Abstract: In this paper, we evaluate the effectiveness of macroprudential capital requirements in the form of Value at Risk and three alternative spectral risk measures from the systemic risk perspective. Overall, we find that prudential instruments based on salience and overweighting of tail market losses are beneficial for policymakers aimed to limit the procyclicality in the financial sector and reduce the likelihood of the systemic crises. In the steady-state, the financial sector exhibits risk-seeking attitudes when the risky asset upside is salient and risk-averse behavior when the downside is salient. In contrast, the overweighting of almost certain market losses results in a rapid leverage acceleration and risk-seeking preferences and exacerbates systemic risk. More important, focusing on both upside and downside risks fulfills the prudential objective of building a more resilient financial system. Our model illuminates how adverse liquidity and uncertainty shocks elicit policy responses, but also how they affect risk attitudes and the time and cross-sectional dimension of systemic risk.
- Marcel Proust-
“The voyage of discovery is not in seeking new landscapes, but having new eyes.”
Work in Progress
The Employment Effects of Corporate Tax Shocks: New Evidence and Some Theory (with Vivien Lewis and Andrea Colciago)
Abstract: A substantial amount of job creation and destruction is associated with firm entry and exit. This paper asks whether corporate tax changes affect employment through firm turnover. We first identify the effect of a corporate income tax cut on the net business and job creation in US data, using a narrative approach. We find a significant positive, though delayed, impact on job creation through the firm entry and an immediate reduction in job losses through lower firm exit rates. Wages of new hires rise significantly, while aggregate wages exhibit a persistent rise in the wake of the policy change. Second, we show that the popular general equilibrium business cycle model with entry, exit and heterogeneous firms is inconsistent with several patterns observed in the data.
Macroeconomics with Financial Sector Risk Constraints
Abstract: This paper presents a two-period simple macro model with the financial sector optimizing under the risk-based capital requirements. The goal of the optimal prudential policy is to maximize welfare by encouraging or discouraging risk-taking but to accomplish this objective through market risk measures and deposit insurance design. If fixed deposit insurance is unavailable, the optimal Value at Risk policy includes countercyclical loss probabilities. With deposit insurance, optimal capital requirements are higher in comparison to VaR capital regulation. Moreover, the optimal policy is procyclical or countercyclical depending on creditors' risk aversion. We also find that the Expected Shortfall embedded in the Basel III is optimal if creditors are risk-neutral and insurance regime with a fixed fee and variable compensation is provided. Our main message is that providing deposit insurance is suboptimal in terms of welfare levels in the absence of significant social costs of bank failure. Comparing different insurance regimes, we find that it is optimal for regulators not to neglect tail market outcomes when creditors are protected by deposit insurance.
Estimating the Probability Weighting Function during the Great Recession
Abstract: This paper empirically tests theories of financial sector decision making under uncertainty in the Great Recession, in particular, prospect theory. Specifically, we estimate the probability weighting function from the asset pricing of the largest banks that were recapitalized under the Capital Purchase Program. We first present model where banks are subject to capital requirements in the form of a distortion risk measure. The results suggest that banks tend to overweight small probability losses during the financial distress and underweight the same when not exposed to insolvency risk. In the long-run, big banks overweight losses of small probabilities and underweight large probabilities, consistent with prospect theory.