Three essays on financial fragility and regulation

My academic work explores issues in banking, prudential regulation, and financial fragility. In my first paper, I study how changes in the returns on banks’ assets affect financial fragility using a model in the tradition of Diamond and Dybvig (1983). In my second paper, the analysis is based on this work augmented to include fiscal policy and bailouts as in Keister (2015). I explore how imposing regulations on both sides of banks’ balance sheets can be used to bring about a stable financial system. My third paper further explores the policy implications of my second paper by incorporating the comparative-statics effects studied in my first paper. What configuration of interest rates will make the banking system most susceptible to a self-fulfilling run? In Chapter 2, I study this question in a version of the model of Diamond and Dybvig (1983) with limited commitment and a non-trivial portfolio choice. I show that the relationship between the returns on banks’ assets and financial fragility is often non-monotone: a higher interest rate may make banks either more or less susceptible to a run by depositors. The same is true for changes in the liquidation cost and the term premium. I derive precise conditions under which changes in each of these returns increase or decrease financial fragility. In Chapter 3, I analyze a version of the Diamond-Dybvig (1983) model of financial intermediation in which bailouts create multiple distortions. Banks anticipate that the policy maker will respond to a crisis with transfers that partially cover their losses, which leads them to hold a more illiquid portfolio of assets and to offer higher payments to depositors who withdraw early. These actions, in turn, tend to make the financial system more fragile. In general, fully correcting these distortions requires restricting both banks’ choice of assets (i.e., liquidity regulation) and their short-term liabilities. However, I show that removing the policy maker’s ability to impose liquidity regulation can sometimes promote financial stability. Chapter 4 studies how the changes in the liquidation cost influence the optimal policy mix. The main result is that implementing a regulation similar to the liquidity coverage ratio is optimal if the liquidation cost is very high. It is optimal to remove the liquidity requirement, in contrast, if the liquidation cost is lower.Ph.D.Includes bibliographical referencesby Yang L