention program that screens investors based on their heterogeneous beliefs about the system's stability. This program attracts only investors who are at the margin of running, and their participation boosts all investors' confidence in the financial system. Compared with government guarantee programs, our proposed program is as effective at reducing panic runs yet features two advantages: it costs less to implement and is robust to moral hazard.
Corruption and Competition (with Franklin Allen and Jun “QJ” Qian)
This paper investigates how a central government can effectively curtail the corruption of local government officials. An interesting aspect of corruption is that its damaging effects on economic performance differ significantly across countries. We show that if a central government collects sufficient taxes, it can fight corruption by rewarding local government officials based on performance. Without sufficient budget, the central government can reduce corruption alternatively by encouraging competition among local government officials. We also provide empirical evidence that differences in taxing ability and the magnitude of competition among government officials can help explain the heterogeneous effects of corruption across countries.
Optimal Regulations in Two Lemon Markets: An Application in Cross-Border Listing
This paper studies regulatory competition in securities markets and its impact on firms’ financing decisions. In the era of globalization, when firms have the option to obtain financing abroad, foreign regulations become relevant for domestic firms’ financing decisions. I build a model with two open economies, each having a stock market with adverse selection problems. The regulators of the two economies strategically set regulations to compete for good firms in both economies. I show that weak economic fundamentals tie the hands of a regulator in the regulatory competition because domestic firms cannot afford high regulatory burden. As a result, consistent with empirical observations of cross-border listing, there exists an equilibrium in which the strong economy has stricter regulations than the weak economy, and the good firms in the weak economy flow to the strong economy to signal for good quality.