Counterparty Risk and Repo Runs
Abstract: I develop a model in which banks finance the purchase of risky assets by borrowing against the assets as collateral. Due to limited liability, banks with impaired balance sheets have incentives to take excessive leverage, exposing their lenders to the risk of counterparty default. I show that lenders’ efforts to deter excessive leverage-taking generate a novel bank-run mechanism through which a small shock on banks’ balance sheets can generate large decreases in collateralized funding and asset prices. According to the model, a central bank’s liquidity backstop is effective in deterring such a run on collateralized funding. In normal times, a countercyclical capital buffer can increase banks’ funding stability, whereas a minimum margin requirement can be ineffective in reducing the risk of a market-wide funding squeeze.
Informational Role of Investment in Bankruptcy
(with Ben Charoenwong and Hyunsoo Doh)
Abstract: We study an informational role of investment when the bankruptcy market suffers from information asymmetry. In our model, equityholders of a levered firm forgo positive-NPV projects when the firm’s asset quality is low. But, due to this underinvestment, ill-informed potential asset buyers can distinguish between good firms and bad firms from their past investment decisions. Put differently, the agency friction between equity and debt can alleviate the information friction in the bankruptcy market. Therefore, policies seeking to stimulate investment during recessions may reduce the informational content of investment, leading to lower recovery value of assets in default.