Figure
Crashes and non-crashes after a 100% runup in the us industry sectors.

Bubbles for Fama (BFFS WP #011)

Robin Greenwood, Andrei Shleifer, and Yang You
FEB 2017

Nobel Laureate Eugene Fama once famously stated that stock markets do not exhibit price bubbles. Evidence supporting this claim boils down to the argument that past run up in stock prices do not seem to predict lower future returns. Authors Greenwood, Shleifer, and You seek to evaluate Fama's claim using stock return data gathered from a variety of US industries, and a gamut of international stock market sectors. They find that while Fama is correct in asserting that sharp price increases do not predict lower returns going forward, these increases do predict substantial heightened probability of a crash. Simple attributes related to the price run up can help predict both the crash probability and future returns.

See Robin’s other research here and Andrei’s other research here.

Related Themes: Measuring Sentiment & Expectations

The Fed, the Bond Market, and Gradualism in Monetary Policy (BFFS WP #010)

Jeremy C. Stein, and Adi Sunderam
Feb 2017

Fed watching has become a routine business for bond market participants and the financial press. Monetary policy announcements are analyzed word by word for clues to the central bank's future actions. Such scrutiny seems inconsistent to interest rate setting models in which policy makers target specific macro variables. If the Fed is simply responsive to publicly observable variables, then the bond market would only react to the release of these variables and not to the policy announcements. Stein and Sunderam posit that private information and preference for volatility smoothing of long term bond yields by the Fed underly this interaction between the Fed and bond market participants. Policy makers are gradual in setting its short term yields to smooth long term yield volatility. However, market participants anticipate this gradualism. In equilibrium, long term yields stay volatile. The authors derive several normative suggestions for policy makers.

Related Themes: Credit Markets,  Monetary Policy and Money Markets

The Financial Regulatory Reform Agenda in 2017 (BFFS WP #009)

Robin Greenwood, Samuel G. Hanson, Jeremy C. Stein, and Adi Sunderam
FEB 2017

In this note, researchers from the Behavioral Finance and Financial Stability Initiative evaluate the regulatory reforms since the financial crisis. The authors highlight several areas in which the reform agenda has made clear progress. These include heightened capital and liquidity requirements, more stress testing and capital planning at banks, and increased regulatory authority and tools for financial dissolution. Likewise, the authors also note several areas in which reforms should be rolled back or modified.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation,  Size and Growth of the Financial Sector

Figure
Graph shows the size and the composition of assets on the Fed Balance sheet from 2007-2015.

How Quantitative Easing Works: Evidence on the Refinancing Channel (BFFS WP #008)

Marco Di Maggio, Amir Kermani, and Christopher Palmer
DEC 2016

This BFFS working paper examines the empirical effects of unconventional monetary policy. Using novel data on mortgage refinancing, the authors argue that the rounds of quantitative easings had variable results depending on the type of asset purchased and the degree of segmentation for that asset market. QE1, which targeted mortgage markets, had significant effects on aggregate demand and consumption. QE2, which targeted treasuries, had more muted effects.

See Marco's other research here, Amir's other research here, and Christopher's other research here

Related Themes: Credit Markets,  Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Figure
This figure presents the fraction of operational risk weighted asset (RWA) as a percentage of total RWA for 30 GSIBs as disclosed in regulatory filings and investor reports.

Rethinking Operational Risk Capital Requirements (BFFS WP #006)

Peter Sands, Gordon Liao, and Yueran Ma
DEC 2016

In a BFFS working paper, Sands, Ma, and Liao assess the latest Basel Committee proposals for reform on operational risk capital. The authors conclude that neither the existing Basel II framework nor the reforms that are designed to replace it are effective in minimizing negative externalities from operational risk events. The authors make recommendations for an alternative approach.

Related Themes: Stabilization Policy & Regulation

Credit Migration and Covered Interest Rate Parity (BFFS WP #007)

By Gordon Liao
DEC 2016

In this paper, Gordon Liao studies the joint determination of two economically large and persistent violations of the Law Of One Price (LOOP) in the global corporate credit market and the foreign exchange rate market. Post-crisis regulatory and intermediary frictions have severely impaired arbitrage in the exchange rate and credit markets each on their own, but capital flows, such as international debt issuance, bundle together the two LOOP violations. Limits of arbitrage spill over from one market to another.

