Essays in Financial Economics

This thesis examines the relationship between regulation and financial innovation, salience and financial fragility, and subprime mortgages and lending bubbles. In Chapter 1, we consider a model of two competing banks offering deposit contracts to households. The traditional bank can only invest in risk-free assets and offers risk-free deposits, while the other, risk-taking bank invests in risky assets and offers a risky contract with a higher return. Risk-averse households invest their wealth within the financial sector in order to trade in the subsequent period with a producer. The producer, representing the real economy, bears a capacity adjustment cost if he encounters demand fluctuations. Thus, by investing in the risky technology, the risk-taking bank creates an externality for the real sector through the contract it provides to households. Within this framework we investigate the role of regulation and financial innovation. The main result of this study is that, even in an extreme scenario where, by innovating, the risky bank can fully bypass regulation, regulation is still effective in reducing overall risk. This is due to the fact that regulation generates a “composition effect”, diverting funds away from the “innovative” bank towards the traditional one. In Chapter 2, we show that salience theory can explain excess volatility of asset prices, and the resulting fire-sales in periods of financial turmoil. Here we classify risk into two types, idiosyncratic and systemic, and postulate that investors over-weigh the type of risk that is salient. Either component of risk (systemic or idiosyncratic) becomes salient when its realisation deviates sufficiently from a reference point. We show that a change in salience – from one component (idiosyncratic) to the other (systemic) – will generate excess volatility. Interestingly, higher risk aversion generally exacerbates excess volatility of prices. In Chapter 3, we consider a model with two types of households; the poor with no initial endowment and the rich with positive endowment, and two types of assets; properties in a poor area and properties in a rich area. In the model, the poor agents require credit to buy an asset, whereas the rich can draw from their endowment. We show that credit-fuelled housing bubbles sometimes may improve welfare, making poorer individuals better-off. More precisely, there exist two types of equilibria in both markets: One is a bubble equilibrium, and the other is an equilibrium where asset prices are stable over time. While the poor always obtain a positive surplus in the bubble equilibrium, this is not necessarily true for the rich. Our results suggest there may be scope for market interventions aimed at sustaining the value of assets held by credit-constrained agents after the burst of a credit bubble.