Financial Frictions within the Macroeconomy

Financial factors are central to the recent economic crisis. Most macroeconomic models treat banks and financial intermediation as a veil. These models are unable to account for the recent financial crisis and they cannot be used for policy evaluation. Financial frictions include default on mortgages, disruptions in financial intermediation, and informational asymmetries, among others. In my dissertation, I propose to analyze the effects of policy in economic models characterized by financial frictions. The thesis is composed of three chapters. The first chapter is joint work with Luisa Lambertini and Pinar Uysal. We explicitly model the housing sector, mortgages, and endogenous default as well as nominal and real rigidities in a dynamic stochastic general equilibrium (DSGE) setting. We use U.S. data for the period 1981-2006 to estimate our model using Bayesian techniques. Our starting point is to have an empirically plausible model with endogenous default in mortgages that can explain the main features of the macroeconomic time series. We analyze how an increase in the mortgage default rate can spread to the rest of the economy and result in a recession. Next we examine different policy options that might mitigate the effects of an increase in the mortgage default rate. In the second chapter I develop a two-country DSGE model with global banks (financial intermediaries in one country lend to banks in the other country). Banks are financially constrained on how much they can borrow from households. The main goal is to obtain a framework that captures the international transmission of a financial crisis through the balance sheet of the global banks as well as to explain the insurance mechanism of the international asset market. A negative shock to the value of the capital in one country generates a global financial crisis through the international interbank market. The third chapter uses the above model to analyze the policy challenges that global banks face. In this chapter, I look at how different unconventional unilateral credit policies help to mitigate the effects of a financial disruption. First, the policies are carried out only by the policy maker of the country directly hit by the shock. Consumers of the country where the intervention and the shock take place are better off with policy than without it; consumers from the other country are worse off. Second, I allow for both policy makers to intervene. Both countries intervening help to reduce the negative effects of the country that is not directly hit by the shock but the intervention is not a Pareto improvement.

Financial Stability and the Macroeconomy

Corinne Dubois

The financial crisis of 2007-2009 drew attention to the essential role of banks for the macroeconomy and to the importance of having a resilient financial sector. A vulnerability in the financial sector spills over to the real economy and can drive it into a deep recession. Following the financial crisis, policy makers have issued rules and regulations aimed at strengthening the banks. My dissertation considers some of those measures, namely bank liquidity regulation and deposit insurance, and tries to assess their effectiveness in stabilizing the financial sector and the economy in general. The first chapter (joint with Prof. Luisa Lambertini) develops a model with regulated banks and a hedge fund to analyze the behavior of wholesale funding and the macroeconomic consequences of liquidity regulation. Banks raise deposits and subordinated wholesale funding from the hedge fund. Wholesale funding amplifies shocks: it is curtailed in economic downturns to avoid leveraging up and risk-taking by banks, further depressing credit and economic activity. By making banks safer, liquidity regulation increases wholesale funding and bank loans at the steady state. However, flat liquidity regulation requiring banks to hold a constant fraction of liquid assets can have unintended consequences and increase macroeconomic volatility. Our model further shows that cyclically adjusted regulation stabilizes the response of the economy to shocks. We also provide empirical evidence suggesting that liquidity helps contain the contraction in wholesale funding and loans during times of funding stress. The second chapter explores the macroeconomic and welfare implications of harmonizing or joining deposit insurance in the Eurozone. I develop a two-country model to represent the core and periphery countries in the Eurozone. The model features fragile banks that can be subject to endogenous and costly runs. The two countries are financially integrated through an international interbank market. I introduce deposit insurance and compare different insurance regimes in steady state and along the business cycle. The model emphasizes that financial integration implies co-movement in asset prices and the transmission of shocks across the border. I find that when deposit insurance has lower coverage in the periphery than in the core, financial stability is undermined in both regions due to higher asset price volatility and a higher probability of deposit runs. Hence, either harmonizing or joining deposit insurance leads to substantial welfare benefits for both countries. In the third chapter, I develop a macroeconomic model with multiple equilibria and bank runs to analyze deposit insurance. A bank run is a sunspot equilibrium, and it is caused by a self-fulfilling panic of all depositors. The model features a unique no-run equilibrium when macroeconomic conditions are good, but an unexpected negative shock may open up the possibility of a run equilibrium. A bank run is a rare but costly event that drives the economy in a long and severe recession. I analyze the introduction and build-up of a deposit insurance fund and show that it reduces the cost and probability of bank runs. The dynamic simulation of the model reveals that deposit insurance diminishes macroeconomic and financial instability following a technological shock.

