Knowledge that Transforms

During a flight to liquidity, investors demand large amounts of governmentbacked safe assets in a rush. The sluggish reaction of the public supply of safe assets opens up a role for government-sponsored shadow banks. We exploit exogenous changes in both demand and supply of safe assets from the 2014 money fund reform and the 2015 debt limit. We find that shadow banks act as a substitute as well as a complement to public supply during a flight to liquidity. Our findings carry over to the dash for cash at the onset of the Covid-19 pandemic.

We assess issues related to borrower beliefs and mortgage performance using new individual panel data that simultaneously cover borrower expectations, forbearance status during the COVID-19 pandemic, and a wide array of demographic characteristics. First, we establish the determinants of borrower expectations, with local experiences and those of social networks playing important roles. We then show that households who, at origination, were optimistic about future house price appreciation or pessimistic about the possibility of future unemployment were more likely to enter forbearance in 2020. However, by early 2021, appreciation-optimistic borrowers who were in forbearance were likely to have cured or prepaid their loan, while those who expected unemployment were likely to still be in forbearance. We offer three channels by which expectations affect forbearance behavior: choices of initial loan terms, associations with actual future events, and factors related to belief formation that are also plausibly associated with forbearance. Our findings highlight the crucial role borrower expectations play in both leverage choices and mortgage performance.

Utilizing a unique and novel setting of disclosure mandate threshold under Regulation AB (Reg AB), we investigate the relationship between disclosure and trust in asset securitization. Post-Reg AB enactment, we observe a significant bunching of originators just below the disclosure threshold. Less trustworthy originators are more likely to adjust their portfolio sizes to remain below this threshold, particularly when loan originators and deal sponsors are unaffiliated, which are cases in which disclosure plays a greater role in reducing information asymmetry. Additionally, these originators are more likely to misrepresent loan quality. Our findings reveal a strong relationship between disclosure and trust—trustworthy originators disclose more and originate higher-quality loans, while less trustworthy originators disclose less and produce lower-quality loans.

This paper is based on a panel discussion at the international bank conference on Frontier Risks, Financial Innovation and Prudential Regulation of Banks in Gothenburg, Sweden, June 2–4, 2024. The panelists were Deborah Lucas, Jan Pieter Krahnen, and Magnus Olsson, with Ted Lindblom moderating. This paper contains the panel presentations, along with a unifying discussion by Paolo Fulghieri and Anjan Thakor. The main themes in the paper focus on how society should balance costs and benefits in designing the prudential regulation of banks. Optimal regulation should take into account how banks and markets interact, the dangers of both under-regulation that spawns excessive risk-taking and over-regulation that depresses value-enhancing innovation in financial services, the somewhat fragmented nature of national-sovereignty-constrained European banking and financial markets regulation relative to bank regulation in the US, and how prudential regulation can be improved by more explicitly dealing with interest rate risk.

Following the global financial crisis, banks lengthened the average maturity of their assets relative to that of their liabilities, principally by increasing their investments in mortgage-related assets. Whether such maturity transformation exposes banks to interest rate risk depends, in part, on the effectiveness of bank deposits as a hedge against interest rate shocks. In this paper we provide evidence that interest pass-through rates on deposits vary significantly with interest rates, which reduces the effectiveness of deposits as a hedge when interest rates increase. The dynamic nature of the deposit betas explains, in part, why the duration of bank equity varies with interest rates and why interest rate risk models need to account for how pass-through rates vary with interest rates.

Loan modifications can ease borrowers’ financial burdens and mitigate loan losses. However, the threat of future strategic renegotiation may cause lenders to tighten ex-ante credit provision. We evaluate this trade-off in a dynamic model of loan underwriting with frictional renegotiation and calibrate it using loan-level CRE data from banks and CMBS. We find that modification frictions can rationalize a number of empirical facts regarding how CRE loan underwriting and performance differ across lenders. Key to this result, high frictions to modifying CMBS loans reduce renegotiation, increase debt capacity, and cause high-leverage-demand borrowers to select into the CMBS market. Consequently, easing CMBS modification frictions reduces welfare by restricting the menu of LTVs available in the market.

We challenge the existing relationship lending literature on how banks manage their relationships with corporate borrowers during crises. We test theories of intertemporal smoothing during the closure period of the COVID-19 crisis when borrowers are in great need of relationship benefits. We find that relationship borrowers receive worse rather than more favorable loan contract terms than others during this period. These and other results provide novel evidence on the functioning of relationship lending during a pandemic and contrast existing evidence gleaned from banking and financial crises.

A historical look at financial boom-bust cycles shows that pro-cyclicality in financial regulation is a common and recurring pattern. This paper shows that inefficient regulatory cycles can naturally arise when electoral concerns are introduced into a simple model of financial intermediation. We explore how financial innovations, public opinion and policymakers’ incentives shape financial regulation within this framework. We show that in the presence of incompetent politicians, competent politicians take regulatory risks to signal their competence. This amplifies the influence of public opinion on policy, leading to an ex ante inefficient pro-cyclicality in financial regulation.