Origins and Transmission of Financial Market Risks

The financial crisis of 2008 has renewed economists’ interest in understanding the causes and consequences of financial instability. This project seeks to make progress on this broad question by focusing on: i) the buildup of risks in financial markets, ii) the transmission of these risks to the real economy, and iii) the consequences of financial regulation on the allocation of credit. With respect to the buildup of risks, we buttress the importance of measuring and analyzing market expectations. Starting from Shiller (1981), behavioral finance has studied the link between non-rational beliefs and asset price volatility. It has done so indirectly, through the predictability of security returns. Our innovation is to directly analyze market beliefs. In one paper, we plan to use data on financial analysts’ expectations of firms’ future earnings. The goal is to assess the extent to which the volatility of the U.S. stock index is driven by volatility in these expectations rather than by discount rate variation, as in conventional accounts. Financial analysts represent only a subset of market participants, which raises the issue of whether or not their beliefs are widely shared. To obtain broader measures of beliefs, in a second set of papers we use the Ross Recovery Theorem (2015) to recover market-wide beliefs from asset-prices data. We first focus on the U.S. corporate bond market, which has received significant attention in recent work. We plan to test whether recovered beliefs are rational or not, whether they display excess volatility, and whether they match professional forecasters’ beliefs. Of course, asset prices are not only influenced by rational or irrational short term volatility in beliefs. They are also affected slow moving secular factors. In a third paper, we seek to assess whether demographics constitutes one important such driver by studying its explanatory power with respect to the total returns of different asset classes in a large sample of countries from 1870 to 2015. This analysis can shed light on highly persistent shocks that can have lasting repercussions in the financial sector or public pension systems. We next analyze how financial market risks influence the real economy through their effects on non-financial firms. In one paper we study how fluctuations in credit spreads affect real investment by firms. Relative to existing work, our innovation is to consider firm-level evidence, which improves our ability to tease out demand and supply factors. In a second paper we study - both theoretically and empirically - the possibility that enhanced risk may affect the payout and investment policies pursued by firms, generating a precautionary demand for cash. Finally, we investigate the consequences of financial stability regulation. In particular, we study how regulations implemented after the 2008 crisis affected the allocation of resources in the real economy via the bank lending channel. In one paper, we consider regulation of the banks’ liability side. New liquidity regulation requires banks to increase reliance on retail deposits as opposed to other forms of short-term funding. To assess this policy, we ask: does greater reliance on deposits influence banks’ lending policies during a crisis? We focus on the Italian tax reform of September 2011, which eliminated a tax disadvantage of bank deposits for households. This reform allows us to study how a shock to the demand for bank deposits affected loan maturity as well as other bank policies during the 2011 sovereign crisis in Italy. In another paper we return to banks’ asset side to study the consequences of different accounting rules for loan provisioning, which play a key role in banking sectors burdened with non-performing loans during a crisis. To do so, we exploit variation in loan provisioning rules induced by the recent adoption of the IFRS9 accounting standard to identify the effects on banks’ credit allocation and the characteristics of loan contracts.