We examine the relationship between default probabilities and default correlations of two firms in the Merton model. We show that default correlations increase under a homogeneous increase of default probabilities. The same is true if the increase of the default probability is more pronounced for the firm with the lower likelihood of default. Default correlations may only decline if the increase of the default probability is significantly larger for the firm with higher default risk. These findings may have important implications for the assessment of credit portfolio risk, loan pricing, and capital requirements when adverse macroeconomic shocks occur.

In a general equilibrium framework, we show that banks may “buy” political influence at a discount: They offer disproportionately small campaign contributions compared to the influence they exert, thus generating abnormal returns. We distinguish between the direct effect of contributions which, as a cost, reduce bank returns, and the indirect effect of contributions which boost returns via inducing bank-favoring policies. Therefore, abnormal returns may or may not increase with the amount of contributions, depending on which effect dominates: Stricter capital requirements decrease contributions and abnormal returns. When politicians attach more weight to households’ welfare, contributions increase and abnormal returns decrease.

The seminal paper by Baron and Ferejohn (1989) leaves significant gaps in our understanding of open rule bargaining. We aim to fill these gaps by providing a fresh analysis of open rule bargaining. Our approach relies on an appealing class of stationary equilibria. In this class, we show that delays tend to be longer and allocations tend to be less egalitarian than originally predicted by Baron and Ferejohn. Our results shed new light on the efficiency and fairness implications of using an open vs. closed rule in legislatures and of bargaining processes in general.

We study financial intermediation in which sufficient sorting is impossible. We identify a new type of market failure that may occur even when returns of investing entrepreneurs are verifiable. Moreover, we suggest that the nature of competition determines the contracts banks offer. A monopoly bank will offer equity contracts. In any pure strategy equilibrium when lenders compete à la Bertrand, however, only debt contracts are offered.

In a two-country general equilibrium setting, we study competition between governments with two policy tools: capital requirements and a bank tax. Since banks raise equity and deposits from domestic and foreign households, governments face cross-country externalities the sign of which depends on the extent of positive spillovers, i.e., revenues from taxing banks, and negative spillovers, i.e., deposit guarantee costs. We show that regulatory competition yields the efficient allocation when governments have at their disposal policy tools that enable them to optimally internalize domestic distortions. Our first finding is that this is the case when governments are not restricted by supranational regulation. Our second finding is that supranational regulation may or may not impede efficiency. This conclusion is the result of a detailed analysis where we consider conceivable supranational regulatory schemes, derive their welfare implications and identify those that cause inefficiencies.

We integrate bank and bond financing into a two-sector neoclassical growth model and identify an automatic stabilization effect due to endogenous bank leverage adjustment. We show that although bank leverage amplifies shocks, the increase of leverage due to a decline in bank equity partially offsets the post crisis decline of bank lending and accelerates economic recovery by reducing the persistence of the bank lending channel. In this case, endogenous leverage adjustment is an automatic stabilizer. Regulatory state-independent capital limits and wage rigidities impair the re-allocation of capital between sectors and weaken this automatic stabilization. A quantitative analysis of the US during the Great Recession shows that the magnitude of automatic stabilization can be significant and informs about potentially high costs of strict capital regulation or wage rigidities during banking crises.

Franklin Allen, Hans Gersbach, Jan-Pieter Krahnen, Anthony M. Santomero; Competition Among Banks: Introduction and Conference Overview, European Finance Re