This paper embeds panic-based runs in financial markets into the analysis of the fragility of financial networks. Panics can be contagious when banks are interconnected. During normal times, when no bank falls into distress before its creditors make their withdrawal decisions, I find a novel mechanism to show that financial networks with weaker connections (corresponding to a more diversified pattern of interbank liabilities) will trigger more panics and, in that sense, be more fragile. When one bank in the network receives a shock that is large enough to make it insolvent, creditors may be uncertain about the financial linkages between their bank and the initial distressed bank. In such a situation, when a crisis is underway, I show that information disclosure is likely to trigger more panics from the initial distressed bank and facilitate financial contagion. In this context, less diversified networks are more sensitive to creditors' information and beliefs about the location of the initial distressed bank, and could be more fragile. I find that, in core periphery networks, core banks with higher exposures and more counterparties will face more panics from their creditors. Moreover, the financial system becomes more fragile when core banks intermediate more loans with periphery banks.
Revise and Resubmit at American Economic Review
Agents face strategic uncertainty in a coordination problem that is akin to debt rollover or currency attacks. We model this as a global game of regime change. A principal wants her preferred regime (PPR) to succeed. She faces the coordination risk that a viable PPR may fail due to the strategic uncertainty. The principal diffuses this coordination risk by making a finite partition of the mass of agents. She abandons her preferred regime if it is no longer viable. We show that with a sufficiently diffused policy, the risk that agents may attack the PPR unravels from the end.
Research in Progress:
"Asymmetric Information, Rollover Risk and Debt Maturity Structure" with Xu Wei and Ho-Mou Wu
Why were financial institutions so reliant on short-term borrowing before the great recession, thereby exposing themselves to a significant amount of rollover risk and why did the market of short-term lending collapse after the recession began? This paper tries to provide an answer to these questions by building a model of optimal debt maturity with information asymmetry. When outside creditors do not have complete information about the firms' asset qualities, good firms are willing to borrow short-term debts, because the extra information released to creditors in the rollover stage could help to distinguish them from bad firms and thus lower their costs of refinancing. This paper constructs a unique pooling equilibrium with an optimal mix of short-term and long-term debt, in which the good firms maximize their profits, and bad firms find it profitable to mimic the good firms. We argue that when the quality of firms' assets starts to deteriorate (the proportion of good firms diminishes) and creditors become more prudential, firms will first incur more short-term debts in order to exploit the value of intermediate information. However, when asset qualities deteriorate further and creditors become very pessimistic, borrowing short-term is too costly and the short-term borrowing market freezes.