In this paper we show in a thought experiment that in an economy where i) investors hold rational expectations, ii) output is generated by a linear homogeneous production function, and iii) real investment is allocated across sectors according to the CAPM, a fractional reserve banking system is not Pareto efficient and amplifies the business cycle. In developing these results we show that these three well known propositions in economics also imply a new view of the business cycle, one where the business cycle is described in terms of the dispersion of an ex-ante probability distribution. The policy implication of this analysis is that bank regulation should go further than the Volcker rule or the Vickers commission proposal by restricting bank investments to currency and deposit accounts on the central bank. Nonbank financial institutions should then carry out the financial intermediation function now carried out by banks. The paper proposes that post office banking perhaps augmented with blockchain technology sometime in the future is one way to implement the transition from fractional reserve banking to full reserve banking. While little academic work has been done on full reserve banking in the aftermath of the Great Crisis, it is interesting to note that it is part of banking reform proposals now (July 2016) before the parliament in Iceland and a special national referendum in Switzerland.

Excessive (substantially above peer) litigation against a bank is indicative of operational risk because it often suggests failure to maintain a strong system of internal control. We examine the relation between bank performance and weak internal control using legal expense as a proxy. We find that legal expense is a strong determinant of loan losses and stock returns. Bank regulators should require reporting of legal expense on call reports to help identify institutions with weaknesses in internal control. Current reporting creates unnecessary information asymmetries because investors are not well informed about operational risk, leading to mispricing of bank securities.

This paper discusses evidence that large, diversified banks lend using `hard' information measures, such as audited financial statements. Structural changes toward larger and more diversified banks may have left some segments of credit markets - those depending on investment in `soft' information - under-served. These trends accelerated following the Financial Crisis. At the same time, bank lending to small businesses, which typically can only supply soft information, has been slow to recover from the Crisis. These trends are worrying because entry of focused banks, the normal market mechanism to counteract such a trend, has been absent since the Crisis.

In line with the psychological theory of place attachments, managers favor hometown workers over others. Consistent with this prediction, I find that following periods of industry distress, establishments located near CEOs’ childhood homes experience fewer employment and pay reductions and are less likely to be divested relative to other firm establishments. While it is not possible to directly test whether this employment bias destroys firm value, managers only implement these policies when governance is weak, suggesting that this favoritism is suboptimal. Together, these results provide direct evidence of employee favoritism and show that idiosyncratic manager styles impact corporate employment decisions. Received December 23, 2013; editorial decision January 3, 2017 by Editor Alexander Ljungqvist.

Recent years have seen increased demand from institutional investors for passive replication products that track the performance of hedge fund strategies using liquid investable assets such as futures contracts. In practice, linear replication methods suffer from poor tracking performance and high turnover. We propose a model combination approach to index replication that pools information from a diverse set of pre-specified factor models. Compared with existing methods, the pooled clone strategies yield consistently lower tracking errors, generate less severe portfolio drawdowns, and require substantially smaller trading volume. The pooled hedge fund clones also provide economic benefits in a portfolio allocation context.

This essay compares the Great Depression to the Great Recession in light of Barry Eichengreen's new book Hall of Mirrors. Eichengreen discusses these two episodes from a historical, Keynesian perspective, and concludes that policies that increase aggregate demand, such as larger fiscal deficits, would have promoted a much stronger and faster recovery from the Great Recession. I review these episodes from a neoclassical approach, which provides a very different perspective on why recoveries from these episodes were so slow and incomplete. I also argue that supply-side policies, rather than demand-side policies, are more likely to restore prosperity today.

We study the impact of a student’s ordinal rank in a high school cohort on educational attainment several years later. To identify a causal effect, we compare multiple cohorts within the same school, exploiting idiosyncratic variation in cohort composition. We find that a student’s ordinal rank significantly affects educational outcomes later in life. Students with a higher rank are significantly more likely to finish high school and to attend college. Exploring potential channels, we find that students with a higher rank have higher expectations about their future career, as well as a higher perceived intelligence.

The Term Auction Facility (TAF) was designed by the Federal Reserve during the financial crisis to inject emergency short-term funds into banks, as a supplement to the lender of last resort discount window offerings. We describe how the Federal Reserve altered the design of the Term Auction Facility (TAF) over the course of the financial crisis and examine the utilization of this stand-alone facility. Most specifically we detail the impact of the greatly increased offering amounts in all auctions after October 2008, which resulted in the facility no longer auctioning scarcely available funds. We also document significantly different usage of the facility by FDIC-insured community and non-community banks, consistent with the notion of a two-tiered banking system in the U.S. Community banks were far less likely to use the facility than larger, non-community banks.

This paper uses experimental data from the Head Start Impact Study (HSIS) combined with nonexperimental data from the Early Childhood Longitudinal Study–Birth Cohort (ECLS-B) to study the performance of nonexperimental estimators for evaluating Head Start program impacts. The estimators studied include parametric cross-section and difference-in-differences regression estimators and nonparametric cross-section and difference-in-differences matching estimators. The estimators are used to generate program impacts on cognitive achievement test scores, child health measures, parenting behaviors, and parent labor market outcomes. Some of the estimators closely reproduce the experimental results, but a priori it would be difficult to know whether the estimator works well for any particular outcome. Pre-program exogeneity tests eliminate some outcomes and estimators with the worst biases, but estimators/outcomes with substantial biases pass the tests. The difference-in-differences matching estimator exhibits the best performance in terms of low bias values and capturing the pattern of statistically significant treatment effects. However, the variation in bias is greater across outcomes examined than across methods.