Francisco Covas

The Role of Debt and Equity Finance Over the Business Cycle

This paper documents that debt and equity issuance are procyclical for most size-sorted firm categories of listed U.S. firms. The procyclicality of equity issuance decreases monotonically with firm size. At the aggregate level, however, the results are not conclusive. The reason is that issuance is countercyclical for very large firms which, although few in number, have a large effect on the aggregate because of their enormous size. We show that the shadow price of external funds is procyclical if firms use the standard one-period contract. This model property generates procyclical equity and - as in the data - the procyclicality decreases with firm size. Another factor that causes equity to be procyclical in the model is a countercyclical cost of equity issuance. The calibrated model (i) generates a countercyclical default rate, (ii) generates a stronger cyclical response for small firms, and (iii) magnifies shocks, whereas the model without equity as an external financing source does the exact opposite.

Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence

This paper quantifies the procyclical effects of bank capital requirements in a general equilibrium model where financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs’ moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). We impose capital requirements under the assumption that raising funds through bank equity is more costly than through deposits. We consider the time-varying capital requirement (as in Basel II) as well as the constant requirement (as in Basel I). Importantly, under both regimes, the cost of issuing equity is higher during downturns. Comparing output fluctuations under the Basel I and Basel II economies with those in the no-requirement economy, we show that capital requirements significantly contribute to magnifying output fluctuations. The procyclicality is most pronounced around business cycle peaks and troughs.

Stress-testing US bank holding companies: A dynamic panel quantile regression approach

We propose an econometric framework for estimating capital shortfalls of bank holding companies (BHCs) under pre-specified macroeconomic scenarios. To capture the nonlinear dynamics of bank losses and revenues during periods of financial stress, we use a fixed effects quantile autoregressive (FE-QAR) model with exogenous macroeconomic covariates, an approach that delivers a superior out-of-sample forecasting performance relative to the standard linear framework. According to the out-of-sample forecasts, the realized net charge-offs during the 2007–09 crisis fall within the multi-step-ahead density forecasts implied by the FE-QAR model, but are frequently outside the density forecasts generated using the corresponding linear model. This difference reflects the fact that the linear specification substantially underestimates loan losses, especially for real estate loan portfolios. Employing the macroeconomic stress scenario used in CCAR 2012, we use the density forecasts generated by the FE-QAR model to simulate capital shortfalls for a panel of large BHCs. For almost all institutions in the sample, the FE-QAR model generates capital shortfalls that are considerably higher than those implied by its linear counterpart, which suggests that our approach has the potential to detect emerging vulnerabilities in the financial system.

Price-level versus inflation targeting with financial market imperfections

Price-level targeting (PT) is compared with inflation targeting (IT) in a DSGE model augmented with imperfections in both debt and equity markets. The PT regime outperforms the IT regime, and the gain depends on the degree of financial market frictions. This is because inflation is better anchored under PT, owing to the expectation channel, and therefore the monetary authority has more leverage to deal with the financial market distortions. We also find that the gain is higher if the optimal rule reacts to asset prices instead of the output gap, and the rule requires a positive response to asset prices.

Private Risk Premium and Aggregate Uncertainty in the Model of Uninsurable Investment Risk

This paper studies cyclical properties of the private risk premium in a model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks, both of which are assumed to be highly persistent. The calibrated model matches highly skewed wealth and income distributions of entrepreneurs found in the Survey of Consumer Finances. The authors provide an accurate numerical solution to the model even though the model is shown to exhibit serious nonlinearities that are absent in incomplete market models with idiosyncratic labor income risk. The model is able to generate the aggregate private risk premium of 2-3 percent and the low risk-free rate. However, it generates very little variation in these variables over the business cycle, suggesting that the model lacks the ability to amplify aggregate shocks. ; Superseded by Working Paper 11-18

Private Equity Premium in a General Equilibrium Model of Uninsurable Investment Risk

This paper studies the quantitative properties of a general equilibrium model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks in the presence of a borrowing constraint. The calibrated model matches the highly skewed wealth and income distributions of entrepreneurs. The authors provide an accurate solution to the model despite the significant nonlinearities that are absent in the economy with uninsurable labor income risk. The model is capable of generating the average private equity premium of roughly 3 percent and a low risk-free rate. The model also produces procyclicality of the risk-free rate and countercyclicality of the average private equity premium. The countercyclicality of the average equity premium is largely driven by tightening (loosening) of financing constraints during recessions (booms).

Capital Requirements in Supervisory Stress Tests and Their Adverse Impact on Small Business Lending

This paper estimates the implicit capital requirements in the U.S. supervisory stress tests. Our results show that stress tests are imposing dramatically higher capital requirements on certain asset classes – most notably, small business loans and residential mortgages – than bank internal models and Basel standardized models. By imposing higher capital requirements on loans to small businesses and mortgage loans, stress tests are likely curtailing credit availability for the types of borrowers that lack alternative sources of finance. In addition, we identify the impact of supervisory stress tests on the availability of credit to small businesses by analyzing differences in small business loan growth at banks subject to stress tests versus those that are not. Our results indicate that the U.S. stress tests are constraining the availability of small business loans secured by nonfarm nonresidential properties, which accounts for approximately half of small business loans on banks’ books.