A Structural Model of Interbank Network Formation and Contagion
with Jamie Coen (LSE)
The interbank network, in which banks compete with each other to supply and demand financial products, creates surplus but may also result in risk propagation. We examine this trade-off by setting out a model in which banks form interbank network links endogenously, taking into account the effect of links on default risk. We estimate this model based on novel, granular data on aggregate exposures between banks. We find that the decentralised interbank market is not efficient, primarily because banks do not fully internalise a network externality in which their interbank links affect the default risk of other banks. A social planner would be able to increase surplus on the interbank market by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains.
The business cycle induces turnover in mutual funds: they exit in recessions and enter in recoveries. The effect of this firm turnover on welfare depends on a key trade-off: on the one hand, the business cycle “cleanses” the market of low quality exiting funds and replaces them with entrants that may on average be higher quality. On the other hand, the entrants have no returns history and so investors have less precise beliefs about their ability, where this “information loss” leads to misallocation that harms welfare. I examine this trade-off by estimating a structural model in which rational investors form and update beliefs about competing mutual funds that endogenously choose to enter and exit the market. I estimate this model using data on US mutual funds. I find that the business cycle has material, persistent effects that are negative in the short-term but turn positive as the effect of information loss decays over time. Finally, I use my estimated model to consider how subsidies can optimally trade off information loss and cleansing in a temporarily predictable recession such as that resulting from the Covid-19 pandemic. I find that aggregate surplus is maximised by subsiding older funds, so as to preserve their socially valuable returns history.
Work in progress
Intermediation and Financial Market Liquidity
with Jamie Coen (LSE)