modern money theory and the facts of experience this paper discusses modern money theory mmt with a particular focus on the role of the state in its monetary system and the nature of money it addresses the main differences between the orthodox heterodox and mmt approaches to monetary theory while reconciling endogenous money theory with the state money approach by emphasising the symmetry between how banks create money as they finance private spending and how the government creates money when it finances its own spending we clarify some of the misconceptions surrounding mmt while showing that it is more consistent with the facts of experience furthermore we argue that mmt s insistence that government spending or lending must precede bond sales is consistent with the keynesian emphasis on effective demand as the driving force behind income and saving we delve into mmt s implications for monetary and fiscal policy with a particular focus on the eurozone we conclude our paper by discussing two proposals of monetary cranks narrow banking and government issue of debt free money this allows us to re emphasise mmt s views on the nature of money

financial intermediary coalitions abstract in this article an environment in which the investment opportunities of agents are private information is studied and it is shown that financial intermediaries arise endogenously within that environment it is established that financial intermediaries are part of an efficient arrangement in the sense that they are needed to support the authors private information core allocations these intermediaries which are coalitions of agents exhibit the following characteristics in equilibrium they borrow from and lend to large groups of agents they produce information about investment projects and they issue claims that have different state contingent payoffs than claims issued by ultimate borrowers

economic effects of federal credit programs since 1980 the federal government has directly subsidized one third of all nonfederal borrowing this paper presents numerical estimates of the effects of federal lending existing credit subsidies appear to have important effects on the allocation of credit but little effect on aggregate investment efficiency costs are shown to be large approximately 1 3 percent of gnp government costs exceed fifty cents per dollar of incremental targeted lending interactions among programs can eliminate much or all of the original gain provided by a subsidy especially if borrowers are rationed the paper also examines the effects of several policy reforms copyright 1991 by american economic association

alternative forms of deposit insurance pricing and bank incentive issues abstract this paper derives formulas for a deposit insuring agency s liability and hence a fair value deposit insurance premium and the equilibrium value of bank equity considering a wide variety of factors affecting individual bank risk both fixed rate and variable rate risk sensitive insurance systems are analyzed consideration is made as to whether the deposit insuring agency makes direct payments to depositors or arranges mergers following bank closings the effect of these various policy choices on banks incentive for risk taking is also analyzed

contingent capital with a capital ratio trigger contingent capital in the form of debt that converts to equity when a bank faces financial distress has been proposed as a mechanism to enhance financial stability and avoid costly government rescues specific proposals vary in their choice of conversion trigger and conversion mechanism we analyze the case of contingent capital with a capital ratio trigger and partial and ongoing conversion the capital ratio we use is based on accounting or book values to approximate the regulatory ratios that determine capital requirements for banks the conversion process is partial and ongoing in the sense that each time a bank s capital ratio reaches the minimum threshold just enough debt is converted to equity to meet the capital requirement so long as the contingent capital has not been depleted we derive closed form expressions for the market value of such securities when the firm s asset value is modeled as geometric brownian motion and from these we get formulas for the fair yield spread on the convertible debt a key step in the analysis is an explicit expression for the fraction of equity held by the original shareholders and the fraction held by converted investors in the contingent capital this paper was accepted by gerard p cachon stochastic models and simulation

pricing risk adjusted deposit insurance an option based model this paper presents a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships betweeen equity and a call option and insurance and a put option the data utilizes the market value of equity to solve for the asset value and its volatility market perceptions of fdic bailout policies are explicitly modeled so as to eliminate the bias in inverted values of assets and their volatility sensitivity analyses are performed to show that rank orderings based on premiums are robust to changes in specification thus facilitating allocation of aggregate premium across banks while economists have long argued in favor of risk adjusted deposit insurance as both more equitable and more efficient than the current system of flatrate premiums various recent developments have further contributed to an increasing dissatisfaction with the current system first both the banking industry and the government seem to be tending to the view that deregulation of the banking industry would be necessary in order to meet more sophisticated future demands on the industry as well as desirable as a policy means of stimulating greater competition among banks moreover a sudden rise in the incidence of bank failures 1 and the vulnerability of the u s banks to the socalled international debt crisis have served to bring to the fore concern about the health of the banking industry in the absence of deposit insurance riskier banks will be able to attract deposits only at higher rates and these higher costs of funding serve as built in market regulated incentives to limit excessive risk taking by banks as introduction of deposit insurance makes deposits equally risk free across banks these incentives disappear and regulation and close supervision of the banking industry must necessarily replace them as deterrents to excessive risk taking thus when insurance is offered at a flat premium regulation is designed to ensure that the risk posed to the insurer both asset and financial risk is appropriately uniform

