Research

What happens when a bank is damaged? Do they stop lending and shrink? This is the standard intuition and much of the academic literature has focused on testing this by looking at a given type of lending - deciding that this indeed is what happens.  We show that the reality is more subtle.  We find that banks do retrench when damaged, but by tuning their lending terms to adjust an array of assets in different directions, not to de-lever, but to de-risk. 

Asset-pricing models have experienced success by augmenting the consumption process with Long-Run Risk and Rare Disasters. Acknowledging that both phenomena are naturally subject to ambiguity, we show that an ambiguity-averse agent may behave as if Long-Run Risk and disasters exist even if they do not or exaggerate them if they do.

How do you value assets when you don't know how the world works? We study an investor who is unsure of the dynamics of the economy. Not only are parameters unknown, but the investor does not even know what order model to estimate -allowing potentially infinite-order dynamics. She prices assets using a pessimistic model that minimizes lifetime utility subject to a constraint on statistical plausibility. We show this helps explainimportant asset pricing phenomena. 

Keynes coined the phrase "animal spirits" and, ever since, people have been interested in defining this nebulous concept. We provide an elegant interpretation by retaining small r "rationality" while relaxing big "R" Rationality, in the sense of Rational Expectations. If reasonable people "doubt" their model of the world, the interaction of these doubts with fluctuations in volatility induces them to behave as if they are subject to waves of sentiment. 

We examine the impact of a central bank digital currency, combining survey evidence from German households with a macroeconomic model featuring endogenous systemic bank runs. The survey reveals non-trivial demand for CBDC as a substitute for bank deposits in normal times (“slow disintermediation”) and increased withdrawal risks during financial distress (“fast disintermediation”). Informed by the survey, the model indicates that naively introducing a CBDC might reduce financial stability because CBDC offers storage-at-scale - making it attractive to run to. We estimate an optimal holding limit which chokes off fast disintermediation and enhances financial stability by shrinking a fragile banking system.

Using novel data on bond trading in the UK, we develop a new measure of selling pressure that can be applied to any trader. We identify exogenous selling pressure in a bond using traders’ sales of other, unrelated bonds.The price impact of a sale depends on who is selling: sales by dealers and hedge funds generate significantly larger impacts than equally sized sales by other investors. We rationalise our findings using a model of differentially informed investors. All else equal, our results suggest that more attention should be devoted to risks to financial stability from these impactful sellers.

This paper documents new facts on the modification of bank loans using FR Y-14Q regulatory data on C&I loans. We find that loan-level modifications of key contractual terms, such as interest and maturity, occur at least once for 41% of loans. Cross sectional differences in modifications are substantial and amplified by borrower distress. Relative to single-lender loans, syndicated loans are 1.5 times more likely to be modified and interest rate changes are twice as likely. Our findings call into question whether 1) creditor dispersion makes loan modifications more challenging and 2) relationship lending between banks and small borrowers creates more scope for flexibility when borrower-level conditions change.

This paper introduces a novel methodology for classifying asset greenness and examines the impact of carbon pricing and climate risk on asset returns and equity premiums of greener versus browner assets in the Euro Area. We construct three distinct portfolios based on exposure to regulation (i.e. subject or not to the EU ETS market). Our results show a positive equity premium for greener assets when carbon prices are low, consistent with the theory that greener assets carry higher risk. However, this premium diminishes with stronger policy commitment and rising carbon prices. Using Bayesian estimation within a macro-finance framework, we confirm the empirical findings and identify climate sentiment shocks as key drivers of asset returns, while carbon pricing shows limited influence on the premium given its low levels over the studied period, it can be a catalyst when price levels are high.

What determines the frequency domain properties of a stochastic process? How much risk comes from high frequencies, business cycle frequencies or low frequency swings? If these properties are under the influence of an agent, who is compensated by a principal according to the distribution of risk across frequencies, then the nature of this contracting problem will affect the spectral properties of the endogenous outcome. We imagine two thought experiments: in the first, the principal is myopic with regard to certain frequencies - his understanding of the true process is intermediated through a filter - and the agent chooses to hide risk by shifting power from frequencies to which the regulator is attuned to those to which he is not. Thus, the regulator is fooled into thinking there has been an overall reduction in risk when, in fact, there has simply been a frequency shift. In the second thought experiment, the regulator is not myopic, but simply cares more about risk from certain frequencies, perhaps due to the preferences of the constituents he represents or because certain types of market incompleteness make certain frequencies of risk more damaging. We model this intuition by positing a filter design problem for the agent and also by a particular type of portfolio selection problem, in which the agent chooses among investment projects with different spectral properties. While abstract, these models suggest important implications for macroprudential policy and regulatory arbitrage.