Weymuller C-H.
Banks as Safety Multipliers: A Theory of Safe Assets Creation. 2013.
Abstract
Why do banks hold so many safe assets such as government bonds? I argue that the economic role of banks is to multiply safety, and their holdings of public debt help them achieve that goal. In a environment with endogenous collateral constraints and multiple assets, risk-neutral banks issue debt securities to cater to the safety demand of risk-averse investors. Private safety creation requires banks to hold on their balance sheets government bonds, whose returns are negatively correlated with macroeconomic shocks. When heterogeneity in risk aversion is large and public debt supply low, there is a safety multiplier in the sense that lowering even more the supply of public debt induces banks to delever, hurting private debt supply. In this regime, public debt crowds-in private investment, because a shortage of public debt constrains risk-sharing. In a dynamic version with maturity choices, I endogeneize the negative correlation of public debt. The expectation of a flight-to-safety transforms long-term securities into hedging instruments. The private equilibrium is constrained inefficient due to an issuance externality. The economy lacks long-term securities, as private agents do not internalize the benefits of the negative beta of their own liabilities. Public debt is non-neutral but there is an interior optimal level of public securities, as their hedging properties deteriorate with their supply.
The model interprets the ongoing European debt crisis as a shortage of public safe assets. Public debt and private debt positively comove in Europe, contrary to the US. Simultaneously, banks increased their holdings of safe public debt to back private debt. As for asset pricing, the spread between public debt yield and private debt yield reveals bank leverage and can be used as a macroprudential tool. In an open economy environment, sovereign risk hurts aggregate private leverage but domestic banks become the natural holders of domestic public debt.
Banks as Safety Multipliers: A Theory of Safe Assets Creation Weymuller C-H.
Leverage and Reputational Fragility in Credit Markets. 2013.
AbstractThis paper analyzes the equilibrium on secured debt markets with heterogeneous borrowers. I develop a bargaining model of endogenous leverage when debt capacity depends not only on the nature of collateral but also on borrower's reputation. Agents with higher reputation secure both more and cheaper credit. As a result, haircuts and rates positively comove in the cross-section, a prediction that cannot be delivered in a model where the heterogeneity among borrowers is about collateral, such as beliefs. I endogeneize reputation by identifying it to continuation value in a repeated borrowing game. Leverage is procyclical because of the endogeneity of reputation. Leverage is high and stable when agents are sufficiently capitalized. However, as their net worth depletes, reputation vanishes in a non-linear way, and leverage then is limited and unstable. Reputation acts as a stabilization mechanism in good times but as an amplification mechanism in bad times. In this dynamic environment, long-term contracts stabilize leverage by avoiding margin calls in the states in which the borrower has low net worth. Reputation also provides an economic rationale to a long intermediation chain, in order to monetize intermediaries franchise. The empirical analysis on repo transactions of money market funds confirms the predictions of the model. First, financial intermediaries with high reputation write repo contracts with lower haircuts and lower rates. Second, haircuts are more sensitive to borrower's reputation when borrower's net worth is low. Third, long-term relationships stabilize funding. It provides evidence that reputation and bilateral relationships matter even in secured funding markets.
Leverage and Reputational Fragility in Credit Markets