Oren Sussman

A Theory of Financial Development

Introduction That financial structure and economic development are interrelated is a well known hypothesis (see Goldsmith, 1969, McKinnon, 1973, Shaw, 1973, Kuznets, 1971, Cameron, 1967 and Townsend, 1983; see also Gertler, 1988, for an excellent survey of the background and Greenwood and Jovanovic, 1989, for a recent contribution). In the present paper, we utilize some recent developments in the theory of contracts and the organization of financial markets (most notably Diamond, 1984, and Gale and Hellwig, 1985), in order to reformulate the financial development hypothesis in a way which is both theoretically comprehensible, and empirically testable. We focus on the ‘gross markup’ of the banking system, roughly the gap between the (real) rate at which banks borrow and lend money. This gap reflects (in addition to the more conventional default-premium component), the cost of financial intermediation. In the theoretical part we construct a spatial model of a monopolistically competitive banking system. When the capital stock increases, the market for financial intermediation grows, and the number of banks increases (due to entry). Each bank becomes more specialized, and thus efficient, over a smaller market share. Also, the industry becomes more competitive. As a result the cost of intermediation falls and the markup decreases. In the empirical part we present some evidence showing that the markup is lower in high-income countries relative to low-income countries.

Sovereign Debt without Default Penalties

We develop a theory of sovereign borrowing where default penalties are not implementable. We show that when debt is held by both domestic and foreign agents, the median voter might have an interest in serving it. Our theory has important practical implications regarding (a) the role of financial intermediaries in sovereign lending, (b) the effect of capital flows on price volatility including the possible overvaluation of debt to the point that the median voter is priced out of the market, and (c) debt restructuring where creditors are highly dispersed.

Optimal Exchange Rates: A Market Microstructure Approach

We analyze exchange-rate management by the central bank when it makes the FX market for the sake of social-welfare objectives. It is assumed that markets are incomplete, so that agents are exposed to exchange-rate volatility against which they cannot fully hedge. It follows that the central bank may provide insurance by smoothing the exchange rate. However, smoothing the exchange rate also creates arbitrage opportunities for spec-ulators. We show that the central bank cannot smooth the exchange rate and deter speculation at the same time. A Tobin tax may provide a way out.

Economic growth with standardized contracts

This paper is motivated by the observation that individuals sometimes tend to use a contract just because others have done so before. To put it more technically, the cost of executing a transaction under an existing standard seems to be much lower than doing so under a new innovation. The economic consequences of contract standardization are analyzed within an ordinary overlapping generations model. The main implications of contract standardization are that (i) financial history matters in the growth process, (ii) early formation of the system may create a drag on economic growth and (iii) the effect may be non-monotonic because the system may be modernized at some point.

A welfare analysis of the Diamond-Dybvig model

I show how to design a welfare-improving tax system for a Diamond-Dybvig (DD) related economy. In addition to its relevance to the DD literature, the paper constructs a nice example for a Pareto-improving intervention when markets are incomplete, and provides a welfare analysis of the market for liquidity.

A Response to Hackethal and Schmidt (2003) 'Financing Patterns: Measurement Concepts and Empirical Results'

Hackethal and Schmidt (2003) criticize a large body of literature on the financing of corporate sectors in different countries that questions some of the distinctions conventionally drawn between financial systems. Their criticism is directed against the use of net flows of finance and they propose alternative measures based on gross flows which they claim re-establish conventional distinctions. This paper argues that their criticism is invalid and that their alternative measures are misleading. There are real issues raised by the use of aggregate data but they are not the ones discussed in Hackethal and Schmidts paper.

A Welfare Analysis of Fragmented Liquidity Markets

The 2008 financial crisis heightened concerns about contagion across high leverage investors. Some have suggested that segmenting markets into stand alone units may contribute to financial stability and enhance social welfare. We provide a welfare analysis of segmentation policies in a two country model with endogenous financial crises and cross country contagion due to fire sales externalities. We model a continuous shock to liquidity demand in each country, which allows us to distinguish between crises, depending on their severity and endogenize crisis probabilities. We identify a new trade-off created by segmentation decisions. When countries segment, they are protected from contagion when their shocks are mild, but exposed to crisis when shocks are large and access to a neighbors liquidity is denied. This trade-off reduces welfare. We also show that segmentation only affects crisis probabilities when governments inject public liquidity. Then and only then can segmentation be welfare enhancing. Finally, failure to coordinate policies may lead to excessive segmentation when governments are involved in liquidity injection, but not when liquidity is provided solely privately.

Liquidity, Contagion and Financial Crisis

We develop a theoretical model where a redistribution of bank capital (e.g., due to reckless trading and/or faulty risk management) leads to a “freeze” of the interbank market. The fire-sale market plays a central role in spreading the crisis to the real economy. In crisis, credit rationing and liquidity hoarding appear simultaneously; endogenous levels of collateral (or margin requirements) are affected by both low fire-sale prices and high lending rates. Relative to previous analysis, this dual channel generates a stronger price and output effect. The main focus is on the policy analysis. We show that i) non-discriminating equity injections are more effective than liquidity injections, but in both the welfare effect is an order-of-magnitude lower than the price effect; ii) a discriminating policy that bails out only distressed banks is feasible but will be limited by incentive-compatibility constraints; iii) a restriction on international capital flows has an ambiguous effect on welfare.

The Privatization of Bankruptcy: Evidence from Financial Distress in the Shipping Industry

We study the resolution of financial distress in shipping, where the ex-territorial nature of assets has distanced the industry from on-shore bankruptcy legislation. We demonstrate how contracts and private institutions have adapted to the industry’s special circumstances so as to deliver an effective resolution of financial distress. We investigate three costs of distress: coordination failures leading to the arrest of ships, the direct costs of arrest and auction, and the fire sale discount. We find that most arrests are not caused by coordination failures but rather are precipitated by debtors whose equity is far out of the money and where the ships are close to their break up values. The direct costs of arrest and auction are 8% of a vessel’s value, and there is an average fire sale discount of 26%. However, when we control for the low quality of such ships (due to under-maintenance), their low value, and corrupt versus non corrupt ports, the discount virtually disappears. The results suggest that bankruptcy laws that are justified by coordination failures between creditors and large fire sale discounts, may not be necessary, at least for some industries.

Marketplace Lending, Information Aggregation, and Liquidity

“Fintech” innovations are redefining the boundaries between financial intermediaries and markets. In this paper, we study the recent experience of Funding Circle, a leading UK online marketplace that directly matches retail investors with small and medium size corporate borrowers. Recently, Funding Circle replaced its auction system, where both prices and loan allocations were determined by the market, with a posted price system, where only the allocation is determined by the market. An important focus of our analysis is the tradeoff between the information aggregation of auctions and their susceptibility to liquidity shortages. We show that auctions generate a price discovery process that reveals information that can improve the prediction of default events. At the same time, increasing difficulties in matching changes in the demand for loans to the supply of funds has led to a fall in the precision of that information over the sample period, and an increase in the volatility of interest rates. We believe this explains the eventual switch to posted prices.