See Gordon's other research here

Related Themes: Credit Markets

Figure
The figure shows the current breakdown of the Fed’s Treasury holdings. The authors suggest that the Fed can keep its balance sheet at its current size of approximately $4.5 trillion, but lower the maturity of the Treasury bonds that it holds.

The Federal Reserve's Balance Sheet as a Financial-Stability Tool

Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein
SEP 2016

In an address at the Fed’s Jackson Hole conference, Greenwood, Hanson and Stein suggest that, going forward, the Fed should use its balance sheet to lean again private-sector maturity transformation. The Fed should keep a large balance sheet in the coming years, replacing the current focus on the asset side and monetary accommodation with a new focus on the liability side and safe-asset provision.

See Robin’s other research here, Samuel’s other research here, and Jeremy’s other research here.

Related Themes: Credit Markets,  Stabilization Policy & Regulation

Figure
This figure shows impulse response of house hold flows to various asset classes to a rise in interest rates.

Low Interest Rates and Risk Taking: Evidence from Individual Investment Decisions (BFFS WP #005)

Chen Lian, Yueran Ma, and Carmen Wang
SEP 2016

A well documented phenomenon in the investment markets is the tendency of investors to "reach for yields" by purchasing risky assets when interest rates are relatively low. A variety of arguments have been presented to explain this phenomenon; however, no single explanation has gained wide acceptance. In randomized experiments using Amazon Mechanical Turk and Harvard Business School MBA participants, Chen Lian, Yueran Ma, and Carmen Wang support the behavioral argument that reaching for yield may originate from investor preferences.

Related Themes: Credit Markets,  Monetary Policy and Money Markets

Credit Cycle Feedback Loop
Credit Cycle Feedback Loop

A Model of Credit Market Sentiment (BFFS WP #002)

Robin Greenwood, Samuel G. Hanson, and Lawrence Jin
AUG 2016

Over the past decade, it has increasingly been recognized that investor beliefs play an important role in driving the credit cycle. In "A Model of Credit Market Sentiment", Robin Greenwood, Sam Hanson and Lawrence Jin (of Caltech) develop a model to explore the feedback between credit market sentiment and credit market outcomes. Their model is able to capture many documented features of credit booms and busts, including the link between credit growth and future returns, and the "calm before the storm" periods in which fundamentals have deteriorated but the credit market has not yet turned.

See Robin’s other research here, Samuel’s other research here, and Lawrence’s other research here

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

Diagnostic Expectations and Credit Cycles (BFFS WP #003)

Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer
JUN 2016

Bordalo, Gennaioli, and Shleifer present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. Diagnostic expectations exhibit excess volatility, over-reaction to news, and systematic reversals. The authors' model can account for several features of credit cycles and macroeconomic volatility.

See Pedro's other research here, Nicola's other research here, and Andrei’s other research here.

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

Expectations and Investment

Nicola Gennaioli, Yueran Ma, and Andrei Shleifer
MAY 2015

Using micro data from Duke University’s quarterly survey of Chief Financial Officers, Gennaioli, Ma and Shleifer show that corporate investment plans as well as actual investment are well explained by CFO’s expectations of earnings growth. Their evidence points to the usefulness of expectations data for understanding economic behavior.

See Nicola's other research here and Andrei's other research here.

Related Themes: Measuring Sentiment & Expectations

Neglected Risks: The Psychology and Financial Crises

Nicola Gennaioli, Andrei Shleifer, and Robert W. Vishny
MAY 2015

Gennaioli, Shleifer and Vishny present a theory of boom-bust financial crises based entirely on beliefs. Their model is based on Kahneman and Tversky’s (1972) idea of representativeness, the idea that people to overestimate the probability of outcomes that are relatively more likely in light of recently observed data.

See Nicola's other research here, Andrei’s other research here, and Robert’s other research here.

Related Themes: Measuring Sentiment & Expectations

Monetary Policy and Global Banking (BFFS WP #004)

Falk Bräuning and Victoria Ivashina
JUN 2016

Global banks primarily receive funding in their domestic currencies, but operate and invest in multiple foreign currencies. These cross country lending/borrowing operations create demand for currency hedges. A tightening of domestic monetary policy may drive a bank to lend more in a foreign currency by its effect on the these currency hedges. Falk and Victoria show evidence supporting this channel of cross border shock transmission from data sets of country level firm-claims and individual level syndicated loans.