does the european financial stability facility bail out sovereigns or banks an event study on may 9 2010 euro zone countries announced the creation of the european financial stability facility this paper investigates the impact of this announcement on bank share prices bank credit default swap cds spreads and sovereign cds spreads the main private beneficiaries were bank creditors furthermore countries with banking systems heavily exposed to southern europe and ireland benefited as evidenced by lower sovereign cds spreads the combined gains of bank debt holders and shareholders exceed the increase in the value of their banks sovereign debt exposures suggesting that banks saw their contingent claim on the financial safety net increase in value

intertemporal cost allocation and managerial investment incentives a theory explaining the use of economic value added as a performance measure this paper provides a formal analysis of how managerial investment incentives are affected by alternative allocation rules when managerial compensation is based on accounting measures of income that include allocations for investment expenditures the main result is that there exists a unique allocation rule that always induces the manager to choose the efficient investment level the income measure created by this allocation rule is usually referred to as residual income or economic value added

valuation of commodity based swing options in the energy markets in particular the electricity and natural gas markets many contracts incorporate flexibility of delivery options known as swing or take or pay options subject to daily as well as periodic constraints these contracts permit the option holder to repeatedly exercise the right to receive greater or smaller amounts of energy we extract market information from forward prices and volatilities and build a pricing framework for swing options based on a one factor mean reverting stochastic process for energy prices that explicitly incorporates seasonal effects we present a numerical scheme for the valuation of swing options calibrated for the case of natural gas

bond pricing and the term structure of interest rates a new methodology for contingent claims valuation this paper presents a unifying theory for valuing contingent claims under a stochastic term structure of interest rates the methodology based on the equivalent martingale measure technique takes as given an initial forward rate curve and a family of potential stochastic processee for its subsequent movements a no arbitrage condition restricts this family of processes yielding valuation formulae for interest rate sensitive contingent claims which do not explicitly depend on the market prices of risk examples are provided to illustrate the key results in relation to the term structure of interest rates arbitrage pricing theory has two purposes the first is to price all zero coupon default free bonds of varying maturities from a finite number of economic fundamentals called state variables the second is to price all interest rate sensitive contingent claims taking as given the prices of the zero coupon bonds this paper presents a general theory and a unifying framework for understanding arbitrage pricing theory in this context of which all existing arbitrage pricing models are special cases in particular vasicek 1977 brennan and schwartz 1979 langetieg 1980 ball and torous 1983 ho and lee 1986 schaefer and schwartz 1987 and artzner and delbaen 1988 the primary contribution of this paper however is a new methodology for solving the second problem i e the pricing of interest rate sensitive contingent claims given the prices of all zero coupon bonds the methodology is new because i it imposes its stochastic structure directly on the evolution of the forward rate curve ii it does not require an inversion of the term structure to eliminate the market prices of risk from contingent claim values and iii it has a stochastic spot rate process with multiple stochastic factors influencing the term structure the model can be used to consistently price and hedge all contingent claims american or european on the term structure and it is derived from necessary and more importantly sufficient conditions for the absence of arbitrage the arbitrage pricing models of vasicek 1977 brennan and schwartz 1979 langetieg 1980 and artzner and delbaen 1988 all require an iformerly titled bond pricing and the term structure of interest rates a new methodology

