Essays on Financial Crises and Financial Regulation

Abstract

This dissertation studies the optimal regulatory response to financial crises. The first two chapters focus on prevention of financial crises, and the third chapter focuses on resolution of financial crises. Chapter 1 develops a quantitative theory of overborrowing based on a systemic risk externality in an emerging market economy. In the model, debt denominated in foreign currency and balance sheet constraints cause depreciations of the real exchange rate to be contractionary. The externality arises because when private agents take debt in good times, they do not internalize that during bad times, the reduction in demand for consumption causes a higher depreciation of the real exchange rate and a further tightening of balance sheet constraints across the economy. The quantitative analysis suggests that there is an important role for policies that ``throw sand in the wheels of international finance." Chapter 2 analyzes an externality that arises because of a feedback loop between asset prices and collateral constraints in a dynamic stochastic general equilibrium model calibrated to US data. In the model, a collateral constraint limits private agents not to borrow more than a fraction of the market value of their collateral assets, which take the form of an asset in fixed aggregate supply (e.g. land). When the collateral constraint binds, fire-sales of assets cause a Fisherian debt-deflation spiral that causes asset prices to decline and the economy's borrowing ability to shrink in an endogenous feedback loop. The externality produces deeper recessions and a larger collapse in asset prices compared to the constrained efficient allocations. Chapter 3 studies the macroeconomic and welfare effects of government intervention in credit markets during financial crises. A DSGE model to assess the interaction between ex-post interventions in credit markets and the build-up of risk ex ante is developed. During a systemic crisis, the central bank finds it beneficial to bail out the financial sector to relax balance sheet constraints across the economy. Ex ante, this leads to an increase in risk-taking, making the economy more vulnerable to a financial crisis. We ask whether the central bank should commit to avoiding a bailout of the financial sector during a systemic crisis. We find that bailouts can improve welfare by providing insurance against systemic financial crises.