Bank Cost of Capital
Saturday, Jan. 4, 2020 8:00 AM - 10:00 AM (PDT)
- Chair: Juliane Begenau, Stanford University
Distressed Banks, Debt Overhang, and Regulation
AbstractExisting literature predicts that highly-levered distressed banks suffer from a debt overhang that leads them to take more risk and avoid actions that decrease their leverage. Using two distinct periods that include financial crises and are subject to different regulations (1985-1994, 2005-2014), we investigate whether these predictions are supported. We find that distressed banks reduce their leverage in various forms: increase their equity, reduce the size of their balance sheet, reduce the number of branches and employees. They also decrease observable measures of riskiness. The global financial crisis is associated with weaker deleveraging. We show that the deleveraging of distressed banks increases after the adoption of FDICIA and does not increase after the adoption of Dodd-Frank compared to the pre-global financial crisis period.
Can Risk Be Shared Across Investor Cohorts? Evidence from a Popular Savings Product
This paper shows how one of the most popular savings products in Europe – life insurance financial products – shares market risk across investor cohorts. Insurers smooth returns by varying reserves that offset fluctuations in asset returns. Reserves are passed on between successive investor cohorts, causing redistribution across cohorts. Using regulatory and survey data on the 1.4 trillion euro French market, we estimate this redistribution to be quantitatively large: 1.4% of savings value per year on average, or 0.8% of GDP. These findings challenge a large theoretical literature that assumes inter-cohort risk sharing is impossible. We develop and provide evidence for a model in which the elasticity of investor demand to predictable returns determines the amount of risk sharing that is possible. The evidence is consistent with low elasticity, sustaining inter-cohort risk sharing despite predictable returns. Demand elasticity is higher for investors with a larger investment amount, suggesting that low investor sophistication enables inter-cohort risk sharing.
- G2 - Financial Institutions and Services