the term structure of credit spreads with jump risk abstract default risk analysis is important for valuing corporate bonds swaps and credit derivatives and plays a critical role in managing the credit risk of bank loan portfolios this paper offers a theory to explain the observed empirical regularities on default probabilities recovery rates and credit spreads it incorporates jump risk into the default process with the jump risk a firm can default instantaneously because of a sudden drop in its value as a result a credit model with the jump risk is able to match the size of credit spreads on corporate bonds and can generate various shapes of yield spread curves and marginal default rate curves including upward sloping downward sloping flat and hump shaped even if the firm is currently in a good financial standing the model also links recovery rates to the firm value at default so that the variation in recovery rates is endogenously generated and the correlation between recovery rates and credit ratings before default reported in altman j finance 44 1989 909 can be justified

quantitative monetary policy and government debt management in britain since 1919 the enormous increase in the united kingdom s national debt during the two world wars of the twentieth century meant that government debt management which had hitherto been regarded as a matter of budgetary convenience acquired great macroeconomic significance the paper examines and compares four episodes in the management of the national debt since 1919 and in each case explores the relationship between debt management and monetary policy the current policy of quantitative easing is a form of government debt management and the paper discusses it in the context of the earlier episodes copyright 2012 oxford university press

bank risk dynamics and distance to default we adapt structural models of default risk to take into account the special nature of bank assets the usual assumption of log normally distributed asset values is not appropriate for banks typical bank assets are risky debt claims which implies that they embed a short put option on the borrowers assets leading to a concave payoff this has important consequences for banks risk dynamics and distance to default estimation due to the payoff non linearity bank asset volatility rises following negative shocks to borrower asset values as a result standard structural models in which the asset volatility is assumed to be constant can severely understate banks default risk in good times when asset values are high bank equity payoffs resemble a mezzanine claim rather than a call option bank equity return volatility is therefore much more sensitive to big negative shocks to asset values than in standard structural models

robust comparative statics in large dynamic economies we consider infinite horizon economies populated by a continuum of agents subject to idiosyncratic shocks this framework contains models of saving and capital accumulation with incomplete markets in the spirit of works by bewley aiyagari and huggett models of entry exit and industry dynamics in the spirit of hopenhayn s work and dynamic models of occupational choice and search models as special cases robust and easy to apply comparative statics results are established with respect to exogenous parameters as well as various kinds of changes in the markov processes governing the law of motion of the idiosyncratic shocks

optimal taxation without state contingent debt in an economy studied by lucas and stokey tax rates inherit the serial correlation structure of government expenditures belying barro s earlier result that taxes should be a random walk for any stochastic process of government expenditures to recover a version of barro s random walk tax smoothing outcome we modify lucas and stokey s economy to permit only risk free debt having only risk free debt confronts the ramsey planner with additional constraints on equilibrium allocations beyond one imposed by lucas and stokey s assumption of complete markets the ramsey outcome blends features of barro s model with lucas and stokey s in our model the contemporaneous effects of exogenous government expenditures on the government deficit and taxes resemble those in lucas and stokey s model but incomplete markets put a near unit root component into government debt and taxes an outcome like barro s however we show that without ad hoc limits on the government s asset holdings outcomes can diverge in importa

dueling policies why systemic risk taxation can fail abstract two policy instruments for the banking sector are investigated namely systemic risk taxation and constructive ambiguity about bailout policy bailout expectations can induce moral hazard in the form of excessive risk taking by banks systemic risk taxation induces banks to prefer uncorrelated investments leading to lower systemic risk formation constructive ambiguity generates uncertainty about bailout prospects however systemic risk taxation also may inform banks about the regulator s concern for financial stability and thereby its bailout policy this result leads to a trade off between systemic risk taxation and constructive ambiguity and highlights the need to consider interdependence across policies when evaluating their effectiveness

evaluating the cost of government credit support the oecd context governments throughout the oecd allocate a large share of societies capital and risk through their credit related activities hence accurate cost estimates for credit support programmes are a prerequisite for efficient resource allocation transparency effective management and public oversight i find that oecd governments generally take their cost of capital to be their own borrowing rate rather than using a weighted average cost of capital that includes the cost of risk borne by taxpayers and the general public in their role as equity holders that practice which is institutionalised in government accounting and budgetary rules results in cost estimates for credit support that are significantly downwardly biased relative to a fair value metric that recognises the full cost of risk the size and possible real consequences of those distortions are illustrated with analyses of the european bank for reconstruction and development the european stability mechanism and the tennessee valley authority deborah lucas