See Falk's other research here. See Victoria’s other project-related financial stability research here, or her homepage here.

Related Themes: Credit Markets,  Monetary Policy and Money Markets

Graph
The figure shows the return on assets of highly levered (dashed line) and low leverage (solid line) banks from 2003-2015. Contrary to popular opinion, highly levered banks were less profitable than low leverage banks pre crisis.

The Private Costs of Highly Levered Banks

Juliane Begenau and Erik Stafford
JUN 2016

The choice of relatively high leverage as a means to reduce the overall cost of capital by many banking practitioners is interpreted as folly by some, and defended by others as a clever decision given the capital market’s apparent failure to appreciate the associated risks. Begenau and Stafford suggest and provide evidence for an additional consideration: that high leverage signals an excessive focus on financing decisions over good management, specifically over value-relevant investment and operating decisions.

See Erik’s other research here and Juliane’s other research here.

Related Themes: Global Crisis and Debt Data

Does Reserve Accumulation Crowd Out Investment

Carmen Reinhart, Vincent Reinhart, and Takeshi Tashiro
MAY 2016

In this paper, Reinhart, Reinhart, and Tashiro study nine Asian economies in an effort to understand why much of the decrease in investment that occurred during the 1997-1998 crisis has persisted in the years between 1998 and 2014. Unlike Latin American economies during the mid- to late-1980s, investment in these economies does not appear to be suffering at the expense of private consumption or capital flight. For this reason, the authors contend that the traditional concepts of crowding out and leakages must be redefined to be more encompassing.

See Carmen’s other research here and Vincent’s other research here.

Related Themes: Global Crisis and Debt Data,  Monetary Policy and Money Markets

Connectedness and Contagion

Hal Scott
MAY 2016

Systematic runs on financial institutions were the main culprits of the financial meltdown of 2008, not over-exposure in connected balance sheets. Hal Scott argues this insight in his new book, "Connectedness and Contagion." In fact, contagion, as caused by these systematic runs of short-term creditors, still imposes great risks on the global financial system. Hal warns that recent legislative efforts by the US congress have weakened the ability of regulatory bodies to adequately combat contagion.

See Hal's other research here

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Secular Stagnation in the Open Economy

Gauti B. Eggertsson, Neil R. Mehrotra, and Lawrence H. Summers
APR 2016

Eggertson, Mehrotra, and Summers develop a two country model to examine how capital markets transmit secular stagnation across countries. In their model, monetary expansion cannot end secular stagnation in an economy and may have "beggar-thy-neighbor" effects, while large fiscal interventions can eliminate secular stagnation and also carry positive externalities.

See Gauti's other research here, Mehrotra's other research here, and Lawrence's other research here.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Chart
The figure shows the fraction of cov-lite loans by quarter

Covenant-Light Contracts and Creditor Coordination

Bo Becker and Victoria Ivashina
31 MAR 2016

Leveraged loan markets go through episodes in which the typical new loan is issued with far fewer protections to the lender, known as “cov-lite.” Many have pointed to cov-lite issuance as a proxy for credit market overheating. In the first empirical analysis of this topic, Bo and Victoria evaluate whether this development can be attributed to market overheating, increased borrower demand for cov-lite loans, or a rise in creditor coordination costs.

See Victoria’s other project-related financial stability research here, or her homepage here. Data related to this study is publicly available here.

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

Global Cycles: Capital Flows, Commodities, and Sovereign Defaults, 1815-2015

Carmen Reinhart, Vincent Reinhart, and Christoph Trebesch
FEB 2016

Empirical works exploring the relationship between capital flows and economic crisises have been limited by data to several episodes in the modern era. Reinhart, Reinhart, and Trebesch explore the rich history of booms and busts in capital flow by uncovering data from sources going back to 1815. The pattern uncovered by the authors have strong implications on the vulnerabilities of many emerging economies today.

See Carmen’s other research here, Vincent’s other research here, and Christoph’s other research work here.

