We provide a theory of trading through intermediaries in OTC markets. The role of intermediaries is to sustain trade, when trade is beneficial. In our model, traders are connected through a network. Agents observe their neighbors' actions, and can trade with their counterparty in a given period through a path of intermediaries in the network. However, agents can renege on their obligations. We show that trading through a network is essential to support trade, when agents infrequently meet the same counteparty in the market. However, intermediaries must receive fees to have the incentive to implement trades. Concentrated intermediation, as represented by a star network, is both a constrained efficient and a stable structure, when agents incur linking costs. Moreover, the center agent in a star can receive higher fees as well.
Modern banking systems are highly interconnected. Despite their various benefits, linkages between banks carry the risk of contagion. In this paper we investigate whether banks can commit ex-ante to mutually insure each other, when there is contagion risk in the financial system. Banks can share the risk through bilateral agreements, and we model their decisions as a network formation game. A financial network that allows losses to be shared among various counterparties emerges endogenously. We show that in an equilibrium network the degree of systemic risk, defined as the probability that contagion occurs conditional on one bank failing, is significantly reduced. In certain equilibria, contagion does not occur.
We develop a model in which asset commonality and short-term debt of banks interact to generate excessive systemic risk. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an unclustered structure, defaults are more dispersed. Portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short-term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered asset structures. In contrast, when bank debt is long-term, welfare is the same under both asset structures.
"Global Stochastic Properties of Dynamic Models and their Approximations" (with Casper de Vries).
Journal of Economic Dynamics and Control, vol. 34, 817-824, 2010.
[Abstract] [Paper] [Link to article]
The dynamic properties of micro based stochastic macro models are often analyzed through a linearization around the associated deterministic steady state. Recent literature has investigated the error made by such a deterministic approximation. Complementary to this literature we investigate how the linearization affects the stochastic properties of the original model. We consider a simple real business cycle model with noisy learning by doing. The solution has a stationary distribution that exhibits moment failure and has an unbounded support. The linear approximation, however, yields a stationary distribution with possibly a bounded support and all moments finite.
We propose a model of trade in OTC markets in which each dealer with private information can engage in bilateral transactions with other dealers, determined by her links in a network. Each dealer's strategy is represented as a quantity-price schedule. We analyze the effect of trade decentralization and adverse selection on information diffusion, expected profits, trading costs and welfare. Information diffusion through prices is not affected by dealers' strategic trading motives, and there is an informational externality constraining the informativeness of prices. Trade decentralization can both increase or decrease welfare. The main determinant of a dealer's trading cost is the centrality of her counterparties. Central dealers tend to learn more, trade more at lower costs and earn higher expected profit.
We study the determinants of asset market fragmentation. We develop a model of market formation in which investors with heterogeneous valuations for an asset trade strategically. When choosing a dealer with whom to trade, investors trade off the lower price impact and the steeper competition for the dealer's liquidity offered by a larger market. When the correlation among investor valuations is high, the increase in competition dominates the decrease in price impact and investors prefer to trade in a smaller market, which makes market fragmentation an equilibrium outcome. Fragmented market structures can Pareto dominate centralized ones and can exhibit higher trading volumes.
Work in Progress
We explore a model in which banks strategically securitize assets and create opaque portfolios that interferes with investors' decisions and leads to more banking crises. In our set-up, banks borrow funds from investors in order to finance risky projects. When debt is issued, the banks, as well as the investors are uninformed about the outcome of the projects. Before maturity, however, investors observe a signal about their bank's project, and can decide whether they liquidate their debt early against a redemption value. Ex-ante, each bank can affect how investors use their information by securitizing a fraction of their project in exchange for another bank's project. This way, banks can create an optimal degree of information asymmetry such that investors continue their debt contract only in those states that are most favorable to banks. Thus, while traditionally securitization arises as a strategic response of the borrower who has better information than the lender, in our model securitization itself is the source of information asymmetry. We characterize banks' optimal portfolio allocation. We show that when securitization takes places in equilibrium, banking crises are more likely to occur and welfare is lower. Our model is suggestive that government interventions and bailout policies can only increase the probability of banking crises by further distorting banks' incentives, and thus are inefficient.
"Trading Financial Innovation " (with Kinda Hachem).
Financial crises have occurred for many centuries. They are often preceded by a credit boom and a rise in real estate and other asset prices as in the current crisis. They are also often associated with severe disruption in the real economy. This paper surveys the theoretical and empirical literature on crises. The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle. Modeling crises as a global game allows the two to be unified. With all the liquidity problems in interbank markets that have occurred during the current crisis, there is a growing literature on this topic. Perhaps the most serious market failure associated with crises is contagion and there are many papers on this important topic. The relationship between asset price bubbles, particularly in real estate, and crises is discussed at length.
Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.