social interaction and stock market participation we propose that stock market participation is influenced by social interaction in our model any given social investor finds the market more attractive when more of his peers participate we test this theory using data from the health and retirement study and find that social households those who interact with their neighbors or attend church are substantially more likely to invest in the market than non social households controlling for wealth race education and risk tolerance moreover consistent with a peer effects story the impact of sociability is stronger in states where stock market participation rates are higher

testing macroprudential stress tests the risk of regulatory risk weights we compare the capital shortfall measured by regulatory stress tests to that o fa benchmark methodology the v lab stress test that employs only publicly available market data we find that when capital shortfalls are measured relative to risk weighted assets the ranking of financial institutions is not well correlated to the ranking of the v lab stress test whereas rank correlations increase when required capitalization is a function of total assets we show that the risk measures used in risk weighted assets are cross sectionally uncorrelated with market measures of risk as they do not account for the risk that risk will change furthermore the banks that appeared to be best capitalized relative to risk weighted assets were no better than the rest when the european economy deteriorated into the sovereign debt crisis in 2011

an integrated model for hybrid securities we develop a model for pricing securities whose value may depend simultaneously on equity interest rate and default risks the framework may also be used to extract probabilities of default pd functions from market data our approach is entirely based on observables such as equity prices and interest rates rather than on unobservable processes such as firm value the model stitches together in an arbitrage free setting a constant elasticity of variance cev equity model to represent the behavior of equity prices prior to default a default intensity process and a heath jarrow morton hjm model for the evolution of riskless interest rates the model captures several stylized features such as a negative relation between equity prices and equity volatility a negative relation between default intensity and equity prices and a positive relationship between default intensity and equity volatility we embed the model on a discrete time recombining lattice making implementation feasible with polynomial complexity we demonstrate the simplicity of calibrating the model to market data and of using it to extract default information the framework is extensible to handling correlated default risk and may be used to value distressed convertible bonds debt equity swaps and credit portfolio products such as collateralized debt obligations cdos applied to the cdx indu credit default index industrials index we find the s p 500 index explains credit premia

quantifying the risk of deflation we propose formal and quantitative measures of the risk that future inflation will be excessively high or low relative to the range preferred by a private sector agent unlike alternative measures of risk our measures are designed to make explicit the dependence of risk measures on the private sector agent s preferences with respect to inflation we illustrate our methodology by estimating the risks of deflation for the united states germany and japan for horizons of up to 2 years the question of how large these risks are has been subject to considerable public debate we find that as of september 2002 when this question first arose there was no evidence of substantial deflation risks for the united states and for germany contrary to some conjectures at the time in contrast there was evidence of substantial deflation risks in japan

optimal fiscal and monetary policy in an economy without capital abstract this paper is concerned with the structure and time consistency of optimal fiscal and monetary policy in an economy without capital in a dynamic context optimal taxation means distributing tax distortions over time in a welfare maximizing way for a barter economy our main finding is that with debt commitments of sufficiently rich maturity structure an optimal policy if one exists is time consistent in a monetary economy the idea of optimal taxation must be broadened to include an inflation tax and we find that time consistency does not carry over an optimal inflation tax requires commitment by rules in a sense that has no counterpart in the dynamic theory of ordinary excise taxes the reason time consistency fails in a monetary economy is that nominal assets should from a welfare maximizing point of view always be taxed away via an immediate inflation in a kind of capital levy this emerges as a new possibility when money is introduced into an economy without capital

financial development and economic growth abstract this paper examines the empirical relationship between long run growth and financial development proxied by the ratio between bank credit to the private sector and gdp we find that this proxy is positively correlated with growth in a large cross country sample but its impact changes across countries and is negative in a panel data for latin america we argue that the latter findings is the result of financial liberalization in a poor regulatory environment our findings also show that the main channel of transmission from financial development to growth is the efficiency rather than the volume of investment