Related Themes: Measuring Sentiment & Expectations,  Global Crisis and Debt Data

Forward Guidance and the Yield Curve: Short Rates versus Bond Supply

Robin Greenwood, Samuel G. Hanson, and Dimitri Vayanos
07 DEC 2015

The term ‘forward guidance’ – when the central bank guides market expectations – is normally used in reference to central bank policy on short rates. However, quantitative easing (or QE) – the other primary monetary policy tool being used since 2008 – also involves some degree of forward guidance as well. In this paper, Greenwood, Hanson, and Vayanos build a no-arbitrage model of the yield curve that allows for a characterization and comparison of the effects of forward guidance on short rates and forward guidance on quantitative easing.

See Robin’s other research here, Samuel’s other research here, and Dimitri’s other research here.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Extrapolation and Bubbles

Nicholas Barberis, Robin Greenwood, Lawrence Jin, and Andrei Shleifer
SEP 2015

At the heart of standard narratives of historical asset bubbles is a high degree of extrapolation – the formation of expected returns based on past returns – by investors. Yet, nearly all bubbles are also defined by very high trading volume, a feature that excessive extrapolation cannot explain alone. Barberis, Greenwood, Jin, and Shleifer develop a novel model of bubbles, wherein extrapolative investors weigh two opposing signals, in an effort to reconcile these two defining features of bubbles.

See Nicholas’s other research here, Robin’s other research here, Lawrence’s other research here, and Andrei’s other research here.

Related Themes: Measuring Sentiment & Expectations

The Pitfalls of External Dependence: Greece, 1829-2015

Carmen Reinhart and Christoph Trebesch
SEP 2015

Carmen Reinhart and Chrstoph Trebesch argue that the history of Greece's entanglement with debt can be summarized by a simple stylized pattern. Since independence in 1829, the Greek government has gone through systematic cycles of external financing, default, and prolonged financial autarky. Even with the potential haircut on the current greek debt, drastic actions must be taken to ensure Greece's future economic viability. The authors prescribe moving toward domestic debt as an alternative source of funding for the current Greek government.

See Carmen’s other research work here and Christoph’s other research work here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Dollar Funding and the Lending Behavior of Global Banks

Ivashina, Victoria, David S. Scharfstein, and Jeremy C. Stein
AUG 2015

Foreign banks play large roles in the US domestic funding market. However, unlike domestic banks, which are funded by insured deposits, these institutions are funded either by uninsured domestic commercial papers or by insured foreign denominated deposits which are then swapped in the FX market. A shock that forces these banks to switch from commercial papers to deposits can have large consequences on the covered interest rate parity relationship given limited arbitrage capital.

See Victoria’s other project-related financial stability research here, or her homepage here. See Jeremy’s other research here.

Related Themes: Credit Markets

Graph
The figure shows the average premium of short-term T-bills, by week-to-maturity. Short-maturity T-bills have very low yields.

A Comparative Advantage Approach to Government Debt Maturity

Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein
AUG 2015

Using a novel model that incorporates monetary benefits that investors derive from holding riskless securities, Greenwood, Hanson, and Stein examine how a government should optimally determine the maturity structure of its debt. They explore the results of their model under multiple scenarios depending on whether a government can directly internalize these monetary benefits and on the presence of private sector competition in the production of riskless, money-like claims.

See Robin’s other research here, Samuel’s other research here, and Jeremy’s other research here.

Related Themes: Credit Markets,  Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds (BFFS WP #001)

Sergey Chernenko and Adi Sunderam
21 JUL 2015

Historically liquidity transformation – the provision of liquid claims that are backed by illiquid assets – has been performed primarily by banks. In this paper, Chernenko and Sunderam study how mutual funds use cash to accommodate fund inflows and outflows and, thereby, actively manage their liquidity provision for the benefit of their investors. They find that the degree to which mutual funds use cash holdings to provide said liquidity depends on both fund-specific and market-wide characteristics.

See Sergey’s other research work here and Adi’s other research work here.

Related Themes: Global Crisis and Debt Data,  Monetary Policy and Money Markets

The Antecedents and Aftermath of Financial Crises

Carmen Reinhart
JUL 2015

Some of the best-known papers by Carlos F. Diaz Alejandro were about Latin America’s financial crises in the 1980s. In this paper, Reinhart reviews and applies Carlos' insights to the recent set of financial crises that have befallen a number of advanced economies. Using Diaz Alejandro’s anatomy and sequence of a crisis as a foundation, she shows that there are five recurring patterns, which she labels as lessons, to be learned about financial crises in general.

