Knowledge that Transforms

It is widely believed that diversification at financial institutions benefits the stability of the financial system. This paper shows that it also entails a cost: even though diversification reduces each institution’s individual probability of failure, it makes systemic crises more likely. When systemic crises induce additional costs (over and above individual failures), full diversification is no longer desirable as a result and the optimal degree of diversification may be arbitrarily low. We show that the analysis can be extended beyond diversification, such as to interbank insurance and financial integration.

We revisit a method used by Das et al. (2007) (DDKS) who jointly test and reject a specification of firm default intensities and the doubly stochastic assumption in intensity models of default. The method relies on a time change result for counting processes. With an almost identical set of default histories recorded by Moody’s in the period from 1982 to 2006, but using a different specification of the default intensity, we cannot reject the tests based on time change used in DDKS. We then note that the method proposed by DDKS is mainly a misspecification test in that it has very limited power in detecting violations of the doubly stochastic assumption. For example, it will not detect contagion which spreads through the explanatory variables “covariates” that determine the default intensities of individual firms. Therefore, we perform a different test using a Hawkes process alternative to see if firm-specific variables are affected by occurrences of defaults, but find no evidence of default contagion.

This paper uses the entry of foreign banks into India during the 1990s—analyzing variation in both the timing of the new foreign banks’ entries and in their location—to estimate the effect of foreign bank entry on domestic credit access and firm performance. In contrast to the belief that foreign bank entry should improve credit access for all firms, the estimates indicate that foreign banks financed only a small set of very profitable firms upon entry, and that on average, firms were 8 percentage points less likely to have a loan after a foreign bank entry because of a systematic drop in domestic bank loans. Similar estimates are obtained using the location of pre-existing foreign firms as an instrument for foreign bank locations. Moreover, the observed decline in loans is greater among smaller firms, firms with fewer tangible assets, and firms affiliated with business groups. The drop in credit also appears to adversely affect the performance of smaller firms with greater dependence on external financing. Overall, this evidence is consistent with the exacerbation of information asymmetries upon foreign bank entry.

In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, and eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos – the primary margin of adjustment for the aggregate balance sheets of intermediaries – forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.

We provide the first systematic empirical analysis of how asymmetric information and competition in the credit market affect voluntary information sharing between lenders. We study an experimental credit market in which information sharing can help lenders to distinguish good borrowers from bad ones. Lenders may, however, also lose market power by sharing information with competitors. Our results suggest that asymmetric information in the credit market increases the frequency of information sharing between lenders significantly. Stronger competition between lenders reduces information sharing. In credit markets where lenders may fail to coordinate on sharing information, the degree of information asymmetry, rather than lender competition, drives actual information sharing behavior.