an options based approach to evaluating the risk of fannie mae and freddie mac abstract fannie mae and freddie mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the 8 trillion u s residential mortgage market their hybrid government private status and the perception that they are too big to fail make them a potentially large but largely unaccounted for risk to the federal government measuring the size and risk of this liability is technically difficult but important for the debate over the appropriate regulation of these institutions here we take an options pricing approach to evaluating these costs and risks under the base case assumptions the estimated value of the guarantees is 7 9 billion over 10 years with a combined 5 percent value at risk of 122 billion we evaluate the sensitivity of these estimates to various modeling assumptions and also to the regulatory regime including forbearance policies and capital requirements the analysis highlights the benefits but also the challenges of taking an options based approach to evaluating the value of federal credit guarantees

bailouts the incentive to manage risk and financial crises a firm s termination leads to bankruptcy costs this may create an incentive for outside stakeholders or the firm s debtholders to bail out the firm as bankruptcy looms because of this implicit guarantee firm shareholders have an incentive to increase volatility in order to exploit the implicit protection however if they increase volatility too much they may induce the guarantee extending parties to walk away i derive the optimal risk management rule in such a framework and show that it allows high volatility choices while net worth is high however risk limits tighten abruptly when the firm s net worth declines below an endogenously determined threshold hence the model reproduces the qualitative features of existing risk management rules and can account for phenomena such as flight to quality

the leverage effect and the basket index put spread abstract benchmark models that exogenously specify equity dynamics cannot explain the large spread in prices between put options written on individual banks and options written on the bank index during the financial crisis however theory requires that asset dynamics be specified exogenously and that endogenously determined equity dynamics exhibit a leverage effect that increases put prices by fattening the left tail of the distribution the leverage effect is larger for puts on individual stocks than for puts on the index thus increasing the basket index spread time series and cross sectional variation in the leverage effect explains option prices well

financial development growth and the distribution of income a paradigm is presented in which both the extent of financial intermediation and the rate of economic growth are endogenously determined financial intermediation promotes growth because it allows a higher rate of return to be earned on capital and growth in turn provides the means to implement costly financial structures thus financial intermediation and economic growth are inextricably linked in accord with the goldsmith mckinnon shaw view on economic development the model also generates a development cycle reminiscent of the kuznet hypothesis in particular in the transition from a primitive slow growing economy to a developed fast growing one a nation passes through a stage in which the distribution of wealth across the rich and poor widens

the valuation of fdic deposit insurance using option pricing estimates when congress set the premium rate for fdic deposit insurance in the banking act of 1935 which authorized a permanent federal insurance system neither experience nor theory could offer much guidance regarding an appropriate fee structure although rates have since been periodically revised the fdic has yet to attempt to set the insurance rate at a ifair level that is a level equal to administrative costs plus the ex ante value of the insurance such a premium is the rate that would be charged by competitive private insurers however7 the garn st germain act of 1982 directed the fdic to consider the feasibility of a risk based premium structure in response the fdic has suggested a trial system in which each insured bank will be placed in one of three risk classes based on credit and interest rate risk relative to capital and a premium rate will be assigned to each group those rates will be determined in part by the loss experience of the entire banking system fdic 1983 another approach to the determination of the appropriate insurance premium has been offered by merton 1977 who suggested using the analogous relationship between deposit guarantees and put options to value fdic insurance in this paper we follow merton s suggestion and calculate bank specific estimates of the proper premium for deposit insurance for the banks in our sample we find that fdic rates greatly exceed estimates of the fair value of the insurance derived from the blackscholes 1972 option pricing model

on the design of contingent capital with a market trigger contingent capital cc which intends to internalize the costs of too big to fail in the capital structure of large banks has been under intense debate by policy makers and academics we show that cc with a market trigger in which direct stake holders are unable to choose optimal conversion policies does not lead to a unique competitive equilibrium unless value transfer at conversion is not expected ex ante the no value transfer restriction precludes penalizing bank managers for taking excessive risk multiplicity or absence of an equilibrium introduces the potential for price uncertainty market manipulation inecient capital allocation and frequent conversion errors these results point to the need to explore alternative designs of a prudential capital structure for banks jel classication

