Collateral requirements in central bank lending, Job Market Paper, [pdf]
Central banks around the world are intervening aggressively to cushion the impact of COVID-19. I develop a model of central bank lending in collateralized credit markets. In this model, borrowing constraints amplify adverse productivity shocks during a downturn because firms face a reduction in both their liquid wealth and the borrowing capacity of their collateral. When the downturn is severe, the central bank optimally responds by lending at more favorable interest rates while simultaneously reducing the haircuts imposed on eligible collateral. In doing so, the central bank takes on greater credit risk, but achieves an outcome that is more productively efficient than simply reducing the risk-free interest rate. Lastly, I show that anticipation of such intervention do not always generate greater inefficiencies ex ante.
The collateral rule: Theory for the credit default swap market (with Agostino Capponi and Stefano Giglio), Revise and resubmit, without commitment to ultimate publication, JME, [pdf]
We study the determinants of collateral requirements in central clearing houses for credit default swaps (CDSs). To do so, we develop a model of endogenous collateral requirements in the CDS market, where counterparties trade state-contingent promises backed by cash as collateral. Trading occurs due to differences in market participants’ beliefs about the uncertain states of the world. We show that it is the nature – rather than the degree – of these belief differences that determines collateral requirements in equilibrium. Specifically, the highly conservative levels of collateral observed in practice can be explained by the clearinghouse’s concerns over extreme tail events.
Capital requirements, the safe real interest rate and the fundamental problem of bank risk taking (with David Miles), [pdf]
We show that bank capital requirements, and variations in the safe real interest rate, operate as imperfect substitutes in countering a tendency for banks to take excessive risks. A tightening of capital requirements, or of the safe real interest rate, can improve ‘prudence’ by disincentivising banks against investing in risky assets with sub-optimally low returns; but only at the cost of decreased ‘participation’ whereby more banks will forego the opportunity to invest. Numerical simulations show that a substantial capital requirement is in general the appropriate policy response. The optimal capital requirement rises as the safe real interest rate falls.
Research in Progress
Multinomial max-min theorem: a generalisation of the binomial no-default theorem
The Binomial No-Default Theorem in Fostel and Geanakoplos (2015) states that “in binomial economies with financial assets serving as collateral, any equilibrium is equivalent in real allocations and prices to another equilibrium in which there is no default”. I extend this theorem to economies with more than two states of nature. For instance, with three states of nature, borrowers can issue both senior secured debt and junior subordinated debt. The terms and credit risks associated with each creditor tier are endogenously determined. The Multinomial Max-Min theorem states that any equilibrium is equivalent to another equilibrium where the senior tranche never defaults, and the junior tranche only defaults in the worst state of the world. The expanded theorem allows for the application of the endogenous leverage framework to a richer set of models.
Supply network fragility (with Agostino Capponi and Joseph Stiglitz)