Students Trace the Causes, Impact of Systemic Financial Crisis

Turbulent times make for compelling research questions

Financial sector growth, credit provision, bank runs and liquidity, housing shocks, and sovereign debt management are all factors that played a role in the recent global economic downturn.

Young scholars funded through the Macro Financial Modeling initiative are adding to our understanding of the macroeconomic effects rippling out from each of these areas. They shared their research in progress at the January 2016 meeting.

N. Aaron Pancost, a doctoral student at the University of Chicago, used data from India to explore the question of whether and to what extent financial development increases economic growth. Aggregate labor productivity in India growing at about six percent a year, and the financial sector is also growing. Is access to capital driving investment that boosts firms’ productivity?

No, Pancost showed. “What I find is that it’s a common shock to productivity across the board, not financial development, that explains cross-sectional productivity. His results show that firms that are unproductive don’t borrow, while productive firms

choose a higher leverage and grow faster on average.

         

Credit Markets and Liquidity

Two students focused on problems in the financial sector during the recent crisis, presenting work addressing issues of liquidity and credit provision.  

Credit market disruptions in the recent crisis were devastating to economy, so Alexander Rodnyansky of Princeton University, in joint work with Olivier Darmouni, looked at how unconventional monetary policy affected bank lending. They found that in the US, the first and third rounds of quantitative easing had a large effect on lending, particularly in real estatecommercial, and industrial lending. QE2 had no significant effect on banks.

The results show that the type of asset used in QE—not just the quantity—makes a difference, Rodnyansky said.

While debt-laden banks stopped lending in the crisis, many also faced insolvency when depositors and investors reclaimed their funds. New Basel rules tried to stabilize the financial system by requiring banks to hold enough assets to withstand a one-month run.

University of Chicago student Fabrice Tourre studied the influence of portfolio liquidity composition on run behavior of banks’ creditors. Taking his model to data, he found that cash can play a novel role in corporate finance, as a run deterrent. Currently liquidity regulations are too conservative for certain firms, and not conservative enough for others, he showed. And it’s not always the case that issuing more long-term debt makes the firm less run-prone.

“The takeaway is that regulators, as opposed to focusing on capital on one side and liquidity on other, should think about them together; the two regulatory regimes talk to each other,” Tourre said. 

  

The Housing Boom Before the Bust

Jack Liebersohn, a Massachusetts Institute of Technology student, shared work that tried to explain the nationwide variation in the severity of the housing bust that precipitated the financial crisis. The standard model holds that local differences in housing supply shocks, mediated by differences in elasticity of the supply response explained the variation. Liberson added a demand shock to the model.

He hypothesized that areas with a large manufacturing sector would have lower payrolls in general and therefore lower demand for housing that would keep prices lower. He comparing areas with high and low manufacturing concentration but also high and low supply elasticity. He found that housing prices rose and fell dramatically in low-manufacturing cities, and less so in cities with greater manufacturing employment.  High elasticity dampened the housing price effect, he found.

To see whether higher housing prices led to more consumption, he looked at auto sales, as measured by employment in the auto industry. He found that wages had a much stronger effect on auto sales than housing prices did.

Turning to more methodological issues, Elisabeth Pröhl of the University of Geneva demonstrated a promising approach to using numerical algorithms to solve a labor income risk model with aggregate risk.

  

Work from Former Grantees  

Zachary Stangebye, an assistant professor of economics at the University of Notre Dame, presented theoretical work on sovereign debt motivated by the recent European debt crises. He presented a model in which such a crisis arises, driven by the sovereign’s inability to commit to future debt issuance.

The intuition behind the model is that when investors anticipate high borrowing in the future, they demand a dilution premium on long-term bonds. That forces the sovereign to borrow more today because they can’t borrow as much tomorrow. As a result, high current borrowing causes need for high rollover, which indeed leads the sovereign to borrowing more in the future, fulfilling expectations.

Stangebye’s model imposes a commitment on borrowing, and finds that multiple financing trajectories arise as result of coordination failures with long-term debt

When the model is calibrated to Ireland’s results, it accounts for about 85 percent of the increase in debt-to-GDP ratio seen in the crisis.

Marco Machiavelli of the Federal Reserve Board presented work on the role of dispersed information in pricing default. Studying modern bank runs with data from the recent crisis, he showed that if forecasts about a bank’s viability are bad, lower dispersion of beliefs about a bank’s prospects greatly increases default risk, and amplifies the reaction to changes in market expectations. In other words, more precise and consistent shared information coordinates bank runs, as all investors respond to the information in the same way.

Finally, Juliane Begenau of Harvard Business School presented an ambitious paper analyzing how regulations affecting capital requirements affect banking and financial intermediation.

Her work focused on the process of intermediation that provides access to assets and turns risky illiquid assets into safe and liquid ones. In a model with households, banks, and shadow banks, she found that increasing capital requirements on regulated banks caused an increase in shadow bank activity. It also led to higher prices of intermediated assets but reduced default risk for both types of banks.

—Toni Shears