Essays in Financial Economics

Abstract

This dissertation contains three essays that study liquidity crises and financial system stability.

The first chapter studies a model of systemic panic among heterogeneously leveraged financial institutions. Concerns about potential spillovers from each other generate strategic interactions among institutions and bring self-fulfilling panic. I show that systemic risk critically depends on the financial health of stronger institutions (less leveraged) in the contagion chain, although financial contagion originates in weaker institutions. My analysis highlights the striking contrast between macroprudential and non-systemic regulatory approaches yielding novel policy implications. Systemic stability can be enhanced by making the institutions more heterogeneous, and bolstering the strong institutions in the contagion chain, rather than the weak, more effectively contains systemic panic.

The second chapter studies a model of a credit crunch (an interbank market freeze) in which risk sharing among banks exacerbates financial fragility. Banks that wish to borrow with liquidity shortages may have to pay extra cost of credit if lenders have a better investment opportunity; collecting fire-sale assets at cheap price from the distressed banks. They thus have to compensate the lender for this outside option in order to borrow. With risk sharing among the banks, this option value can become more sensitive to aggregate uncertainty fluctuations since joint distress arises and the lender anticipates large price discounts. Credit costs and aggregate output can become more volatile, and credit rationing more likely with risk sharing.

The third chapter studies feedback between asset market distress and money market distress. The market clearing asset price can act as a public signal from which agents can extract information about the asset fundamental. As the asset price drops, the creditors in the money market become concerned and less willing to lend. This distress in the money market forces financial institutions to liquidate their assets in the asset market, and the asset price becomes even lower, generating vicious cycle between the two markets. I combine noisy rational expectation equilibrium setup and global game setup to characterize this feedback. The asset price volatility becomes larger as the economic fundamental deteriorates, and the asset price distribution becomes negatively skewed.