Essays on Financial Frictions

The 2008 financial crisis exposed risks inherent in the financial system and changed the structure of financial markets. It sparked an interest in frictions in the financial markets and their impact on the economy. The lessons of how markets behave in a crisis and its impact on the broader is a crucial area of research in developing a toolkit to handle future crises. Against this backdrop, the three chapters of this dissertation study explore three types of friction in markets and explore their macroeconomic impact. Impact of increasing bank concentration: A growing area of research has examined the effects of zombie loans on the broader economy. The literature, however, is generally silent regarding the processes that drive zombie lending. I present evidence that for banks with a substantial market share in a region, the fear of fire sales and the spill-over effects of a collapse in real estate prices on their lending portfolio (ultimately) prompts them to subsidize loans to distressed firms. This hinders the creative destruction process and reduces the investment and profitability of healthy firms. Impact of bank capital constraints: I document a new anomaly in the interest rate market. The variance risk premium in the interest rate market changed sign after the 2008 financial crisis and became positive. This is a puzzle because the variance risk premium compensates for bearing volatility risk, and previous studies have found a negative variance risk premium in multiple asset classes. We then demonstrate the impact of balance sheet constraints on the pricing of variance risk. Together these findings provide new evidence for the importance of intermediaries in asset pricing. Impact of biases on investments: The recovery in investment after the 2008 crisis was much slower than expected. More than a decade after the crisis, investments have yet to return to their pre-crisis trend. The final essay demonstrates how large shocks to volatility (such as the 2008 crisis) can persistently alter investors’ risk preferences. The final essay provides new evidence for volatility extrapolation without relying on survey data and quantifies its significant macroeconomic implication