See Carmen’s other research work here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Sovereign Debt Relief and its Aftermath

Carmen Reinhart and Christoph Trebesch
JUN 2015

Despite the policy relevance and controversy surrounding the issue, surprisingly little is known about the economic consequences of sovereign debt relief. In an effort to shed light on the matter, Reinhart and Trebesch analyze two instances of debt relief in the 20th century which each encompassed a substantial number of countries. Their analysis suggests that while debt write-offs improve the economic landscape of debtor countries, softer forms of relief do not have a similar effect.

See Carmen’s other research work here and Christoph’s other research work here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Figure
Shifts in the Fed's Monetary Policy Rule from 1950 to 2010.

Monetary Policy Drivers of Bond and Equity Risks

John Y. Campbell, Carolin Pflueger, and Luis M. Viceira
JUN 2015

Campbell, Pflueger, and Viceira develop a macroeconomic model of habit formation that explains both bond and stock returns. They argue that the risk premia associated with bonds depends crucially on shifts in the central bank's monetary policy. The increased risk related to bonds in the 1980s can be attributed to the Fed's focus on anti-inflationary measures, while the lower bond risk in the 2000s can be explained by a shift in the monetary policy regime toward managing output fluctuations.

See John's other research here, Carolin's other research here, and Luis's other research here.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Public Debt Overhangs: Advanced-Economy Episodes since 1800

Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff
SUMMER 2012

Central to the debate on public debt is the idea that large unsustainable debt overhangs can interfere with the ability of governments to function. Carmen Reinhart and Kenneth Rogoff identify 26 historic episodes where gross public debt exceeded 90 percent of the GDP on a sustained basis. Economies in many of these episodes then had prolonged spells of slow growth that lasted more than a decade.

See Carmen’s other research here, and Kenneth’s other research here.

Related Themes: Credit Markets,  Global Crisis and Debt Data

The Fed, the Bond Market, and Gradualism in Monetary Policy

Jeremy C. Stein and Adi Sunderam
FEB 2016

It has been suggested that gradualism – the idea that the Federal Reserve tends to adjust interest rates incrementally – is the optimal behavior on the part of the central bank. In this paper, Stein and Sunderam develop a model accounting for the two-way transmission of information between the central bank and public markets in order to examine whether such a policy is actually ideal. They find that, in the case that such a mutual exchange is present, the observed degree of policy inertia is not optimal from an ex-ante perspective.

See Jeremy’s other research work here and Adi’s other research work here.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Who Neglects Risk? Investor Experience and the Credit Boom

Sergey Chernenko, Samuel G. Hanson, and Adi Sunderam
19 MAY 2015

It has been suggested that over optimism on the part of lenders helps fuel credit booms and, in doing so, engenders financial crises. In this paper, Chernenko, Hanson, and Sunderam explore this narrative of credit cycles in the context of mutual fund holdings of securitizations of nonprime mortgages in the years leading up to the financial crisis of 2007-2009. They find evidence that suggests that fund managers’ personal experiences were highly determinate of both the quantity and quality of these risky assets held prior to the crisis.

See Sergey’s other research work here, Samuel’s other research work here, and Adi’s other research work here.

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

The Stock Market and Bank Risk Taking

Antonio Falato and David Scharfstein
MAY 2015

While it is widely accepted that excessive risk taking by financial institutions was a prominent cause of the financial crisis, the causes of such risk taking are not as well understood. In this paper, Falato and Scharfstein contend that market earnings pressure may have led publicly traded financial institutions to increase their risk levels for the purpose of boosting near-term profitability. They find evidence that banks which either went public or were purchased by a publicly traded financial institution took on increased risk relative to those that did not.

See Antonio’s other research work here and David’s other research work here.

Related Themes: Global Crisis and Debt Data

Credit Market Sentiment and the Business Cycle

David Lopez-Salido, Jeremy C. Stein, and Egon Zakrajsek
APR 2015

Does exuberance in asset markets create risks to future macroeconomic performance? Using a novel analysis, Lopez-Salido, Stein, and Zakrajsek analyze the ability of investor sentiment within equity and credit markets to forecast economic growth. The authors find that, while equity market sentiment has no predictive power, the unwinding of past investor sentiment in credit markets has strong explanatory power for future real economic activity.

