Essays in financial economics

Abstract

In the first chapter we examine the effects of limited liability on mortgage dynamics. While the literature has focused on default rates, renegotiation, or loan rates individually, we study them together as equilibrium outcomes of the strategic interaction between lenders and borrowers. We present a simple model of default and renegotiation where the degree of limited liability plays a key role in agents' strategies. We then use Fannie Mae loan performance data to test the predictions of the model. We focus on Metropolitan Statistical Areas that are crossed by a State border in order to exploit the discontinuity in regulation around the borders of States. As predicted by the model, we find that limited liability results in higher default rates and renegotiation rates. Regarding loan pricing, while the model predicts higher interest rates for limited liability loans, we find no such evidence in the Fannie Mae data. We further investigate this by using loan application data, which contains the interest rates on loans sold to private vs public investors. We find that private investors do price in the difference in ex-ante predictable default risk for limited liability loans. The second chapter estimates the effect of deposit insurance on the risktaking behaviour of banks. As shown in the theoretical literature, deposit insurance may induce moral hazard and incentivise banks to take on more risk. We provide an experimental setup in which we exploit an increase in the coverage limit of deposit insurance in the U.S. in order to identify the difference in risk-taking by banks that were affected and banks that were not. This difference comes from the fact that state-chartered savings banks in Massachusetts had unlimited deposit insurance coverage at the time when it was increased for all other banks in the US. Given that all banks in the sample are subject to the same regulatory and supervisory requirements, and that they are similar in other characteristics, we can isolate the effect of such an increase in deposit insurance. We find, contrary to the literature, that this increase in deposit insurance did not increase bank risk-taking, nor did it affect market discipline, evident through a lack of effect on deposit rates. In the third chapter, I estimate the interest rate pass-through in the Euro Area using transaction-level data on all money market transactions performed by the 52 largest banks in the Euro Area. This allows me to first, move beyond the use of an aggregate rate such as EONIA for pass-through estimation, and second, exploit the cross-sectional variation in collateral characteristics underlying each transaction as an instrument for the identification of individual banks' money market rates. I find that the interest rate pass-through is smaller than estimated in the literature once confounding factors and reverse causality are addressed. I also find that banks pass on short-term rates differently across firms and households and across different maturities.