pareto optima and competitive equilibria with adverse selection and moral hazard this paper explores the extent to which standard general equilibrium analysis of pareto optima and of competitive equilibria can be applied to environments with moral hazard and adverse selection problems allowing for lotteries contracts with random components we first establish that an adverse selection insurance economy a moral hazard insurance economy a signaling economy and a private information labor market economy are all special cases of a simple general structure we then show that techniques for characterizing pareto optimal contracts as solutions to concave programming problems are useful and nice and appear to be broadly applicable allowing for lotteries we show how to characterize the optimal allocations for the adverse selection insurance and labor market economies we then show that standard existence and optimality theorems for competitive equilibria apply in the linear space containing lotteries if agents with characteristics which are distinct and privately observed at the time of initial trading enter the economy wide resource constraints in a homogeneous way other kinds of diversity are not critical for economies with moral hazard which satisfy the homogeneity condition competitive contract markets single out a subset of the optima and thus can be consistent with apparent unemployment and with a random allocation of labor supplied though all households are averse to risk the adverse selection insurance and signaling economies however do not satisfy the homogeneity condition and are difficult to decentralize efficiently with a price system

efficiency and stability of a financial architecture with too interconnected to fail institutions abstract the regulation of large interconnected financial institutions has become a key policy issue to improve financial stability regulators have proposed limiting banks size and interconnectedness i estimate a network based model of the over the counter interbank lending market in the us and quantify the efficiency stability implications of this policy trading efficiency decreases with limits on interconnectedness because the intermediation chains become longer while restricting the interconnectedness of banks improves stability the effect is non monotonic stability also improves with higher liquidity requirements when banks have access to liquidity during the crisis and when failed banks depositors maintain confidence in the banking system

correlated default risks and bank regulations bank regulatory design relies critically on bank risk modeling traditionally the bank s aggregate value is assumed to obey an exogenously specified process e g a lognormal diffusion we demonstrate that this assumption is generally invalid given the truncated and correlated payoff structure of individual bank loans instead the bank s aggregate terminal payoff is significantly left fat tailed this skewness remains even when the bank holds an infinitely large number of loans in its portfolio unless they are uncorrelated by ignoring skewness in bank payoffs deposit insurance premia and capital requirements have traditionally been significantly mis calculated

the value of pension benefit guaranty corporation insurance this paper considers the cost of pension benefit guaranty corporation pbgc insurance for single employer defined benefit pension plans it derives a formula for the pbgc s liability that explicitly recognizes the two necessary conditions that must arise for the pbgc to sustain a loss first the corporation sponsoring the pension iund must undergo bankruptcy and second this pension plan must be underfunded the pbgc s liability is valued as a contingent put option and expressed as infinite series of modified bessel functions the comparative statics of the model are examined and are quite consistent with economic intuition copyright 1994 by ohio state university press

from global savings glut to financing infrastructure summary samama and joseph stiglitz this paper proposes an institutional solution that can help unlock the flow of low yielding long term savings towards high return infrastructure investments the solution is to transform public private partnerships ppps in infrastructure as well as the classic model of multilateral development banks instead of thinking of ppps as bilateral contracts between a private concession operator and a government agency we argue that they should be conceived as partnerships that also involve a development bank and long term institutional investors as partners we propose a new model for development banks which is to transform them into originate and distribute banks for ppp infrastructure projects the new model allows them to conserve their valuable capital and leverage their expertise and capabilities by making them available to long term institutional investors

valuing the treasury s capital assistance program the capital assistance program cap was created by the u s government in february 2009 to provide backup capital to large financial institutions unable to raise sufficient capital from private investors under the terms of the cap a participating bank receives contingent capital by issuing preferred shares to the treasury combined with embedded options for both parties the bank gets the option to redeem the shares or convert them to common equity with conversion mandatory after seven years the treasury earns dividends on the preferred shares and gets warrants on the bank s common equity we develop a contingent claims framework in which to estimate market values of these cap securities the interaction between the competing options held by the buyer and issuer of these securities creates a game between the two parties and our approach captures this strategic element of the joint valuation problem and clarifies the incentives it creates we apply our method to the 18 publicly held bank holding companies that participated in the supervisory capital assessment program the stress test launched together with the cap on average we estimate that compared to a market transaction the cap securities carry a net value of approximately 30 of the capital invested for a bank participating to the maximum extent allowed under the terms of the program we also find that the net value varies widely across banks we compare our estimates with abnormal stock price returns for the stress test banks at the time the terms of the cap were announced we find correlations between 0 78 and 0 85 depending on the precise choice of period and set of banks included these results suggest that our valuation aligns with shareholder perception of the value of the program prompting questions about industry reactions and the overall impact of the program this paper was accepted by wei xiong finance

