Session 9: Financial Regulation

Moderator: Chenzi Xu (Stanford University)

We study the relationship between credit expansions, macroeconomic fluctuations, and financial crises using a novel database on the sectoral distribution of private credit for 116 countries starting in 1940. Theory predicts that the sectoral allocation of credit matters for distinguishing between “good” and “bad” credit booms. We test the prediction that lending to households and the non-tradable sector, relative to the tradable sector, contributes to macroeconomic boom-bust cycles by (i) fueling unsustainable demand booms, (ii) increasing financial fragility, and (iii) misallocating resources across sectors. We show that credit to non-tradable sectors, including construction and real estate, is associated with a boom-bust pattern in output, similar to household credit booms. Such lending booms also predict elevated financial crisis risk and productivity slowdowns. In contrast, tradable-sector credit expansions are followed by stable output and productivity growth without a higher risk of a financial crisis. Our findings highlight that what credit is used for is important for understanding macro-financial linkages.

Moderator: Isil Erel (Ohio State University)

We study how shocks to individual firms propagate globally, beyond countries where shocked firms operate. We identify a shock to one firm, a German bank, which resulted in a lending cut to German firms. Multinational parent firms located in Germany were directly harmed by the lending cut. International affiliates of affected multinationals supported their parents through internal lending and their real growth fell sharply. The total impact in foreign countries was large. The findings reveal that shocks to individual firms can impact growth internationally, even if firms operate only in one country, and that global internal capital markets propagate shocks.

Moderator: Rodney Ramcharan (USC)

We show that production networks are important for the transmission of unconventional monetary policy. Firms with bonds eligible for purchase under the European Central Bank’s Corporate Sector Purchase Program act as financial intermediaries by extending more trade credit to their customers. The increase in trade credit is more pronounced from core countries to periphery countries and for financially constrained customers. Customers increase investment and employment in response to the increase in trade financing, while suppliers expand their customer base, contributing to upstream industry concentration. Our findings suggest that trade credit redistributes the effects of monetary policy across regions and firms. 

Moderator: Arvind Krishnamurthy (Stanford University)

This paper uses new bond-level data on sovereign borrowing and defaults during 1869-1914 to quantify a channel of contagion via banks’ reputation for monitoring borrowers. Concerns over reputation incentivized Britain’s merchant banks (who underwrote sovereign bonds) to monitor and exert influence over sovereigns. Default signaled to investors that a bank was less willing or able to write and support quality issues, indicating that its other bonds may underperform in the future. Consistent with reputation-based contagion, I find that comovement between defaulting and non-defaulting bonds is six times larger when the bonds share an underwriter. To isolate the causal effect of a shared underwriter, I exploit within-country variation in bonds’ underwriters. Testing predictions from a dynamic game where underwriters build a reputation for monitoring, I find further evidence supporting reputation as the mechanism – as opposed to alternative explanations such as wealth effects. These findings highlight that the reputation of intermediaries that monitor and intervene in crises can be a powerful source of contagion unrelated to a borrower’s fundamentals.

Moderator: Arpit Gupta (NYU)

Adverse selection is known in theory to lead to inefficiently low credit provision, yet empirical estimates of the resulting welfare losses are scarce. This paper leverages a randomized experiment conducted by a large fintech lender to estimate welfare losses arising from selection in the market for online consumer credit. Building on methods from the insurance literature, we show how exogenous variation in interest rates can be used to estimate borrower demand and lender cost curves and recover implied welfare losses. While adverse selection leads to large equilibrium price distortions, we find only small overall welfare losses, particularly for high-credit-score borrowers.

Moderator: Paul Pinkham-Goldsmith  (Yale)

There are large differences in mean income across US cities, but little is known about the levels of standard of living in each city—defined as the amount of market-based consumption that residents are able to afford. In this paper we provide estimates of standard of living by commuting zone for households in a given income or education group, and we study how they relate to local cost of living. Using a novel dataset, we observe all debit and credit card transactions, check and ACH payments, and cash withdraws of 5% of US households’ in 2014 and use it to measure mean consumption expenditures by commuting zone and income group. To measure local prices, we build income-specific consumer price indices by commuting zone. We uncover vast geographical differences in material standard of living for a given income level. Low income residents in the most expensive commuting zone enjoy a level of consumption that is about half that of low income residents in the most affordable commuting zone. In the second part of the analysis, we endogenize income and estimate the standard of living that low-skill and high-skill households can expect in each US commuting zone, once we account for geographical variation both in cost of living and also in expected income. We find that for college graduates, there is essentially no relationship between consumption and cost of living, suggesting that college graduates living in cities with high costs of living — including the most expensive coastal cities—enjoy a standard of living on average similar to college graduates with the same observable characteristics living in cities with low cost of living— including the least expensive Rust Belt cities. For high school graduates and high school drop outs we find a significant negative relationship between consumption and cost of living, indicating that expensive cities offer lower standard of living than more affordable cities. The differences are quantitatively large: High school drop outs moving from the most to the least affordable commuting zone would experience a 23.5% decline in consumption.

