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Credit Allocation

Paper Session

Friday, Jan. 5, 2018 8:00 AM - 10:00 AM

Pennsylvania Convention Center, 105-A
Hosted By: American Economic Association
  • Chair: Robert Rich, Federal Reserve Bank of New York

Bank Regulation Under Fire Sale Externalities

Gazi Kara
Federal Reserve Board
S. Mehmet Ozsoy
Ozyegin University


We examine the optimal design of and interaction between capital and liquidity regulations. Banks, not internalizing fire sale externalities, overinvest in risky assets and underinvest in liquid assets in the competitive equilibrium. Capital requirements can alleviate the inefficiency, but banks respond by decreasing their liquidity ratios. When capital requirements are the only available tool, the regulator tightens them to offset banks' lower liquidity ratios, leading to fewer risky assets and less liquidity compared with the second best. Macroprudential liquidity requirements that complement capital regulations implement the second best, improve financial stability, and allow for more investment in risky assets.

Credit Misallocation During the European Financial Crisis

Fabiano Schivardi
Guido Tabellini
Bocconi University
Enrico Sette
Bank of Italy


Do banks with low capital extend excessive credit to weak firms, and does this matter for aggregate efficiency? Using a unique data set that covers almost all bank-firm relationships in Italy in the period 2004-2013, we find that, during the Eurozone financial crisis: (i) Under-capitalized banks were less
likely to cut credit to non-viable firms. (ii)\ Credit misallocation increased the failure rate of healthy firms and reduced the failure rate of non viable firms. (iii) Nevertheless, the adverse effects of credit misallocation on the growth rate of healthier firms were negligible, and so were the effects on TFP dispersion. This goes against previous influential findings that, we argue, face serious identification problems. Thus, while banks with low capital can be an important source of aggregate inefficiency in the long run, their contribution to the severity of the great recession via capital misallocation was modest.

The Collateral Composition Channel

Russell Cooper
Pennsylvania State University
Frederic Boissay
Bank for International Settlements


Wholesale financial markets help reallocate deposits across heterogeneous banks. Because
of incentive problems, these flows are constrained and collateral is needed. The com-
position of collateral matters. The use of inside collateral, such as loans, creates a "collateral
pyramid", in that cash flows from one loan are pledged to secure another. Outside collateral,
such as treasuries, serves as a foundation of, and stabilizes, the pyramid. Through collateral
pyramids the financial sector can sustain a large volume of reallocation across banks, but
at the cost of systemic panics. During panics, the safe asset creation process stalls, the
pyramid collapses, collateral becomes scarce. The exposure to these panics depends on the
composition of collateral: all else the same, markets are more fragile when loans are secured
by inside collateral

Banking Competition and Shrouded Attributes: Evidence From the United States Mortgage Market

Sumit Agarwal
Georgetown University
Changcheng Song
National University of Singapore
Vincent Yao
Georgia State University


We document that banking deregulation increases competition, increased competition leads banks to offer lower initial rate on adjustable-rate mortgages (ARMs) to attract borrowers, but they also shroud these contracts by designing them with back-loaded resetting rates. Shrouding helps banks to offset about 73% of their losses from price discount due to competition. Deregulation increases the proportion of naïve borrowers, and banks shroud more where there is higher proportion of naïve borrowers. These results support the theory that sophisticated firms can exploit consumer biases by designing exploitative contracts. Although competition reduces firm revenues and benefits consumers initially, the overall effect is mitigated by the banks shrouding strategy.
JEL Classifications
  • G2 - Financial Institutions and Services