Short-Term Funding Markets and Systemic Risk

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This dissertation presents two essays to study both theoretically and empirically the interaction of short-term funding and the banking system and its effects on systemic risk.

Before its collapse in September 2008, Lehman Brothers had been using the repurchase agreement (repo) market to hide up to $50 billion from their balance sheet at the end of each quarter. When this "Repo 105" scheme was uncovered (a type of strategy called window dressing), the Securities and Exchange Commission conducted an inquiry into public US financial institutions and concluded that Lehman was an isolated case. Using confidential regulatory data on daily repo transactions from July 2008 to July 2014, in my first essay, I show that non-US banks continue to remove an average of $170 billion from the US tri-party repo market every quarter-end. This amount is more than double the $76 billion market-wide drop in tri-party repo during the turmoil of the 2008 financial crisis and represents about 10% of the entire tri-party repo market. Window dressing induced deleveraging spills over into agency bond markets and money market funds and affects market quality each quarter.

Demand deposit contracts provide liquidity to investors; however by their nature they can expose the issuer to self-fulfilling runs. Existing models treat depositors as agents facing uncertain liquidity shocks, who seek to insure against that liquidity risk through use of a bank financed solely by deposits. Welfare-reducing bank runs then arise from the inherent difficulties depositors face in coordinating their withdrawals. My second essay extends the classic model of Diamond & Dybvig (1983) to allow for a more realistic mixed capital structure where the bank's investments are partly financed by equity, and where differing incentives between shareholders and depositors are allowed to operate. I also further extend the model to allow shareholders to choose the level of risk in bank-financed projects. I compute the ex-ante probability of a bank run in consideration of the bank capital ratio, and I additionally compute the level of bank risk chosen by utility-maximizing shareholders who are disciplined by uncoordinated depositors. I find that even in the absence of bank negotiating power of the form in Diamond & Rajan (2000), banks can be welfare-improving institutions, and there exists a socially optimal level of bank capital. I consider the policies of a minimum capital requirement, deposit insurance, and suspension of convertibility, and provide guidance on creating optimal bank regulation. I show that the level of bank capital involves a tradeoff between sharing portfolio risk and sharing liquidity risk. Increased bank capital results in less risk-sharing between shareholders and depositors. The demand deposit contract disciplines the bank and its shareholders, and equity capital in effect disciplines the depositors (by making runs less likely). There is a socially optimal level of natural bank capital, even when I make no further social planner restrictions on bank portfolio choice in the model.