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440
The Leverage Cycle
, 2009
"... Equilibrium determines leverage, not just interest rates. Variations in leverage cause wild fluctuations in asset prices. This leverage cycle can be damaging to the economy, and should be regulated. 1 Introduction to the Leverage Cycle At least since the time of Irving Fisher, economists, as well as ..."
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Cited by 167 (10 self)
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Equilibrium determines leverage, not just interest rates. Variations in leverage cause wild fluctuations in asset prices. This leverage cycle can be damaging to the economy, and should be regulated. 1 Introduction to the Leverage Cycle At least since the time of Irving Fisher, economists, as well as the general public, have regardedtheinterestrateasthemostimportantvariableintheeconomy. Butintimes of crisis, collateral rates (equivalently margins or leverage) are far more important. Despite the cries of newspapers to lower the interest rates, the Fed would sometimes
A Macroeconomic Model with a Financial Sector," 41
- Journal of Monetary Economics
, 2009
"... This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an enviro ..."
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Cited by 145 (8 self)
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This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes- a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other by not maintaining adequate capital cushion.
Monetary Policy as Financial-Stability Regulation
, 2010
"... This paper develops a model that speaks to the goals and methods of financial-stability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an external ..."
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Cited by 87 (12 self)
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This paper develops a model that speaks to the goals and methods of financial-stability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, it shows how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust frictionlessly and there are other transactions media besides bank-created money that are outside the control of the central bank.
Presidential Address: Discount Rates
- Journal of Finance
, 2011
"... Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend ..."
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Cited by 79 (2 self)
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Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We also thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Incorporating discount-rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics. ASSET PRICES SHOULD EQUAL expected discounted cashflows. Forty years ago, Eugene Fama (1970) argued that the expected part, “testing market efficiency,” provided the framework for organizing asset-pricing research in that era. I argue that the “discounted ” part better organizes our research today. I start with facts: how discount rates vary over time and across assets. I turn
A macroprudential approach to financial regulation.
- Journal of Economic Perspectives
, 2011
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How Debt Markets Have Malfunctioned in the Crisis
- Journal of Economic Perspectives
, 2010
"... This article explains how debt markets have malfunctioned in the crisis, with deleterious consequences for the real economy. I begin with a quick overview of debt markets. I then discuss three areas that are crucial in all debt markets decisions: risk capital and risk aversion, repo financing and ha ..."
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Cited by 59 (5 self)
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This article explains how debt markets have malfunctioned in the crisis, with deleterious consequences for the real economy. I begin with a quick overview of debt markets. I then discuss three areas that are crucial in all debt markets decisions: risk capital and risk aversion, repo financing and haircuts, and counterparty risk. In each of these areas, feedback effects can arise, so that less liquidity and a higher cost for finance can reinforce each other in a contagious spiral. I document the remarkable rise in the premium that investors placed on liquidity during the crisis. Next, I show how these issues caused debt markets to break down: fundamental values and market values seemed to diverge across several markets and products that were far removed from the “toxic ” subprime mortgage assets at the root of the crisis. Finally, I discuss briefly four steps that the Federal Reserve took to ease the crisis, and how each was geared to a specific systemic fault that arose during the crisis.
Intermediary Asset Pricing
, 2008
"... We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of ..."
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Cited by 58 (7 self)
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We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of risk premia during crises and the speed of reversion in risk premia from a crisis back to precrisis levels. We evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets. Injecting equity capital is particularly effective because it alleviates the equity capital constraint that drives the model’s crisis.
The crisis of fair-value accounting: Making sense of the recent debate, in: Accounting,
- Organizations and Society
, 2009
"... a r t i c l e i n f o a b s t r a c t The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters' push to extend FVA into other areas. In this article, we hig ..."
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Cited by 57 (1 self)
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a r t i c l e i n f o a b s t r a c t The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters' push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or US GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation. Finally, we identify several avenues for future research.
HOW SOVEREIGN IS SOVEREIGN CREDIT RISK?
"... Abstract. We study the nature of sovereign credit risk using an extensive sample of CDS spreads for 26 developed and emerging-market countries. Sovereign credit spreads are surprisingly highly correlated, with just three principal components accounting for more than 50 percent of their variation. So ..."
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Cited by 51 (2 self)
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Abstract. We study the nature of sovereign credit risk using an extensive sample of CDS spreads for 26 developed and emerging-market countries. Sovereign credit spreads are surprisingly highly correlated, with just three principal components accounting for more than 50 percent of their variation. Sovereign credit spreads are generally more related to the U.S. stock and high-yield bond markets, global risk premia, and capital flows than they are to their own local economic measures. We find that the excess returns from investing in sovereign credit are largely compensation for bearing global risk, and that there is little or no country-specific credit risk premium. A significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.
Liasons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic risk,” Unpublished working paper.
, 2009
"... Abstract We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The av ..."
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Cited by 50 (11 self)
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Abstract We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The average level of risk diversification of the agents coincides with the density of links in the network. In addition to a process of diffusion of financial distress, we also consider a discrete process of default cascade, due to the re-evaluation of agents assets. In this framework we investigate the probability of individual defaults as well as the probability of systemic default as a function of the network density. While it is usually thought that diversification of risk always leads to a more stable financial system, in our model a tension emerges between individual risk and systemic risk. As the number of counterparties in the credit network increases beyond a certain value, the default probability, both individual and systemic, starts to increase. This tension originates from the fact that agents are subject to a financial accelerator mechanism. In other words, individual financial fragility feeding back on itself may amplify the effect of an initial shock and lead to a full fledged systemic crisis. The results offer a simple possible explanation for the endogenous emergence of systemic risk in a credit network.