EPFL2018

Essays on Mortgage Supply in a Low Rate Environment and Gender Effects of Covid-19

Yu Wu

After the financial crisis, policy rates in the major advanced economies have moved downwards to near/below zero. Some countries have experienced an increase in house prices and an expansion of mortgages. Also, there have been considerable changes in the mortgage market share, with only a few bank categories contributing to this mortgage expansion. Such change in exposure to real estate risk may pose a risk to financial stability. My dissertation research studies the role played by specific bank features, such as reliance on deposits and covered bonds or capital surplus relative to the required level, in explaining banks' different mortgage lending behavior. The first chapter (joint with Prof. Luisa Lambertini) studies the Swiss mortgage market dynamics in a low rate environment. After 2008, small banks (cantonal banks and Raiffeisen) have primarily contributed to this mortgage expansion at the expense of two big global systemic banks (UBS and Credit Suisse). We set up a model featuring big and small banks that compete in the deposit and mortgage market and face different capital requirements. We calibrate it to the Swiss banking sector. In this model, a falling policy rate drives up borrowing demand and leads to an expansion in mortgage supply; however, an asymmetric tightening of capital requirement gives small banks a competitive advantage and causes a shift in market share towards small banks. In the second chapter, with Prof. Luisa Lambertini, we use the Swedish bank-level data and employ a triple diff strategy to investigate whether funding side differences also play a role in explaining banks' different lending responses to the negative rate policy. First, we find that high-deposit banks expand their mortgage supply less than low-deposit banks during negative rate periods, confirming the well-documented deposit channel effect. However, this pattern works only for weakly-capitalized banks, which have a low capital buffer. Second, we show that banks more reliant on covered bonds to finance mortgage lending lend out more under negative rates; they can shift into cheap deposits to reduce their funding costs. We extend our model in the first chapter to be consistent with these empirical findings and use it to study the implications of the Covid-19 pandemic for the mortgage market. The third chapter analyzes the transmission of housing price dynamics to the real economy in the context of China, which went through a decade-long housing boom. Understanding its propagation to other economic activities is thus important. I build up a real business cycle model for this study and find that land-use conversion by the governments and land finance of housing firms can amplify the crowding-out effects of housing price fluctuations on the non-housing sector. The year 2020 was marked by the outbreak of the Covid-19 pandemic, which adversely affected the labor market. The fourth chapter is an additional line of work, with Dr. Corinne Dubois and Prof. Luisa Lambertini exploring gendered consequences of the pandemic in the Swiss labor market. We use the Swiss labor force survey data and find that all else equal, women have been more likely to exit the labor market altogether or to use short-term working schemes than their male counterparts. Contrary to expectations, increased family-care responsibility is not the main driver. Telework availability of occupation, however, explains some of the differential impact of Covid-19 on men and women.

EPFL2021

Essays in Information-Based Asset Pricing

Michael Hasler

I started my Ph.D. studies in the Fall 2008, a period ex-post perceived as being at the core of the Financial Crisis. At that time my ideas were vague and I struggled to find a good research topic. As surprising as it might appear, in one single week the discussions I had with my relatives provided me with enough ideas needed to write my thesis. Indeed, during that single week my relatives contacted me and complained about the fact that they had lost money invested in the financial market. They wanted me to advise them. I simply told them to invest their money in relatively safe bonds. My relatives did not realize how fruitful their behavior was for me. Indeed, after having advised them I wondered whether their willingness to gather information in bad times was optimal or pure irrationality. This issue is addressed in the first chapter of my thesis. The last two chapters investigate the impact of the willingness to gather more information in bad times than in good times on the dynamics of asset prices. My thesis answers two very important questions: When should investors acquire information given that information-processing is costly and what is the impact of the optimal information acquisition strategy on asset price dynamics? Consequently, the main topic of my thesis is the transmission of acquired information in financial markets. In the first chapter I consider a dynamic portfolio choice and costly information acquisition problem. Consistent with my relatives behavior, I show that it is optimal to gather more information in bad times than in good times. As the state of the economy worsens, investors optimally re-balance their portfolio towards safer investment and spend more and more money to gather more and more accurate information regarding future market moves. This result derived in a purely rational setup helps to understand the empirical observation that people tend to pay fluctuating attention to news, focusing more in downturns than in upturns. To the best of my knowledge, this paper is the first to consider costly information acquisition in a dynamic setting. The main contribution is to provide insights on how investors should optimally allocate their wealth to the financial market on the one hand and to information market on the other hand given current market conditions. In the second chapter (with Daniel Andrei) we model the optimal information acquisition strategy obtained in the first chapter in a general equilibrium framework and we show that this strategy (fluctuating attention paid to news) has very interesting implications on the dynamics of asset prices. Our main contribution is to highlight a J-shaped relationship between attention and volatility. By constructing an empirical measure of attention to news, we show that the theoretical prediction of our model holds in the data. Moreover, we are the first to provide a theoretical foundation for the fact that the slope of the term structure of equity premia is pro-cyclical. In the third chapter I investigate the impact of fluctuating attention to news in a multi-asset general equilibrium framework. My main contribution is to show that fluctuating attention to news generates return and volatility spillover effects among financial markets. As a bad shock hits one market, investors raise their attention to that particular market. This implies a simultaneous increase in each market volatility and in each cross-market correlation, a phenomenon called financial contagion. Moreover, I document that the interconnection between attention and uncertainty generates persistence in cross-market correlations. This very interesting result proves that persistence can be generated through Bayesian learning. Finally, I am the first to provide a theoretical foundation for the observed shape of the term structure of correlation. Consistent with empirical findings, I show that fluctuating attention implies an upward sloping term structure of correlation where the shorthand is wider than the longhand.

EPFL2013