Moderator: Erica Jiang (USC)

Compiling new liability-level data from the balance sheets of personal bankruptcy filers, we document that a sizable share of reported liabilities are “shadow debt,” debt not reported to credit bureaus that often arises from the non-payment of goods and services. We use this new data to evaluate how debtor cash flows affect when consumers file for bankruptcy and how much debt they have at bankruptcy. We find that filers respond to a quasi-exogenous $100 increase in monthly cash flows by delaying filing by an average of one month and by increasing unsecured indebtedness by $4,000 in the months preceding filing. Essentially all of the additional debt incurred by delaying filers is shadow debt, and is incurred in the six months prior to bankruptcy.

Moderator: Mark Egan (Harvard University)

Banks are becoming “one-stop shops" serving multiple customer and product segments. This expansion in bank scope can generate complementarities across products and customers (e.g., deposits and loans), potentially leading to lower marginal costs and prices. In this paper we quantify cost synergies for banks using new data from a major commercial credit bureau for firm credit in the United States. Moreover, we consider how banks with a wider scope may have incentives to steer some firms into specific products or loan sizes. We develop and estimate a supply and demand equilibrium model of firm credit. The model allows for cost synergies and steering by banks, while in competition with non-banks. We find that banks’ incentives generate product and quantity distortions for firms, while non-banks that are more specialized in their product offerings do not show such distortionary behavior. We use our estimated model to evaluate the counterfactual equilibrium effects of restricting bank scope and regulating firm credit.

Moderator: Andreas Fuster (Swiss Finance Institute)

We characterize optimal oversight of algorithms in a world where an agent designs a complex prediction function but a principal is limited in the amount of information she can learn about the prediction function. We show that limiting agents to prediction functions that are simple enough to be fully transparent is inefficient as long as the bias induced by misalignment between principal's and agent's preferences is small relative to the uncertainty about the true state of the world. Ex-post algorithmic audits can improve welfare, but the gains depend on the design of the audit tools. Tools that focus on minimizing overall information loss, the focus of many post-hoc explainer tools, will generally be inefficient since they focus on explaining the average behavior of the prediction function rather than sources of mis-prediction, which matter for welfare-relevant outcomes. Targeted tools that focus on the source of incentive misalignment, e.g., excess false positives or racial disparities, can provide first-best solutions. We provide empirical support for our theoretical findings using an application in consumer lending.

Moderator: Jialan Wang (University of Illinois at Urbana-Champaign)

Mortgage amortization schedules are illiquid savings plans comparable in size to pension programs; however, little is known about their effects on wealth accumulation. Using individual administrative data and plausibly exogenous variation in the timing of home purchase (ex. childbirth-driven) around a 2013 Dutch reform, we find a near one-forone rise in net worth for each dollar of amortization. Households leave other savings and liabilities unchanged, and instead increase labor supply and reduce consumption. Effects hold even for regular savers and older households. This has important macroprudential implications and suggests homeownership financed via amortizing mortgages is instrumental for household wealth building.

Moderator: Tim McQuade (UC Berkeley)

Household inaction in mortgage refinancing is pervasive despite financial incentives to take action. Inactive households implicitly cross-subsidize active households, allowing competitive lenders to set lower average mortgage rates. To provide a money-metric assessment of this cross-subsidy, we build a model of household refinancing behaviour and structurally estimate it on rich administrative data on the stock of loans in the U.K. mortgage market, an institutional setting well-suited to this calculation. The model and data reveal the existence of sizeable cross-subsidies, and reveal that cross-subsidies flow from relatively poorer households and those located in less-wealthy areas towards households that are richer and located in wealthier areas. These findings highlight how the design of household finance markets can contribute to wealth and income inequality.

Moderator: Adi Sunderam (Harvard University)

We quantify the impact that central bank refinancing operations and funding facilities had at reducing the banking sector’s intrinsic fragility in the euro area in 2014-2019. We do so by constructing, estimating and calibrating a micro-structural model of imperfect competition in the banking sector that allows for runs in the form of multiple equilibria, in the spirit of Diamond & Dybvig (1983), banks’ default and contagion, and central bank funding. Our framework incorporates demand and supply for insured and uninsured deposits, and for loans to firms and households, as well as borrowers’ default. The estimation and the calibration are based on confidential granular data for the euro area banking sector, including information on the amount of deposits covered by the deposit guarantee scheme and the borrowing from the European Central Bank (ECB). We document that the quantitative relevance of non-fundamental risk is potentially large in the euro area banking sector, as witnessed by the presence of alternative equilibria with run-type features, but also that central bank interventions exerted a crucial role in containing fundamental as well as non-fundamental risk. Our counterfactuals show that 1 percentage point reduction (increase) in the ECB lending rate of its refinancing operations reduces (increases) the median of banks’ default risk across equilibria by around 50%, with substantial heterogeneity of this pass-through across time, banks and countries.