Financial Cycles with Heterogeneous Intermediaries with Hélène Rey
[Review of Economic Studies, April 2023]
This paper develops a dynamic macroeconomic model with heterogeneous financial intermediaries and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behaviour of financial intermediaries combined with entry and exit. We show that when interest rates are high, a decrease in interest rates stimulates investment and increases financial stability. In contrast, when interest rates are low, further stimulus can increase systemic risk while inducing a fall in the risk premium through increased risk-shifting. In this case, there is a trade-off between stimulating the economy and financial stability.
Central Bank Policy and the concentration of risk: Empirical estimates with Daisoon Kim and Hélène Rey
[Journal of Monetary Economics, January 2022,vol 125]
Before the 2008 crisis, the cross-sectional skewness of banks’ leverage went up and macro risk concentrated in the balance sheets of large banks. Using a model of profit-maximizing banks with heterogeneous Value-at-Risk constraints, we extract the distribution of banks’ risk-taking parameters from balance sheet data. The time series of these estimates allow us to understand systemic risk and its concentration in the banking sector over time. Counterfactual exercises show that (1) monetary policymakers confront the trade-off between stimulating the economy and financial stability, and (2) macroprudential policies can be effective tools to increase financial stability.
Sovereigns at Risk: A dynamic model of sovereign debt and banking leverage
[Journal of International Economics, May 2020, vol. 124]
This paper develops a dynamic model with heterogeneous investors and sovereign default to analyze the dynamic link between banking sector capitalization and sovereign bond yields. The banking sector is modelled as operating under a Value-at-Risk (VaR) constraint, which can bind occasionally. As default risk rises, the constraint may bind, generating a fall in demand for sovereign bonds that can be accompanied by a rise in the risk premium if other agents are more risk averse. In turn, the rise in risk premium leads to a feedback effect through debt accumulation dynamics and the probability of government default.
Financial Cycles and Credit Growth Across Countries (2018) with Hélène Rey
[AEA Papers and Proceedings, May 2018, vol. 108, pp 509-12 ]
In Coimbra and Rey (2019) we develop a dynamic macroeconomic model with heterogeneous financial intermediaries and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behavior of financial intermediaries. We test empirically in a broad panel of countries the implication that credit creation is more elastic to funding costs when the distribution of leverage in the banking system is more positively skewed.
Asset Pricing and Risk Sharing Implications of Alternative Pension Plan Systems
with Francisco Gomes, Alex Michaelides and Jialu Shen
[SSRN Working Paper, Conditionally accepted at the Journal of Finance]
We show that incorporating defined benefit pension funds in an asset pricing model with incomplete markets improves its ability to jointly match the historical equity premium and riskless rate, and has important implications for risk sharing. We emphasize the importance of the pension fund's size and asset demands in determining equilibrium asset prices and discuss a new risk channel arising from fluctuations in the fund's endowment. We use our calibrated model to study the implications of a shift from an economy with defined benefit pension schemes to one with defined contribution plans. We find that the new steady-state is characterized by a higher riskless rate and a lower equity premium. Consumption volatility increases for retirees but decreases for workers.
Privilege Lost? The Rise and Fall of a Dominant Global Currency
with Kai Arvai
How does a country obtain the status of a safe haven with a dominant global currency? This paper argues that size matters: as a country becomes larger and more diversified, the underlying shock process of the economy becomes less variable. Shocks that can drive a government to default become less likely, implying lower default probability, lower interest rates and higher debt-to-GDP. Furthermore, the larger a country’s share in the supply of global safe assets, the more liquid and attractive its bonds are for investors. If the dominant currency country grows less than the rest of the world, its status as a safe haven erodes and interest rate differentials decline. This could explain the recent evidence of shrinking US return differentials on its cross-border bond portfolios.
Corporate debt structure and heterogeneous monetary policy transmission
with Marie Alder and Urszula Szczerbowicz
Using French firms’ balance sheet data, we show that corporate debt structure plays a significant role in ECB monetary policy transmission. In addition to interest rate policy, we analyse the impact of a novel ECB-induced bond liquidity shock. While both types of policy tightening diminish French firms’ investment, the transmission of conventional monetary policy shocks is stronger for firms with a higher share of bank debt. Conversely, contractionary bond liquidity shocks lower investment more for firms with higher bond shares of total debt. We further investigate the transmission channels and show that bond liquidity tightening reduces French sovereign bond market liquidity and leads to higher bond-bank loan interest rate spreads and lower bond issuance.
The Cross-Section of Risk-Taking and Asset Prices
with Rustam Jamilov and Hélène Rey
The distribution of institutional investor risk-taking carries significant explanatory power for the cross-section of asset returns. We compute an investor-level Value-at-Risk (VaR) measure - our proxy for ex-ante riskiness - from a structural model with stochastic volatility that we estimate with a particle filter. Our pricing factor - CrossRisk - is then constructed from shocks to the procyclical dispersion of the time-varying VaR distribution. CrossRisk is able to price equity, bond, CDS, options, currency, and commodity market portfolios comparably to numerous single and multi-factor benchmarks. We show that the mechanism behind our results is the extensive margin - dynamic entry and exit of investors into the risky market. A synthetic high-minus-low CrossRisk beta pre-sorted equity portfolio built on the full universe of CRSP firms has an annualized returns spread of 5.8%.
An Iberian Disease? On current account imbalances within a monetary union
During the process of accession to the Eurozone, some member countries experienced a rapid increase in credit availability fuelled by the fast convergence of interest rates. This was accompanied by large current account deficits and booms in the housing sector. This paper argues that these features are intimately related to the fast expansion of the household credit market, namely the financing of housing purchases. A model is presented of a small open economy where the fall of interest rates is associated with an increase in the collateral value of housing, which in turn shifts production towards the housing sector. This also impacts on competitiveness, leading to a deterioration of the trade balance. Similar effects may also imply an asymmetry across member countries in the transmission of monetary policy, depending on how important collateral constraints are in each country.
Financial Market Liquidity and Exchange rates
with Wei Cui and Yi Huang