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FIIT-3: Financial Institutions: Risks & Profit Sharing
Markets, Banks and Shadow Banks
1Universidad Carlos III de Madrid; 2CEMFI
We analyze the effect of bank capital regulation on the structure and risk of the financial system. Banks intermediate between entrepreneurs and investors, and can monitor entrepreneurs' projects. Monitoring is not observed by investors, so there is a moral hazard problem. Banks choose whether to be subject to the regulation, in which case a supervisor certifies their capital, or not be subject to it, in which case they have to resort to more expensive private certification. Market finance, regulated banks, and shadow banks can coexist in equilibrium. Under both flat and risk-based capital requirements, safer entrepreneurs borrow from the market and riskier entrepreneurs borrow from intermediaries. The difference is that flat (risk-based) requirements are especially costly for relatively safe (risky) entrepreneurs which may be better off borrowing from shadow banks. We compare these regulations in terms of welfare, and characterize the optimal requirements taking into account the existence of both market and shadow bank finance. 0.2in
Asset Encumbrance, Bank Funding and Fragility
1Bank of Canada; 2Deutsche Bundesbank; 3University of Auckland
We offer a model of asset encumbrance by banks subject to rollover risk and study how secured debt issuance influences fragility, funding costs, and welfare. A banker encumbers assets to trade off expanding profitable investment funded with secured debt with greater fragility due to unsecured debt runs. We derive several testable implications about the privately optimal level of encumbrance. A constrained planner encumbers more assets, since the bankruptcy-remote pool of assets satisfies a demand for safety. We evaluate the efficacy of policy tools aimed at boosting private encumbrance levels, including interest rate cuts, capital injections, guarantees, lender of last resort, and stable funding ratios.
Profit Sharing: A Contracting Solution to Harness the Wisdom of the Crowd
George Mason University
In the context of financing a risky project from a group of investors with dispersed private information, I show that simple profit-sharing contracts with decentralized decision making could first best coordinate individuals' investment choices, and hence optimally utilize the group's collective wisdom. This result extends the traditional diversification insight underpinning portfolio theory to applications in information economics. In an information age, the role of profit sharing in harnessing the wisdom of the crowd could provide guidance for the organization of many business activities, including the optimal contract design for the emerging practice of security-based crowdfunding.
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Conference: EFA 2017
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