Knowledge that Transforms

Abstract We analyze optimal cross-country risk sharing and bank capital requirements amid collective moral hazard by governments and banks. Transfers provide insurance but weaken fiscal discipline. Since lenient fiscal policies amplify banks’ risk-shifting, optimal support must be contingent on banking system health. For fiscally weak countries, support is larger in sovereign crises with solvent banks. For fiscally strong countries, support is larger in joint sovereign and bank crises, requiring deposit insurance mutualization. Optimal contracts feature lower capital requirements than without cross-country transfers, raising the cost of joint sovereign and bank crises to strengthen fiscal discipline and enable greater risk sharing.

Abstract Using a novel measure of investment companies’ reliance on generative artificial intelligence (GenAI), we document a sharp increase in GenAI usage by hedge funds after ChatGPT’s 2022 launch. A difference-in-differences test shows that hedge funds adopting GenAI earn 2-4% higher annualized abnormal returns than nonadopters, while non-hedge funds do not benefit. The outperformance originates from funds’ AI talent and ChatGPT’s strength in analyzing firm-specific information. We conduct a new survey of fund managers’ GenAI usage to provide direct validation of our measure and offer additional new insights on how managers adopt GenAI tools in their practice.

Abstract We examine the role of race and ethnicity in the mutual fund context at two distinct levels. At the fund manager level, we document a co-racial tilt—funds managed by minority-dominant (White-dominant) teams allocate larger portfolio weights to minority-led (White-led) firms. This tilt is not associated with superior performance. It diminishes as fund managers gain experience, suggesting the presence of inaccurate statistical discrimination. At the investor level, we find that minority-dominant funds are penalized similarly to White-dominant funds for poor performance but are not rewarded as much for superior performance. Overall, our results uncover race-related investment choices at both levels.

Abstract We present and discuss the papers in this special issue. We use the themes that these papers study to illustrate interesting new directions that are being pursued in the household finance literature and highlight open questions on which more work is needed.

Abstract Using a unique data set on the ownership composition of euro area equity funds, we find substantial differences in the flow-performance sensitivity across mutual fund clienteles. Households, followed by insurers, display the weakest sensitivity, whereas investment funds—as investors in mutual funds—exhibit the strongest sensitivity. Crucially, these behavioral differences hold within the same fund-quarter, ruling out heterogeneity across funds as a potential driver. We relate these clientele effects to monitoring incentives and balance sheet constraints. Lastly, we find that households respond more strongly to poor performance when surrounded by more performance-sensitive investors, indicating strategic interactions in investor flows.

Abstract We model credit competition between a bigtech platform and a bank lending to a merchant under limited commitment and asymmetric information about the merchant’s incentives to default. The platform leverages its control over a marketplace to enforce partial loan repayments, enabling it to serve certain unbanked borrowers. When directly competing with the bank, the platform gains an endogenous screening advantage as borrowers with stronger incentives to default self-select into bank loans to avoid the platform’s enforcement. Whereas the platform improves financial inclusion for unbanked borrowers, social welfare may decline because the bank tightens credit in response to adverse screening.

Abstract I investigate how index membership affects firms’ product-market strategy. After plausibly exogenous index inclusion, firms gain market share by reducing product prices, giving better trade credit, and increasing sales and marketing expenses. Firms reduce prices for products with low market share and higher switching costs and habits. This comes at the cost of lower profitability, which increases in subsequent periods. Further analysis suggests that managerial learning about an improved funding environment from the post–index inclusion stock price increase is the underlying channel that leads to the observed increase in investment to gain market share. A model further corroborates these findings.

Abstract In a monetary union, the risk-free rate cannot adjust to country-level fiscal positions, leaving only default spreads and convenience yields to respond. Empirically, we find that convenience yields explain a large share of the variation in eurozone (EZ) sovereign bond yields. EZ sovereign bonds earn larger convenience yields when their governments run larger surpluses. Since convenience yields generate substantial seigniorage revenue from debt issuance, our estimates imply economically large fiscal costs from low convenience yields for peripheral countries in the EZ.

Abstract We causally test alternative theories of expectation formation. Using a randomized information experiment we show overreaction is a key feature of individuals’ return expectations, and individuals’ response to the price-earnings ratio is opposite of academic consensus. Our evidence is inconsistent with standard models of expectation formation, but subjective mental models that deviate from objective benchmarks can jointly explain the updating behavior in the experiment, the link between individuals’ prior perceptions and expectations, and the heterogeneity of updating. Conditional on their beliefs, individuals’ sensitivity of equity shares in a hypothetical portfolio choice experiment is consistent with the standard Merton model.

Abstract Flooding is among the costliest natural disasters in many countries. To protect collateral, many mortgage borrowers in the United States are legally required to maintain flood insurance. However, lax enforcement leads to frequent policy lapses. This paper shows that lenders provide credit contingent on borrowers’ insurance incentives. Exploiting exogenous premium rises ($266 annually) that disincentivize insurance take-up, I find mortgage denial rates dramatically increase by 0.49–0.81 pp. By comparison, lowering income by $266 has an effect of only 0.01 pp. Mortgage applicants’ composition remains unchanged, refuting demand-side explanations. Evidence suggests lenders internalize ex-post monitoring costs into ex-ante credit restrictions.