Collateral Reuse in Shadow Banking and Monetary Policy (Job Market Paper)
Abstract: I study the optimality of the reuse of collateral, a practice which is widespread in the shadow banking system. Rehypothecation is the direct repledging of the collateral received in a debt contract by the lender, while securitisation (pyramiding) is the use of the debt contract itself as collateral. With securitisation, the value of the repledgeable collateral, and hence the amount that can be borrowed, is limited by the face value of the original debt contract. Rehypothecation of the collateral enables borrowing of an amount that is typically greater than the face value of the debt backed by that collateral. The rehypothecating lender effectively borrows from the borrower the excess value of the collateral over the face value of the debt. I show that when the lender's cash flows are sufficiently pledgeable to the borrower, rehypothecation is a Pareto improvement on securitisation. I also investigate the implications of rehypothecation for monetary policy. I show that when a central bank removes collateral from the system through an open market operation, the collateral stays idle with the central bank, leading to tighter collateral constraints down the rehypothecation chain and retarded borrowing and investment. I find empirical evidence for this channel in the cost of borrowing in the bilateral repo market. The policy implications of this result include conducting open market operations when collateral is idle. It also suggests that using interest on reserves may be more effective as a policy tool compared to open market operations when collateral is scarce.
Identifying the Push Impact of Foreign Institutional Investor Flows on Indian Equity Prices (with Ajay Shah)
Abstract: Equity prices and foreign portfolio investor flows are strongly correlated. The correlation can be due to the information about the equities (the "pull" effect), or due to the price impact of the order flows (the "push" effect). We estimate the "push" impact of Foreign Institutional Investor (FII) flows on equity prices of Indian firms in which FII's are active. We instrument for the endogenous flows by the exogenous variation in them produced by fire sales and purchases by US mutual funds caused by capital inflows and outflows into these funds. We find that for firms in which FII's are active, the flows do not affect prices controlling for the market factor. Our result indicates that the FII's are mindful of the price impact of their flows and are active in the most liquid securities.
Macroeconomic Models for Monetary Policies: A Critical Review from a Finance Perspective (with Andrew Lo, Winston Dou and Harald Uhlig)
Abstract: We survey the macroeconomic models for monetary policy at central banks from a finance perspective. The complex yet crucial role played by financial systems in monetary policy and macroeconomic forecasting had been largely overlooked in the formal tools used by monetary authorities. We review the history of the monetary policy modeling and set forth a simple and canonical framework that incorporates the key up-to-date theoretical advances for the reader unfamiliar with the literature. As this is done, challenges for the existing models and quantitative methodologies are brought out. The topics discussed are: (1) government balance sheet and unconventional monetary policies, (2) heterogeneity, reallocation and redistribution effects, (3) macroeconomic impact of sizable and nonlinear risk premium dynamics, (4) time-varying uncertainty, (5) financial sector and systemic risks, (6) imperfect product market and markups, and (7) solution, estimation and evaluation methods for dynamic quantitative structural models. At last, we review the core monetary models employed by the major central banks.
Research in Progress