Nicola Gennaioli

Sovereign Default, Domestic Banks, and Financial Institutions

We present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are costly because they destroy the balance sheets of domestic banks. In our model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign defaults. Our predictions: government defaults should lead to declines in private credit, and these declines should be larger in countries where financial institutions are more developed and banks hold more government bonds. In these same countries, government defaults should be less likely. Using a large panel of countries, we find evidence consistent with these predictions.

A Model of Shadow Banking

We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry-ups when investors ignore tail risks.

The Evolution of Common Law

We present a model of lawmaking by appellate courts in which judges influenced by policy preferences can distinguish precedents at some cost. We find a cost and a benefit of diversity of judicial views. Policy‐motivated judges distort the law away from efficiency, but diversity of judicial views also fosters legal evolution and increases the law’s precision. We call our central finding the Cardozo theorem: even when judges are motivated by personal agendas, legal evolution is, on average, beneficial because it washes out judicial biases and renders the law more precise. Our paper provides a theoretical foundation for the evolutionary adaptability of common law.

Judicial Discretion in Corporate Bankruptcy

We study a demand and supply model of judicial discretion in corporate bankruptcy. On the supply side, we assume that bankruptcy courts may be biased for debtors or creditors, and subject to career concerns. On the demand side, we assume that debtors (and creditors) can engage in forum shopping at some cost. A key finding is that stronger creditor protection in reorganization improves judicial incentives to resolve financial distress efficiently, preventing a “race to the bottom” towards inefficient uses of judicial discretion. The comparative statics of our model shed light on a lot of evidence on U.S. bankruptcy and yield novel predictions on how bankruptcy codes should affect firm-level outcomes. JEL classification: G33, K22.

State Capacity and Military Conflict

Powerful, centralized states controlling a large share of national income only begin to appear in Europe after 1500. We build a model that explains their emergence in response to the increasing importance of money for military success. When fiscal resources are not crucial for winning wars, the threat of external conflict stifles state building. As finance becomes critical, internally cohesive states invest in state capacity while divided states rationally drop out of the competition, causing divergence. We emphasize the role of the “Military Revolution�?, a sequence of technological innovations that transformed armed conflict. Using data from 374 battles, we investigate empirically both the importance of money for military success and patterns of state building in early modern Europe. The evidence is consistent with the predictions of our model.

Financial Innovation and Financial Fragility

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive. Financial innovation can make both investors and intermediaries worse off. The model mimics several facts from recent historical experiences, and points to new avenues for financial reform.

Judicial Fact Discretion

Following legal realists, we model the causes and consequences of trial judges exercising discretion in finding facts in a trial. We identify two motivations for the exercise of such discretion: judicial policy preferences and judges’ aversion to reversal on appeal when the law is unsettled. In the latter case, judges exercising fact discretion find the facts that fit the settled precedents, even when they have no policy preferences. In a standard model of a tort, judicial fact discretion leads to setting of damages unpredictable from true facts of the case but predictable from knowledge of judicial preferences, distorts the number and severity of accidents, and generates welfare losses. It also encourages litigants to take extreme positions in court and raises the incidence of litigation relative to settlement, especially in new and complex disputes for which the law is unsettled.

Expectations and Investment

Using micro data from Duke University quarterly survey of Chief Financial Officers, we show that corporate investment plans as well as actual investment are well explained by CFOs’ expectations of earnings growth. The information in expectations data is not subsumed by traditional variables, such as Tobin’s Q or discount rates. We also show that errors in CFO expectations of earnings growth are predictable from past earnings and other data, pointing to extrapolative structure of expectations and suggesting that expectations may not be rational. This evidence, like earlier findings in finance, points to the usefulness of data on actual expectations for understanding economic behavior.

Contractual Resolutions of Financial Distress

In a financial contracting model we study the optimal debt structure to resolve financial distress. We show that a debt structure where two distinct debt classes co-exist - one class fully concentrated and with control rights upon default, the other dispersed and without control rights - removes the controlling creditors liquidation bias when investor protection is strong. These results rationalize the use and the performance of floating charge financing, debt financing where the controlling creditor takes the entire business as collateral, in countries with strong investor protection. More broadly, our theory predicts that the efficiency of contractual resolutions of financial distress should increase with investor protection.

Standardized Enforcement: Access to Justice vs. Legal Innovation

The use of standard contracts is usually explained by generic transaction costs. In a model where more resourceful parties can distort enforcement, we show that standard contracts reduce enforcement distortions by simplifying judicial interpretation of preset terms, training judges on a subset of admissible evidence. In this setup, the introduction of a standard contract statically expands the volume of trade but it hampers legal and contractual innovation by crowding out the use of non-standard contracts. We rationalize the large scale standardization effort (by commercial codification and private standards) that occurred in Civil and Common Law systems in the XIX century during a period of booming commerce and long distance trade.