Research

Liquidity Provision and Financial Stability, with Greg Phelan

Journal of Money, Credit, and Banking (2024) 56(2-3): 455-487

RePEc

When financial intermediaries' key characteristic is provision of liquidity through their liabilities, with financial frictions the financial sector in the aggregate is likely to over-accumulate equity, thus decreasing liquidity provision and household welfare. Aggregate household welfare is therefore decreasing in the level of aggregate intermediary equity even though the individual value of intermediaries is increasing in equity, which is why intermediaries over-accumulate equity. Subsidizing intermediary dividends can improve welfare by encouraging earlier payout and decreasing aggregate equity in the financial sector. This policy increases the likelihood that intermediaries provide more liquidity and improves the stability of the economy, even though asset prices fall.

Should Monetary Policy Target Financial Stability?, with Greg Phelan

Review of Economic Dynamics (2023) 49(7): 181-200.

RePEc

Monetary policy can promote financial stability and improve household welfare. We consider a macro model with a financial sector in which banks do not actively issue equity, output and growth depend on the aggregate level of bank equity, and equilibrium is inefficient. Monetary policy rules responding to the financial sector are ex-ante stabilizing because their effects on risk premia decrease the likelihood of crises and boost leverage during downturns. Stability gains from monetary policy increase welfare whenever macroprudential policy is poorly targeted. If macroprudential policy is sufficiently well-targeted to promote financial stability, then monetary policy should not target financial stability.

International coordination of macroprudential policies with capital flows and financial asymmetries, with Greg Phelan

Journal of Financial Stability (2021), 56

RePEc

Lack of coordination for prudential regulation hurts developing economies but benefits advanced economies. We consider a two-country macro model in which countries have limited ability to issue state-contingent contracts in international markets. Both countries have incentives to stabilize their economy by using prudential limits, but the emerging economy depends on the advanced economy to bear global risk. Intermediating global risk requires bearing systemic risk, which financially developed economies are unwilling to bear, preferring financial stability over credit flows. Advanced economies prefer tighter prudential limits than would occur with coordination, to the harm of emerging economies.

Digital Currency and Banking-Sector Stability, with Greg Phelan

SSRN

Digital currencies provide a potential form of liquidity competing with bank deposits. We introduce stable digital currency into a macro model with a financial sector in which financial frictions generate endogenous systemic risk and instability. In the model, digital currency is fully integrated into the financial system and depresses bank deposit spreads, particularly during crises, which limits banks' ability to recapitalize following losses. As a result, the probability of the banking sector being in crisis or distressed states can grow significantly with the introduction of digital currency. While banking-sector stability suffers, asset price volatility decreases, and household welfare can improve significantly. Despite the potential welfare gains, our theoretical results suggest that financial frictions may limit the potential benefits of digital currencies. The optimal level of digital currency may be below what would be issued in a competitive environment.