See David’s other research work here, Jeremy’s other research work here, and Egon’s other research work here.

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

Financial Crises, Development, and Growth: A Long-Term Perspective

Carmen M. Reinhart and Vincent R. Reinhart
24 APR 2015

With the financial crisis of 2007-2009 still in recent memory, economic crises remain a pertinent topic among both academics and policy makers. But while most studies focus on the more immediate or short-term consequences of such crises, Reinhart and Reinhart show that there are significant long-term consequences as well. In particular, they find evidence that a high relative incidence of crises is associated with slower economic growth in both the medium- and long-term.

See Carmen’s other research work here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Dealing with Debt

Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff
9 JAN 2015

Following the 2008 financial crisis, many of the world’s economies experienced significant expansion in public sector balance sheets. This occurred as advanced economies faced near record levels of private and external debt as well as severely underfunded pension and health programs – a problem Reinhart, Reinhart, and Rogoff refer to as ‘quadruple debt overhang’. In this paper, the authors lay out a menu of available policy options for normalizing the level of public debt relative to nominal activity in the long run.

See Carmen’s other research here, and Kenneth’s other research here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Figure
The authors recommend opting for treasury rates over the LIBOR as the reference rate for many interest rate derivatives

Reforming LIBOR and Other Financial Market Benchmarks

Darrell Duffie and Jeremy C. Stein
JAN 2015

Duffie and Stein review the history and the role of LIBOR and similar benchmarks used in the modern financial market. The authors argue that the incentive to distort these benchmarks is severe given the benchmarks' polling nature and the sheer volume of the derivative market linked to these rates. The authors make several recommendations on how changes to benchmark definition and the adoption of new overall regulatory policies, can reduce the susceptibility of reference rates to manipulation.

Related Themes: Credit Markets,  Stabilization Policy & Regulation,  Size and Growth of the Financial Sector

Graph
Hanson et al develop an “asset liquidity index” which they suggest drives the funding structure of banks and shadow banks.

Banks as Patient Fixed Income Investors

Samuel G. Hanson, Andrei Shleifer, Jeremy C. Stein, and Robert W. Vishny
JUN 2015

What defines the role of traditional banks in a financial system where they compete with ‘shadow banks’? Hanson, Shleifer, Stein, and Vishny present a model in which both traditional and shadow banks produce money-like claims, but do so in different ways and, as a result, with different payoff risk profiles for their depositors and investors, respectively. The authors evaluate the equilibrium predictions of their model first in theory and then through empirical evidence.

See Samuel’s other research here, Andrei’s other research here, Jeremy’s other research here, and Robert’s other research here.

Related Themes: Credit Markets,  Global Crisis and Debt Data,  Stabilization Policy & Regulation

An Evaluation of Money Market Reform Proposals

Samuel G. Hanson, David S. Scharfstein, and Adi Sunderam
MAY 2014

U.S. money market funds proved to be a source of considerable instability during the financial crisis of 2007-2009. As a result of the funds’ evident structural vulnerabilities, the Financial Stability Oversight Committee proposed three alternatives for their reform. In this paper, Hanson, Scharfstein, and Sunderam evaluate each of these proposals in the context of safeguarding financial stability while simultaneously preserving the monetary services that money market funds provide savers.

See Samuel’s other research work here, David’s other research work here, and Adi’s other research work here.

Related Themes: Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Vulnerable Banks

Robin Greenwood, Augustin Landier, and David Thesmar
MAR 2014

Fire sales – the sale of illiquid assets at depressed prices – are one of the primary channels by which financial shocks propagate across institutions. Greenwood, Landier, and Thesmar present a model that estimates how the effects of fire-sales accumulate across banks and the degree to which individual banks are susceptible to deleveraging by their counterparts. In addition, they explore the potential role of the model in the determination of more precise regulatory policy.

See Robin’s other research here, Augustin’s other research here, and David’s other research here.

Related Themes: Global Crisis and Debt Data,  Stabilization Policy & Regulation

Graph
The figure shows the relationship between past stock market returns and investors’ self-reported expectations of future returns: investors are highly extrapolative.

