Essays on Finance and Macroeconomics

Essays on Finance and Macroeconomics Cynthia Mei Balloch My dissertation studies the impact of banks on macroeconomic outcomes. Chapter 1 explores the effects of bond market growth on the financing decisions of firms, the lending behavior of banks, and the resulting equilibrium allocation of credit and capital. This chapter makes three contributions to understand the impact of bond market liberalization. First, using evidence from reforms in Japan that gave borrowers selective access to bond markets during the 1980s, it shows that firms that obtained access to the bond market used bond issuance to pay back bank debt. More importantly, this large, positive funding shock led banks to increase lending to small and medium enterprises and real estate firms. Second, it proposes a model of financial frictions that is consistent with the empirical findings, and uses the model to derive general conditions under which bond liberalization has this effect on banks. The model predicts that bond liberalization can significantly worsen the quality of the pool of bank borrowers, and so lower bank profitability. These results suggest that Japan’s bond market liberalization contributed to both the real estate bubble in the 1980s and bank problems in the 1990s. Third, the model implies that bond markets amplify the effects of shocks to the risk-free rate and firm borrowing, in addition to attenuating the effects of financial shocks. In Chapter 2, I explore how the incentives of domestic banks and sovereign governments interact. I build a model of government default and banks that invest in the debt of their own sovereign. In the model, banks demand safe assets to use as collateral, and default affects bank equity. These losses inhibit banks’ ability to attract deposits, leading to lower private credit provision, and lower output. This disincentivizes the sovereign from defaulting. The extent of output losses depends on characteristics of the banking system, including sovereign exposures, equity, and deposits. In turn, bank exposures are affected by default risk. The model is also used to show that policies such as financial repression can improve welfare, but worsen output losses in the event of default, and may also worsen losses in some non-default states. Underlying much research on the role of financial intermediaries in macroeconomics is an implicit recognition that there is matching between banks and firms, which I turn to in Chapter 3. Matching between banks and firms has implications for both the transmission of macroeconomic shocks and for empirical estimates of the effects of such shocks. This paper presents a theory of matching in corporate loan markets, between heterogeneous banks and heterogenous firms. The model demonstrates how assortative matching can cause shocks to have distributional consequences, where particular types of banks and firms are disproportionately affected. The framework is used to show (1) why growth without financial development is limited, (2) how capital inflows affect bank and firm outcomes, and (3) how financial regulation for certain banks also has implications for other borrowers and lenders. Further, this theory demonstrates that matching in corporate lending markets is analytically tractable, and generates predictions that are consistent with existing empirical evidence.