PAPERS

“Risk, Uncertainty and Monetary Policy,” (with Geert Bekaert, Columbia GSB and Marco Lo Duca, ECB), February 2010. -NEW-

We document a strong co-movement between the VIX, the stock market option-based implied volatility, and monetary policy. We decompose the VIX into two components, a measure of risk-aversion and expected stock market volatility ("uncertainty"), and analyze their dynamic interactions with monetary policy in a structural vector autoregressive framework. A lax monetary policy decreases risk aversion after about six months. Monetary authorities react to periods of high uncertainty by easing monetary policy. These results are robust to controlling for business cycle movements. We further investigate channels through which monetary policy may affect risk aversion, e.g., through its effects on broad liquidity measures and credit.

“Interbank Lending, Credit Risk Premia and Collateral,” (with Florian Heider, ECB), International Journal of Central Banking, Vol. 5, No. 4, pp. 1-39, December 2009. -NEW-

We study the functioning of secured and unsecured interbank markets in the presence of credit risk. The model generates empirical predictions that are in line with developments during the 2007-2009 financial crises. Interest rates decouple across secured and unsecured markets following an adverse shock to credit risk. The scarcity of underlying collateral may amplify the volatility of interest rates in secured markets. We use the model to discuss various policy responses to the crisis.

“Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk,” (with Florian Heider, ECB and Cornelia Holhausen, ECB), ECB Working Paper No. 1126, December 2009. -UPDATED-

We study the functioning and possible breakdown of the interbank market in the presence of counterparty risk. We allow banks to have private information about the risk of their assets. We show how banks' asset risk affects funding liquidity in the interbank market. Several interbank market regimes can arise: i) normal state with low interest rates; ii) turmoil state with adverse selection and elevated rates; and iii) market breakdown with liquidity hoarding. We provide an explanation for observed developments in the interbank market before and during the 2007-09 financial crisis (dramatic increases of unsecured rates and excess reserves banks hold, as well as the inability of massive liquidity injections by central banks to restore interbank activity). We use the model to discuss various policy responses.

“Money Talks,” (with Cyril Monnet, FRB Philadelphia and Ted Temzelides, Rice University), ECB Working Paper No. 1091, September 2009.

We study credible information transmission by a benevolent short-lived central bank. We consider two possibilities: direct revelation through an announcement, versus indirect transmission through monetary policy. These two ways of transmitting information have very different consequences. Since the objectives of the central bank and those of individual investors are not always aligned, private investors might rationally ignore announcements by the central bank. In contrast, information transmission through changes in the interest rate creates a distortion, thus lending an amount of credibility. This induces the private investors to rationally take into account information revealed through monetary policy.

“What Do Asset Prices Have to Say About Risk and Uncertainty?” (with Geert Bekaert, Columbia GSB and Martin Scheicher, ECB), ECB Working Paper No. 1037, March 2009.

Implied volatility indices should have information about risk parameters, once they are cleansed of the influence of normal volatility dynamics and macroeconomic uncertainty. Building on intuition from the dynamic asset pricing literature, we uncover unobserved risk aversion and fundamental uncertainty from the observed time series of the VIX and the credit spreads while controlling for realized volatility, expectations about the macroeconomic outlook, and interest rates. We apply this methodology to monthly data from both Germany and the US. We find that implied volatilities contain a substantial amount of information regarding risk aversion whereas credit spreads have a lot to say about both risk aversion and uncertainty. Moreover, there is a significant comovement in the German and US risk aversion.

“Run-prone Banking and Asset Markets,” ECB Working Paper No. 845, December 2007. An earlier version: “Financial Deepening and Bank Runs,” Working Paper 05-07, Center for Analytic Economics, Cornell University, Ithaca, May 2005.

I analyze the role that asset markets play in the performance and stability of the run-prone banking sector. Banks insure consumers against privately observed liquidity shocks. Asset market investments insure consumers against losses from bank runs. If the probability of a run is small, then banks specialize fully into the provision of liquidity insurance: They provide a higher degree of liquidity insurance when compared to the economy with banks alone. If the probability of a run is high, consumers prefer to invest solely through the asset market. Insurance against runs provided by the market investment reduces consumers' incentives to run. Increased provision of liquidity insurance by banks has the opposite effect. I derive conditions under which the latter effect dominates and the probability of a run is higher than with banks alone.

“Financial System in Development: Implications for the Liquidity Provision,” May 2005.

I study liquidity provision by a financial system consisting of run-prone banks and an asset market which is illiquid due to limited market participation. I find that for low probabilities of a run, banks enhance the supply liquidity to the asset market and asset prices are higher than in the economy with asset markets alone. This enables consumers to economize on liquid asset holdings (Diamond 1997). By contrast, if there is a run, banks need to liquidate their portfolio holdings by selling them in the asset market and this depresses asset prices. As a result, as the banking sector becomes more unstable, consumers hedge against the state of the world in which liquidity is scarce by holding part of their portfolio in liquid funds. Such an outcome is inefficient since a smaller amount is devoted to the long-term (productive) asset.

WORK IN PROGRESS

Financial Stability and Monetary Policy Money Markets and Asymmetric Information Financial Innovation, Market Discipline and Regulatory Design