optimal taxation in the presence of bailouts the termination of a representative financial firm due to excessive leverage may lead to substantial bankruptcy costs a government in the tradition of ramsey 1927 may be inclined to provide transfers to the firm so as to prevent its liquidation and the associated deadweight costs it is shown that the optimal taxation policy to finance such transfers exhibits procyclicality and history dependence even in a complete market these results are in contrast with pre existing literature on optimal fiscal policy and are driven by the endogeneity of the transfer payments that are required to salvage the financial firm

callable contingent capital valuation and default risk this paper proposes the use of contingent capital with a call provision in which the insurer has an option to redeem the contingent capital at any time i characterize in detail a unique dynamic equilibrium of common stock subordinated contingent capital and a senior standard bond under a simple yet sufficient and necessary condition that can be implemented easily i further show that the issuance of callable contingent capital does not affect the default risk of an outstanding senior standard bond as a result callable contingent capital provides an alternative design for contingent capital using a prudential capital structure for a bank that is too big to fail this paper was accepted by jerome detemple finance

bank capital interbank contagion and bailout policy abstract this paper develops a theoretical framework in which asset linkages in a syndicated loan agreement can infect a healthy bank when its partner bank fails we investigate how capital constraints affect the choice of the healthy bank to takeover or liquidate the exposure held jointly with the failing bank and how the bank s ex ante optimal capital holding and possibility of contagion are affected by anticipation of bail out policy capital requirements and the joint exposure we identify a range of factors that strengthen or weaken the possibility of contagion and bailout recapitalization with common stock rather than preferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to hold capital to cope with potential contagion increasing the minimum regulatory capital does not necessarily reduce contagion while the requirement of holding conservation capital buffer could increase the bank s resilience to avoid contagion

term structures of credit spreads with incomplete accounting information we study the implications of imperfect information for term structures of credit spreads on corporate bonds we suppose that bond investors cannot observe the issuer s assets directly and receive instead only periodic and imperfect accounting reports for a setting in which the assets of the firm are a geometric brownian motion until informed equityholders optimally liquidate we derive the conditional distribution of the assets given accounting data and survivorship contrary to the perfect information case there exists a default arrival intensity process that intensity is calculated in terms of the conditional distribution of assets credit yield spreads are characterized in terms of accounting information generalizations are provided

coordination failures and the lender of last resort was bagehot right after all the classical doctrine of the lender of last resort lolr elaborated by bagehot 1873 asserts that the central bank should lend to illiquid but solvent banks under certain conditions several authors have argued that this view is now obsolete in modern interbank markets a solvent bank cannot be illiquid this paper provides a possible theoretical foundation for rescuing bagehot s view our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs we built a model of banks liquidity crises that possesses a unique bayesian equilibrium in this equilibrium there is a positive probability that a solvent bank cannot find liquidity assistance in the market we derive policy implications about banking regulation solvency and liquidity ratios and interventions of the lender of last resort furthermore we find that public bailout and private bail in involvement are complementary in implementing the incentive efficient solution and that bagehot s lender of last resort facility must work together with institutions providing prompt corrective action and orderly failure resolution finally we derive similar implications for an international lender of last resort ilolr jel g21 g28

is mark to market accounting destabilizing analysis and implications for policy abstract fundamental economic principles provide a rationale for requiring financial institutions to use mark to market or fair value accounting for financial reporting the recent turmoil in financial markets however has raised questions about whether fair value accounting is exacerbating the problems in this paper we review the history and practice of fair value accounting and summarize the literature on the channels through which it can adversely affect the real economy we propose a new model to study the interaction of accounting rules with regulatory capital requirements and show that even when market prices always reflect fundamental values the interaction of fair value accounting rules and a simple capital requirement can create inefficiencies that are absent when capital is measured by adjusted book value these distortions can be avoided however by redefining capital requirements to be procyclical rather than by abandoning fair value accounting and the other benefits that it provides

