Knowledge that Transforms

This paper investigates the impact of the first system-wide capital relief package adopted by euro area prudential authorities, to support bank lending to firms at the outbreak of the COVID-19 pandemic. By leveraging confidential supervisory and credit register data, we uncover two main findings. First, capital relief measures support banks’ capacity to supply credit to firms. Second, the type of relief matters. Banks increase their credit supply in response to measures that reduce binding capital requirements and affect banks’ ability to distribute dividends. By contrast, discretionary relief measures that do not affect dividend policy are met with limited success. Moreover, requirement releases are more effective for banks with ex-ante lower capital headroom and for lending to smaller firms. These findings provide novel insights on the design of effective bank capital requirement releases in crisis times and, more generally, of policies to support bank credit in times of economic distress.

Decentralised finance (DeFi) lending protocols have experienced significant growth recently, yet the motivations driving investors remain largely unexplored. We use granular, transaction-level data from Aave, a leading player in the DeFi lending market, to study these motivations. Our theoretical and empirical findings reveal that the search for yield predominantly drives liquidity provision in DeFi lending pools, whereas borrowing activity is mainly influenced by speculative and, to some extent, governance motives. Both retail and large investors seek potential high returns through market movements and price speculation, however the latter engage in DeFi borrowing relatively more than the former also to influence protocol decisions and accrue more significant governance rights.

This paper shows that anticipation can meaningfully impact inferences about the effects of covenant violations. Using textual analysis of SEC filings and earnings call transcripts, I construct a measure of covenant concerns that identifies instances where firms disclose forward-looking risks related to their debt covenants. On average, nearly 30 percent of U.S. non-financial firms report covenant concerns each year. While the real effects of covenant violations are robust for most outcomes, the estimated impact of some variables, including cash acquisitions, default risk, and credit line availability, can be overstated. This finding highlights the importance of selection around violation: firms that anticipate and successfully avoid violations differ systematically from firms that fail to avoid them.

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This study examines how geographically diversified banks adjust lending practices in response to abnormal hot temperatures, a proxy for climate risk, and finds that these banks reduce small farm lending by 2–3 percent more than geographically constrained banks after a standard deviation increase in abnormal temperatures. Geographically diversified banks demonstrate proactive portfolio risk management by prioritizing credit in core markets and reallocating funds away from high-risk non-core regions, leaving lending gaps in affected counties. These findings highlight the importance of geographic diversification in building climate resiliency for banks while reducing the total credit available to farmers in a region.

Recent studies provide strong evidence that credit default swap (CDS) markets play a leading role in information intermediation. This paper proposes a model to rationalize the information transmission mechanism between the CDS and equity markets. In our model, informed traders with an informational advantage obtained from monitoring credit markets engage in capital structure arbitrage and trade strategically to exploit mispricings between individual stocks and CDS. In line with our model’s prediction, our empirical results provide evidence of a contemporaneous channel transmitting structural CDS shocks to equities. A positive shock to CDS decreases stock returns contemporaneously and over the long run. This credit-to-equity channel dominates the reverse transmission channel from stocks to CDS. Robustness tests confirm the role of the CDS market as a preferred venue for informed trading, independently of credit rating events or business sectors.

In standard banking models a demand for liquidity arises because investors want to take precautions against sudden consumption needs. It has long been taken for granted that banks’ maturity transformation is because they insure against such risk, exposing them to crises and justifying bank regulation. We show that if a demand for liquidity arises additionally for another important reason, their co-existence substantially alters equilibrium outcomes. Specifically, we introduce investors who want to preserve flexibility in case better investment opportunities arrive later. We show that (1) there is no maturity transformation if the funding liquidity of new investment opportunities is not sufficiently limited, (2) equilibria in models that consider only a single reason for liquidity demand are not necessarily robust, (3) an equilibrium in pure strategies in the depositing game may not exist at all.

Firms’ currency exposure can lead to financial distress and macroeconomic instability. Over-the-counter (OTC) derivatives provided by financial institutions are the primary risk management tool for nonfinancial firms. However, the role of financial institutions in providing these derivatives remains underexplored in the literature. Using novel loan and derivatives microdata, we examine how lending relationships influence access to foreign exchange (FX) OTC derivatives. We find that firms are more likely to trade derivatives with their lending relationship banks than with other banks, with a stronger preference for their main lender. These effects are more pronounced for small firms and first-time derivatives users, highlighting how lending relationships reduce informational and search costs, thereby facilitating access to hedging. Additionally, derivatives prices are lower when traded with the firms’ main lender and lenders providing loans in foreign currency, indicating that banks encourage hedging to reduce risks in their loan portfolios.