Expectations of Returns and Expected Returns

Robin Greenwood and Andrei Shleifer
11 JAN 2014

Models of expected returns are currently founded on the belief that, on average, investors hold rational expectations about future returns. Counter to this, Greenwood and Shleifer find that investors’ expectations of returns are highly correlated with past returns, the stock market level, and mutual fund inflows. Greenwood and Shleifer’s argument is that the evidence suggests a pervasive view about future returns that is not rational, but extrapolative in nature.

See Robin’s other research here and Andrei’s other research here.

Related Themes: Measuring Sentiment & Expectations

Bar graph
The figure shows insurance company holdings of corporate bonds, by risk category. From Figure 1 in the paper

Reaching for Yield in the Bond Market

Bo Becker and Victoria Ivahsina
12 OCT 2013

Reaching-for-yield—investors’ propensity to buy riskier assets in order to achieve higher yields—is believed to be an important factor contributing to the credit cycle. Victoria and Bo show that insurance companies, the largest institutional holders of corporate bonds, reach for yield in choosing their investments by holding the riskiest highest yielding bonds within a ratings class. This behavior is related to the business cycle, being most pronounced during economic expansions.

See Victoria’s other project-related financial stability research here, or her homepage here. Data related to this study is publicly available here.

Related Themes: Credit Markets

Chart
The figure shows the relationship issuer quality (blue line) and subsequent high yield returns (red dashed line). When issuers are of low quality, subsequent returns to the corporate bond market are poor.

Issuer Quality and Corporate Bond Returns

Robin Greenwood and Samuel G. Hanson
FEB 2013

Absent from past accounts of credit cycles is the possibility that time variation in investors’ beliefs and tastes play a role in determining the quantity and allocation of credit. Operating under the hypothesis that the price of credit disproportionately affects the financing costs of low credit quality firms, Greenwood and Hanson evaluate whether issuance by low credit quality firms functions as a proxy for credit conditions and, by extension, a predictor of future excess corporate bond returns.

See Robin’s other research here and Samuel’s other research here.

Related Themes: Measuring Sentiment & Expectations,  Credit Markets

Time Series
The figure shows the relationship between alpha and beta in the US banking industry

Do Strict Capital Requirements Raise the Cost of Capital?

Malcolm Baker and Jeffrey Wurgler
MAY 2013

Counter to conventional finance logic, bank executives have often claimed that reducing their leverage would substantially increase banks’ overall cost of capital. In this paper, Baker and Wurgler suggest that there may be some truth to that claim. Baker and Wurgler’s argument is that low leverage and, hence, low risk firms experience higher returns than theory would predict.

See Malcolm’s other research here, and Jeffrey’s other research here.

Frictions in Shadow Banking: Evidence from the Lending Behavior of Money Market Funds

Sergey Chernenko and Adi Sunderam
02 FEB 2013

Central to our understanding of the relationship-based financing of traditional banking is the idea that risk taking by banks can cause distress to be transmitted across firms due to frictions in lending. Chernenko and Sunderam contend that risk taking by shadow banks, whose lending is largely market-based, can have similar consequences. In their analysis, they show that money market funds with large exposures to risky Eurozone banks suffered substantial redemptions which, in turn, had significant spillover effects on other firms.

See Sergey’s other research work here and Adi’s other research work here.

Related Themes: Global Crisis and Debt Data,  Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Figure
Finance has grown considerably as a percentage of GDP, particularly in credit intermediation and securities.

The Growth of Finance

Robin Greenwood and David Scharfstein
SPRING 2013

Regardless of whether one measures it by its share of GDP, the quantity of financial assets, employment, or average wages, it is clear that the financial sector has grown tremendously since 1980. By examining the principle activities – asset management and the provision of household credit – underpinning this growth, Greenwood and Scharfstein provide a preliminary assessment of whether and in what ways society as a whole has benefited from this growth.

See Robin’s other research here and David’s other research here.

