Florian Heider

Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk

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.

As Certain as Debt and Taxes: Estimating the Tax Sensitivity of Leverage from Exogenous State Tax Changes

We use a natural experiment in the form of 121 staggered changes in corporate income tax rates across U.S. states to show that tax considerations are a first-order determinant of firms capital structure choices. Over the period 1990-2011, firms increase long-term leverage by 104 basis points on average (or

Liquidity hoarding and interbank market rates: The role of counterparty risk

32.5 million in extra debt) in response to an average tax increase of 131 basis points. Contrary to static trade-off theory, the tax sensitivity of leverage is asymmetric: firms do not reduce leverage in response to tax cuts. Using treatment reversals, we find this to be true even within-firm: tax increases that are later reversed nonetheless lead to permanent increases in a firms leverage - an unexpected and novel form of hysteresis. Our findings are robust to various confounds such as unobserved variation in local business conditions, union power, or unemployment risk. Treatment effects are heterogeneous and confirm the tax channel: tax sensitivity is greater among profitable and investment-grade firms which respectively have a greater marginal tax benefit and lower marginal cost of issuing debt.

A Theory of Bank Liquidity Requirements

We develop a model of interbank lending and borrowing with counterparty risk. The model has two key ingredients. First, liquidity in the banking sector is endogenous, so there is an opportunity cost of holding liquid assets. Second, banks are privately informed about the risk of their long-term assets, which can lead to adverse selection and high interest rates in the interbank market. We identify a novel form of a market break-down, which can lead to liquidity hoarding. It arises because adverse selection in the interbank market changes the opportunity cost of holding liquidity. We use the model to shed light on developments in interbank markets prior to and during the 2007–09 financial crisis, as well as the effectiveness of policy interventions aimed at restoring interbank market activity.

The Benefit and Cost of Winner-Picking: Redistribution Vs. Incentives

We develop a theory of bank liquidity (cash reserve) requirements. Because cash is both observable and riskless, greater cash holdings improve bank incentives to manage risk in the remaining, non-cash portfolio of risky assets. In a model with a single bank, cash is held voluntarily to stem depositors incentives to withdraw funds early in response to adverse news. In a model with multiple banks and information externalities, deposit insurance may be optimal, and cash reserve requirements are needed to incentivize prudent behavior by banks. In a model with multiple banks subject to liquidity shocks, an interbank market can emerge as long as the group of banks imposes a cash requirement to prevent free riding on interbank liquidity assistance. Our theory has several implications for the design of liquidity regulation that are absent from existing regulatory initiatives.

The benefit and cost of winner-picking: redistribution versus incentives

Representative implementations of devices and techniques provide communication between networked nodes operating on a communication network medium. In an implementation, a node generates a broadcast frame that includes at least a preamble and a payload. The preamble of the broadcast frame may include supplemental information. The supplemental information may be associated with one or more symbols of the preamble. The supplemental information may contain predetermined header information for use by nodes operating on the communication network medium.

Life Below Zero: Bank Lending Under Negative Policy Rates

This paper examines the agency cost of winner-picking in multidivision firms and uses explicit incentive contracts to analyze the interaction between corporate headquarters´ investment and incentive policies. Winner-picking, i.e., the efficient reallocation of scarce resources in an internal capital market, adds an extra layer of noise to the moral-hazard problem of incentivizing division managers to produce the resources that can then be redistributed. In particular, division managers with strong future investment opportunities anticipate that headquarters will bail them out should they fail to produce enough resources themselves. This reduces incentives to create the resources in the first place, with possible consequences for the optimal investment policy.

Optimal margins and equilibrium prices

We show that negative policy rates affect the supply of bank credit in a novel way. Banks are reluctant to pass on negative rates to depositors, which increases the funding cost of high-deposit banks, and reduces their net worth, relative to low-deposit banks. As a consequence, the introduction of negative policy rates by the European Central Bank in mid-2014 leads to more risk taking and less lending by euro-area banks with greater reliance on deposit funding. Our results suggest that negative rates are less accommodative, and could pose a risk to financial stability, if lending is done by high-deposit banks.

On collateral: implications for financial stability and monetary policy

In order to share risk, protection buyers trade derivatives with protection sellers. Protection sellers actions affect the riskiness of their assets, which can create counterparty risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation margins. When margins are called, protection sellers must liquidate some assets, depressing asset prices. This tightens the incentive constraints of other protection sellers and reduces their ability to provide insurance. Despite this fire-sale externality, equilibrium is information-constrained efficient. Investors, who benefi t from buying assets at fire-sale prices, optimally supply insurance against the risk of fire sales.

The Determinants of Bank Capital Structure

This paper examines the role of collateral in the financial system, with special emphasis on the implications for financial stability and the conduct of monetary policy. First, we review what drives the demand and supply for both real and financial collateral assets. Then we examine financial stability issues and the case for regulating the use of collateral. We discuss the role and design of market infrastructures such as central clearing counterparties (CCPs). Finally, we examine the interaction of standard and non-standard monetary policy and the functioning of private collateralised markets. We show that the use of collateral is neither a sufficient nor a necessary condition for financial stability. To ensure the stability of collateralised markets a mix of micro- and macro-prudential regulation, as well as a sufficient supply of safe public assets that can be used as collateral, are needed. JEL Classification: E59, E44, G18