This paper explores how speculators can destabilize financial markets by amplifying negative shocks in periods of market turmoil, and confirms the main predictions of the theoretical analysis using data on money market funds (MMFs). I propose a dynamic trading model with two types of investors - long-term and speculative - who interact in a market with search frictions. During periods of turmoil created by an uncertainty shock, speculators react to declining asset prices by liquidating their holdings in hopes of buying them back later at a gain, despite the asset's cash flows remaining the same throughout. Interestingly, I show that a reduction in trading frictions leads to more severe fluctuations in asset prices. At the root of this result are the strategic complementarities between speculators expected to follow similar strategies in the future. Using a novel dataset on MMFs' portfolio holdings during the European debt crisis, I gauge the strength of funds' strategic interactions as the number of funding relationships each issuer has with MMFs. I show that funds are more likely to liquidate the securities of issuers that have fewer funding relationships with other funds, obliging them to borrow at shorter maturity and higher interest rates.
To be presented at:
Financial Disclosure and Market Transparency with Costly Information Processing (with Marco Pagano) PDF SUBMITTED
We study a model where some investors ("hedgers") are bad at information processing, while others ("speculators") have superior information-processing ability and trade purely to exploit it. The disclosure of financial information induces a trade externality: if speculators refrain from trading, hedgers do the same, depressing the asset price. Market transparency reinforces this mechanism, by making speculators' trades more visible to hedgers. As a consequence, asset sellers will oppose both the disclosure of fundamentals and trading transparency. This policy is socially inefficient if a large fraction of market participants are speculators and hedgers have low processing costs. But in these circumstances, forbidding hedgers' access to the market may dominate mandatory disclosure.
- Presented at: European Finance Association 2011, MIT Finance, CREI-CEPR conference on "Decision Theory and its Applications to Economics and Finance" (CREI, June 2012), SFS Finance Cavalcade (2013), FIRS (Scheduled), Ninth CSEF-IGIER Symposium on Economics and Institutions, AFA 2014 (Scheduled).
What drives workers to seek information from their peers? And how does communication affect employee performance? Answers have proven elusive due to problems obtaining precise measures of white collar output and of observing the information individuals consume. We address these questions using an original panel data set that includes all accesses to an information-sharing platform, together with performance measures of all loan officers at a major Japanese bank. This paper makes three contributions. First, we show that skill level differences, job rotation, and differences among branches each affect the demand for information. There also exists substitution between an agent's ability and the amount of information consumed. Low skill agents benefit the most from consuming others' information. Second, restricting attention to officers who switched branches, we show that they perform on average significantly worse than before the switch, suggesting that job rotation destroys specialized human capital. We also find that an officer who shares information increases his chances of promotion rather than competes for promotion less effectively. Third, we measure the size of productivity gains based on consuming shared information. After controlling for unobserved heterogeneity over time, between branches, and among officers, a standard deviation increase in information access increases performance by roughly ten percent. By instrumenting the demand for information with the exogenous variation arising from cultural differences among branches, we are able to assess the causal effect of communication on performance.
- Presented at NBER Summer Institute 2011, European Economic Association 2011, IDEI Toulouse, NYU Stern School of Business, MIT, Carnegie Mellon University, Einaudi Institute for Economics and Finance (Rome), North American Summer Meeting of Econometric Society 2012.
Reputation Traps, Tail Risk and Business Cycle (coming soon)
Reputation concerns are important sources of discipline for institutional investors, but the effectiveness of these concerns varies along the business cycle. We propose a dynamic model of reputation formation in which investors learn about fund managers' skill upon observing past returns. Managers can generate active returns at a disutility and determine the fund's exposure to tail risk. The model delivers rich dynamics for managers' behavior. Good reputation managers exploit their status by extracting higher rents from investors, while intermediate-reputation managers tend to improve their returns to attract more funds. Finally, for bad performers there exists a reputation trap: their perceived low quality prevents them from attracting investors' capital and then also from improving their track record. Furthermore, when the economy is subject to aggregate shocks, fund managers tend to exacerbate fluctuations by hoarding excess liquidity to preserve their reputation or by exposing the fund to tail risk to increase short-term returns. The model provides a framework to analyze the investment strategies adopted by mutual funds and hedge funds during the recent financial crisis.
- Presented at Ninth CSEF-IGIER Symposium on Economics and Institutions (Scheduled).
Adverse Targeting, Housing Prices and Foreclosure Externality (with Abhijit Banerjee) First Draft available soon
We analyze the contracting features and loan-repayment behavior that emerge in a competitive mortgage market when borrowers have self-control issues and housing prices are time-varying. When banks' monitoring effort influences borrowers' expenditures, teaser rates and “balloon” payments might be optimal as they relax banks’ incentive compatibility constraint. However, the banks’ equilibrium behavior and the borrowers’ probability of default crucially depend on the expectations about the housing market. When housing prices are expected to rise, the interest rates and the loan amount are inefficiently high, and the borrowers who are unable to repay are forced to resell their house at a loss, which is not internalized by the banks. Consistent with the events of the recent financial crisis, when housing prices plummet, the banks over-monitor by tightening the credit available to borrowers, especially when borrowers can strategically default. Finally, we show that an externality among banks naturally emerge when foreclosure costs depend on the fraction of houses foreclosed, as the lower expected value of the house increases the borrowers’ incentive to strategically default, which further depress banks’ incentive to grant credit. The model can guide the discussion on the recent policy debate on the mortgage relief programs.
Households' Indebtedness and Financial Fragility with Marco Pagano and Tullio Jappelli PDF
The paper studies the determinants of international differences in household indebtedness, and inquires whether indebtedness is associated with increased “financial fragility”, as measured by the sensitivity of household arrears and insolvencies to macroeconomic shocks. It also investigates whether financial fragility is affected by institutional factors, such as information sharing arrangements, judicial efficiency and individual bankruptcy regulation. We address these issues by tapping three data sets: (i) cross-country data on household indebtedness; (ii) European panel data for households lending and arrears; and (iii) time series data for household lending and insolvencies in the U.K., the U.S.A. and Germany. Overall, the analysis underscores the importance of institutional arrangements in determining the size and fragility of household credit markets.