Research

Publication

Non-dilutive CoCo Bonds: A Necessary Evil? (joint with Andrea Gamba and Joe Gong) Accepted at Review of Corporate Finance Studies

We empirically document and theoretically investigate why non-dilutive CoCos are prevalent, even though advocates of CoCos suggest such securities should be dilutive to reduce bank risk-taking. In an agency model with two subsequent moral hazards, we show that while dilutive CoCos deter ex-ante risk-taking and prevent a bank from being undercapitalized, penalizing existing shareholders with dilution when the bank is already undercapitalized leads to risk shifting. CoCos’ designs and risk implications depend on banks’ equity capitalization, with nondilutive CoCos particularly attractive to capital-constrained banks, because such securities can maximize the banks’ ﬁnancing capacity by tackling only the ex-post risk-shifting.

Contagious Bank Runs and Committed Liquidity Support (joint with Zhao Li), 2022, Management Science, 68, 12, 9152-9174

In a crisis, regulators and private investors can find it difficult, if not impossible, to tell whether banks facing runs are insolvent or merely illiquid. We introduce such an information constraint into a global-games-based bank run model with multiple banks and aggregate uncertainties. The information constraint creates a vicious cycle between contagious bank runs and falling asset prices and limits the effectiveness of traditional emergency liquidity assistance programs. We explain how a regulator can set up committed liquidity support to contain contagion and stabilize asset prices even without information on banks' solvency, rationalizing some recent developments in policy practices.

Corporate Governance of Banks and Financial Stability (joint with Deniz Anginer, Asli Demirguc-Kunt and Harry Huizinga) 2018, Journal of Financial Economics, 130, 2, 327-246

We find that shareholder-friendly corporate governance is associated with higher stand-alone and systemic risk in the banking sector. Specifically, shareholder-friendly corporate governance results in higher risk for larger banks and for banks that are located in countries with generous financial safety nets as banks try to shift risk toward taxpayers. We confirm our findings by comparing banks to nonfinancial firms and examining changes in bank risk around an exogenous regulatory change in governance. Our results underline the importance of the financial safety net and too-big-to-fail guarantees in thinking about corporate governance reforms at banks.

How Does Corporate Governance Affect Bank Capitalization Strategies? (joint with Deniz Anginer, Asli Demirguc-Kunt and Harry Huizinga), 2016, Journal of Financial Intermediation, 26, p.1-27

This paper examines the relationship between banks’ capitalization strategies and their corporate governance and executive compensation schemes for an international sample of banks over the 2003–2011 period. Shareholder-friendly corporate governance, in the form of a separation of the CEO and chairman of the board roles, intermediate board size, and an absence of anti-takeover provisions, is associated with lower bank capitalization, consistent with shareholder incentives to shift risk towards the financial safety net. Higher values of executive option and stock wealth invested in the bank are associated with higher capitalization as a potential reflection of executive risk aversion, but the risk-taking incentives embedded in executive compensation packages are associated with lower capitalization.

Working Papers

The Informational Impacts of Prudential Regulations (Joint with Tamas Vadasz) [Paper] Revise & Resubmit at Journal of Financial Intermediation

Banks can take costly actions (such as higher capitalization, liquidity holding, and advanced risk management) to fend off runs. While such actions directly affect bank risks, they also carry informational content as signals of the banks' fundamentals. A separating equilibrium due to such signalling, however, involves two types of inefficiency: the high type chooses excessively costly signals, whereas the low type is vulnerable to runs. This provides a novel rationale for financial regulations: by restricting banks’ actions, regulators can maintain a pooling equilibrium where the cross-subsidy among types promotes financial stability. We build a theoretical model to illustrate the point and also obtain supporting evidence from the US capital and liquidity regulations.

Asymmetric Cartels: Who Gains, Who Defects, and Some Unintended Consequences of Anti-Trust Policies (Joint with Lucy White) [Paper]

We investigate how colluding asymmetric firms divide markets. We provide conditions under which, contrary to conventional wisdom, the efficient firm gains more from collusion, while the inefficient firm is more tempted to defect. Both anti-trust investigations and leniency policies have the intended effect of deterring some cartels, but also have unintended consequences for surviving cartels. Cartels surviving the introduction of leniency move towards a more inefficient distribution of output, worsening allocative and productive efficiency. Traditional investigation improves the efficiency of relatively symmetric surviving cartels but may worsen the efficiency of more asymmetric surviving cartels.

Bank Information Sharing and Liquidity Risk (joint with Fabio Castiglionesi, and Zhao Li) [Paper]

We propose a novel rationale for the existence of bank information sharing schemes. Banks may voluntarily disclose borrowers' credit history to maintain asset market liquidity. By sharing such information, banks mitigate adverse selection when selling their loans in secondary markets. This reduces the cost of asset liquidation in case of liquidity shocks. Information sharing arises endogenously when the liquidity benefit dominates the cost of losing market power in the primary loan market competition. We show banks having incentives to truthfully disclose borrowers' credit history, even if such information is non-verifiable. We also provide a rationale for promoting public credit registries.

Banking Competition and Stability: The Role of Leverage (joint with Xavier Freixas) [Paper]

This paper re-examines the classical issue of the possible trade-offs between banking competition and financial stability by highlighting different types of risk and the role of leverage. We show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on a bank's type of funding (retail deposits vs. wholesale debts) and whether leverage is exogenous or endogenous. In particular, we argue that while competition might increase financial stability in a classical originate-to-hold banking industry, the opposite can be true for an originate-to-distribute banking industry with a large fraction of market short-term funding.

Systemic Risk and Market Liquidity [Paper]

The paper studies herding driven by the need for market liquidity. By investing in the same asset, investors can expect homogeneous returns and thereby limit private information on asset qualities. This mitigates adverse selection and generates asset liquidity. Such liquidity creation, however, results in systemic risk: When the asset experiences a loss, all investors become stressed at the same time. Herding therefore presents a trade-off between systemic risk and liquidity creation. The model also suggests that systemic risk and leverage are mutually reinforcing: Investing in a systemic but liquid asset increases collateral value and debt capacity. Moreover, investors leveraged with short-term debt will find the systemic but liquid asset attractive for reducing the risk of runs. The model offers an explanation of why banks collectively exposed themselves to mortgage-backed securities prior to the crisis, and why the exposure grew when banks were increasingly leveraged using wholesale short-term funding.

Work in Progress

"The Making of (Modern) Banks" (joint with Zhao Li and Lucy White)

Banks are made of contracts. For a bank to issue riskless, money-like, claims, its financing and executive compensation contracts must be jointly designed to induce banker effort and discourage risk-taking. Our model explains why bankers receive high pay for producing mediocre outcomes, and why pure charter value (or market value of equity) is insufficient to prevent banker risk-taking. Outside shareholders, contributing book equity, are useful despite introducing another layer of agency problems. It is efficient for shareholders to finance bankers' projects with joint liabilities, and when bankers’ incentive contracts are opaque, each banker’s pay should depend on the entire bank’s performance although he controls only his own performance.