credit market frictions and political failure we study how an excessively favorable regulatory environment for banks could arise even with a perfectly competitive credit market in a median voter world in our occupational choice model with heterogeneous wealth endowments market failure due to unobservability of entrepreneurial talent endogenously creates a misalignment between surplus maximizing reforms and reforms that are preferred by the median voter who is a worker this is in contrast to the world without market failure where the electorate unanimously vote in favor of surplus maximizing institutional reforms this paper illustrates how market failure could lead to political failure even in the benchmark political system that is free from capture by interest groups

government monetary and fiscal operations generalising the endogenous money approach the traditional endogenous money approach can be generalised substantially by including the insights of modern money theory regarding the necessary coordination of fiscal and monetary policies a monetarily sovereign government is composed of two entities involved in the issuance and redemption of government monetary instruments as such one should include the role of the treasury in monetary policy and the role of the central bank in fiscal policy the paper suggests a simple way to model that interaction shows some of the theoretical insights that can be drawn from that interaction and illustrates the relevance of that interaction with the monetary and fiscal practices of the us treasury and the federal reserve over the past century times of stress in the monetary system such as the recent great recession usually bring to light more forcefully this necessary interaction

risk models at risk the experience from the global financial crisis has raised serious concerns about the accuracy of standard risk measures as tools for the quantification of extreme downward risks a key reason for this is that risk measures are subject to a model risk due e g to specification and estimation uncertainty while regulators have proposed that financial institutions assess the model risk there is no accepted approach for computing such a risk we propose a remedy for this by a general framework for the computation of risk measures robust to model risk by empirically adjusting the imperfect risk forecasts by outcomes from backtesting frameworks considering the desirable quality of var models such as the frequency independence and magnitude of violations we also provide a fair comparison between the main risk models using the same metric that corresponds to model risk required corrections

financial markets in development and the development of financial markets what is the relationship between markets and development it is argued that markets promote growth and that growth in turn encourages the formation of markets two models with endogenous market formation are presented to analyze this issue the first examines the role that financial markets banks and stock markets play in allocating funds to the highest valued use in the economic system it is shown that intermediation will arise under weak conditions the second focuses on the role that markets play in supporting specialization in economic activity the consequences of perfect competition in market formation are highlighted

financial development and economic growth views and agenda this critique argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive first order relationship between financial development and economic growth the body of work would push even most skeptics toward the belief that the development of financial markets and institutions is a critical and inextricable part of the growth process and away from the view that the financial system is an inconsequential sideshow responding passively to economic growth many gaps remain however and the paper highlights areas in acute need of additional research

deposit insurance and wealth effects the value of being too big to fail this paper investigates the effect on bank equity values of the comptroller of the currency s announcement that some banks were too big to fail and that for those banks total deposit insurance would be provided using an event study methodology we find positive wealth effects accruing to tbtf banks with corresponding negative effects accruing to non included banks we demonstrate that the magnitude of these effects differed with bank solvency and size we also show that the policy to which the market reacted was that suggested by the wall street journal and not that actually intended by the comptroller the role of deposit insurance has become a topic of increasing debate advocates argue that by removing the incentive to run deposit insurance protects individual financial institutions from instability in the intermediation process thereby providing stability to the financial system as a whole 1 the recent rise in bank failures and the concomitant crises in the s l industry however demonstrate that this stability is not guaranteed moreover critics note that deposit insurance may introduce incentive problems and wealth effects into the financial system both of which can impede the effective functioning of any deposit insurance system these problems have prompted concern about the structure of the current deposit insurance system and have led to numerous proposals regarding its restructuring 2 this paper investigates one aspect of this debate by analyzing the effect on bank equity values of the policy decision to insure completely some banks but not others specifically in september 1984 the comptroller of the currency testified before congress that some banks were simply too big to fail tbtf and that for those banks total deposit insurance would be provided while not explicitly naming the banks the comptroller admitted that this policy would apply to the eleven largest banks using an event study methodology we analyze