Related Themes: Credit Markets,  Size and Growth of the Financial Sector

Comovement and Predictability Relationships between Bonds and the Cross-Section of Stocks

Malcolm Baker and Jeffrey Wurgler
16 MAR 2012

The relationships between stock and bond returns have proved difficult to pin down, with the correlation between stock index and government bond returns remaining highly unstable over the last four decades. In this paper, Baker and Wurgler seek to clarify this relationship through the novel perspective of examining the links between government bonds and the cross-section of stocks. They find that government bonds commove more strongly with bond-like stocks, and that variables that are known to predict bond returns also predict returns of bond-like stocks.

See Malcolm’s other research work here and Jeffrey’s other research work here.

Related Themes: Credit Markets

Monetary Policy as Financial Stability Regulation

Jeremy C. Stein
JAN 2012

What is the central bank's role in fostering financial stability? Stein develops a model of private money creation and monetary policy in order to address issues surrounding financial stability and regulation. In the model, financial instability is the result of excess short term debt issuance by financial intermediaries. However, central banks can use traditional tools of monetary policy, in particular open market operations, to curb this activity to a socially optimal level.

See Jeremy’s other research here.

Related Themes: Credit Markets,  Monetary Policy and Money Markets

Figure
Global and Local Sentiment Indices

Global, Local, and Contagious Investor Sentiment

Malcolm Baker, Jeffrey Wurgler, and Yu Yuan
OCT 2011

Baker, Wurlger, and Yuan created proxies for sentiment in 6 major stock markets. These proxies are then decomposed into local and global components and used to study the relationship between sentiment and stock market returns. The authors find evidence suggesting private capital flow plays a potential role in the propagation of sentiment across markets.

See Malcolm’s other research here and Jeffrey’s other research here.

Related Themes: Measuring Sentiment & Expectations

A Model of Shadow Banking

Nicola Gennaioli, Andrei Shleifer, and Robert W. Vishny
JUN 2011

The rise and extent of shadow banking – the origination and acquisition of loans by financial intermediaries, their assembly into diversified pools, and the financing of these pools with external debt – has received much attention since the financial crisis. In this paper, Gennaioli, Shleifer, and Vishny present a new model of shadow banking in which outside investors are only interested in riskless debt. In line with actual experience, the model predicts that the diversification designed to eliminate intermediary-specific risks raises the exposure of intermediaries to tail aggregate risks.

See Nicola’s other research work here, Andrei’s other research work here, and Robert’s other research work here.

Related Themes: Measuring Sentiment & Expectations,  Global Crisis and Debt Data

The Liquidation of Government Debt

Carmen Reinhart and M. Belen Sbrancia
MAR 2011

Due to the rising levels of public debt in advanced economies following the financial crisis, the topic of debt reduction has recently received considerable attention. Debt ratios have historically been reduced in a number of different ways. In this paper, Reinhart and Sbrancia document debt restructuring that has occurred through ‘financial repression’ – defined as directed lending to government by captive domestic audiences, caps on interest rates, regulation of capital movements, and a tighter connection between government and banks.

See Carmen’s other research work here.

Related Themes: Global Crisis and Debt Data,  Monetary Policy and Money Markets,  Stabilization Policy & Regulation

Neglected Risks, Financial Innovation, and Financial Fragility

Nicola Gennaioli, Andrei Shleifer, and Robert W. Vishny
JUN 2012

Many recent episodes of financial innovation have shared a common narrative. It begins with strong investor demand for a set pattern of cash flows being met by seemingly substitute securities engineered by intermediaries, which is then followed by the realization of an improbable risk, and finally ends with a flight to the originally desired assets. Using two recurring characteristics of such episodes, Gennaioli, Shleifer, and Vishny develop a model that captures this narrative and then explore the general results.

See Nicola’s other research work here,/a>, Andrei’s other research work here, and Robert’s other research work here.

Related Themes: Measuring Sentiment & Expectations

Investor Sentiment and the Cross Section of Stock Returns

Malcolm Baker and Jeffrey Wurgler
AUG 2006

Classic financial theory dictates that equilibrium asset prices are the aggregate result of rational investors individually optimizing their portfolios, with any irrational behavior immediately offset by arbitragers. Counter to this, a growing body of research has suggested that investor sentiment may play a role in determining asset prices. In this paper, Baker and Wurgler evaluate whether investor sentiment plays a substantive role in the determination of the cross section of equity prices and, thus, subsequent returns.

See Malcolm’s other research here, and Jeffrey’s other research here.

Related Themes: Measuring Sentiment & Expectations