Essays on financial instability

This dissertation is composed of three separate, but also related, essays on financial instability. It focuses on the broad question of how the stability of the banking system can be improved or undermined by financial innovations and evolving government policies. Chapter 1 investigates the potential impact from the introduction of a privacy-preserving payment method. Chapter 2 analyzes the interaction between banking competition and fragility under bailout policy. Chapter 3 provides a novel government guarantee mechanism to explain the growth of the Chinese shadow banking sector after the recent global financial crisis. In each chapter, I explore the underlying mechanisms through which changes in the environment affect financial stability and draw some policy implications. In chapter 1, I study how lenders’ access to the information in borrowers’ payments data affects financial stability and welfare. Some policy makers have expressed concern that if households and firms shift from using bank deposits to digital currencies or other payment methods, banks will have less information about their customers and, as a result, will end up taking more risk. My paper shows that this change does not necessarily make banks riskier. I construct a model in which borrowers have heterogeneous incentives to keep their production information private from their lenders. Banks pool depositors’ resources and choose a portfolio of liquid reserves and illiquid loans. If a bank observes a borrowers’ payment data, it can better infer the loan quality and more quickly terminate projects with low pledgeable returns. When borrowers use alternative payment methods, they effectively delay the bank’s acquisition of this information. I show that both bank deposits and the alternative payment method are used in equilibrium. Borrowers who value privacy more will use the privacy preserving payment and face a higher interest rate, contributing to lower aggregate loan demand. Banks respond to the changing composition of borrowers by holding more liquid assets. As a result, the probability of a liquidity shortage decreases in equilibrium, meaning that banks are more stable. In addition, a tradeoff in welfare arises: privacy in payments makes borrowers better off but leaves depositors worse off. In chapter 2, I revisit the classic question of how banking competition affects financial stability. I identify a new channel that makes the banking system more fragile when banking competition intensifies and interacts with bailout policy. Using a model of spatial competition, I show that a more competitive banking system will be larger because it issues more total liabilities to depositors. In the event of a bank run, a government with limited resources will then choose bailout amounts that are smaller as a fraction of banks’ liabilities. Depositors anticipate these smaller bailouts and, therefore, have a stronger incentive to run on their banks. In other words, increased competition can make the banking system “too big to save.” A prime example of this mechanism at work is the 2008 banking crisis in Iceland, during which the deposit guarantee fund could not meet depositors’ claims, and there was a rush to withdraw. As a policy implication, I show that a form of interest rate ceiling policy is more efficient to promote financial stability than restricting competition. In chapter 3, I study the role of government guarantees in credit lending. This paper is motivated by the intriguing growth of the Chinese shadow banking sector after the global financial crisis, in which government guarantees are believed to play a crucial role. Such guarantees can turn information-sensitive investments into insensitive ones, which changes depositors’ investment incentives. When the underlying investment’s verification cost and risk are high, government guarantees facilitate lending and help borrowers obtain a more efficient level of funding. However, they come with the cost of reducing public-good provision and may lead to instability in the banking system. This tradeoff highlights both the pros and cons of government guarantees.Ph.D.Includes bibliographical reference