Stress Testing and Bank Lending (with Joel Shapiro)
Accepted, Review of Financial Studies
Stress tests convey information about the strictness of future tests, creating incentives for banks to alter their future lending behavior. Regulators recognize and use this influence: they may conduct softer stress tests to encourage lending or tougher stress tests to reduce risk-taking. This information management can lead to inefficiencies when (a) the test loses credibility or (b) the test becomes self-fulfilling. In addition, banks may distort their lending behavior in anticipation of the stress test design, leading to further surplus losses. The analysis applies to banking supervision and regulation more broadly.
Organizational Structure and Investment Strategy (with Gyoengyi Loranth and Alan Morrison)
R&R, Review of Corporate Finance Studies
We show that a firm can use its organizational structure to commit to an investment strategy. The firm delegates sequential search and project management tasks to a manager. Ex post, the firm turns away projects that generate high project management rent. However, because the expectation of such rent serves to defray the manager's search cost, investment might be optimal ex ante. A leveraged subsidiary mitigates this time-inconsistency problem by creating ex post risk-shifting incentives that counteract underinvestment. Subsidiaries are more valuable for projects with costly search, intermediate management costs, and returns that are uncorrelated with the existing business.
Voluntary Support and Ring-Fencing in Cross-Border Banks (with Gyoengyi Loranth and Anatoli Segura)
Lamfalussy Fellowship 2020, European Central Bank
We study supervisory interventions in cross-border banks under different institutional architectures in a model in which a bank may provide voluntary support to an impaired subsidiary using resources in a healthy subsidiary. While a supranational architecture permits voluntary support, a national architecture gives rise to inefficient ring-fencing of a healthy subsidiary when there is high correlation between the subsidiaries' assets. The enhanced cross-subsidiary support allowed by a supranational architecture affects banks' risk-taking, leading to a convergence of the subsidiary risk of banks with heterogeneous fundamentals. Finally, the objective to minimize national expected deposit insurance costs is achieved through a supranational architecture for riskier banks, but not so for safer banks even in situations in which it would be aggregate welfare improving.
Contingent Capital Structure
Belgrade Young Economists Conference UnitCredit & Universities Best Paper Award 2014
This paper studies the optimal financing contract of a bank with risk-shifting incentives and private information, in an environment with macroeconomic uncertainty. Leverage mitigates adverse selection problems owing to debt information-insensitivity, but leads to excessive risk-taking. I show that the optimal leverage is procyclical in the laissez-faire equilibrium, and contingent convertible (CoCo) bonds emerge as part of the implementation of the optimal contingent capital structure. However, the equilibrium entails excessive leverage and risk-taking, due to a bank's private incentives to minimise market mispricing of its securities. It is socially optimal to impose countercyclical capital requirements, implemented by CoCo bonds in addition to straight debt and equity.