Financial Market Regulation

October 6, 2017
Supported by the Puelicher Center for Banking Education at the University of Wisconsin
Dean Corbae of the University of Wisconsin and Robert Townsend of MIT, Organizers

Greg Buchak, the University of Chicago; Gregor Matvos, the University of Texas at Austin and NBER; Tomasz Piskorski, Columbia University and NBER; and Amit Seru, Stanford University and NBER

Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks (NBER Working Paper No. 23288)

This research studies the rise of fintech and non-fintech shadow banks in the residential lending market. The market share of shadow banks in the mortgage market has nearly doubled from 2007-2015. Shadow banks gained a larger market share in the refinancing market and among less creditworthy borrowers accounting for three-quarters of loan originations to most indebted borrowers. Shadow banks were significantly more likely to expand their market share where traditional banks faced more capital and regulatory constraints. This suggests that traditional banks facing increased capital and regulatory burden retreated from residential mortgage lending, and that shadow banks stepped into this gap. Fintech firms accounted for almost a third of shadow bank loan originations by 2015. To investigate the role of technology in the decline of traditional banking, Buchak, Matvos, Piskorski, and Seru focus on technology differences between shadow banks, holding the regulatory differences between different lenders fixed. Fintech lenders serve more creditworthy borrowers and are more active in the refinancing market. Analyzing fintech firms' pricing decisions, the researchers find some evidence that fintech lenders use different methods in determining corresponding interest rates. Importantly, the online origination technology appears to allow fintech lenders to originate loans with greater convenience for their borrowers. Among the borrowers most likely to value convenience, fintech lenders command an interest rate premium for their services. The researchers use a simple model to decompose the relative contribution of technology and regulation to the rise of shadow banks. This simple quantitative assessment indicates that increasing regulatory burden faced by traditional banks and financial technology can account, respectively, for about 55% and 35% of the recent shadow bank growth.

Andrea L. Eisfeldt, the partment of the Treasury; and Emil Siriwardane, Harvard University

Risk Reallocation in OTC Derivatives Networks

Over-the-counter (OTC) derivatives markets are the key venue for quickly reallocating exposures to key risk factors such as interest rates, exchange rates, and credit amongst market participants. These markets are very large, and are characterized by a complex trading network with disperse prices. In this paper, Siriwardane, Herskovic, Rajan, and Eisfeldt ask how the structure of the OTC derivatives trading network, the preferences and technologies of the participants, and the distribution of endowed exposures to the underlying risk factor, jointly determine the observed patterns of trade, post-trade exposures, and prices. The researchers use detailed data from the DTCC to estimate the key parameters of our model. Finally, they use the model at estimated parameters to study comparative statics related to risk management and regulation.

Lin William Cong, the University of Chicago, and Zhiguo He, the University of Chicago and NBER

Blockchain Disruption and Smart Contracts

Distributed ledger technologies such as blockchains feature decentralized consensus as well as low-cost, tamper-proof, and algorithmic executions, and consequently enlarge the contracting space and facilitate the creation of smart contracts. Meanwhile, the process of generating decentralized consensus alters the informational environment. Cong and He analyze how decentralization improves consensus effectiveness, and how the quintessential features of blockchain reshape industrial organization and the landscape of competition. Smart contracts can mitigate information asymmetry and deliver higher social welfare and consumer surplus through enhanced entry and competition, yet blockchain may also encourage collusion due to irreducible distribution of information. In general, blockchains can sustain market equilibria with a larger range of economic outcomes. The researchers further characterize smart contracts used in equilibrium and discuss anti-trust policy implications, such as separating users from consensus generators, and encouraging platform competition.

Victor Aguirregabiria, the University of Toronto; Robert Clark, Queen's University; and Hui Wang, Peking University

The Geographic Flow of Bank Funding and Access to Credit: Branch Networks and Local-Market Competition

The integration of deposit and loan markets may be constrained by the geographic dispersion of depositors, borrowers, and banks. Asymmetric information between geographic locations, monitoring costs, transaction costs, and imperfections in interbank wholesale markets can all serve as frictions to the flow of funds across markets, leaving some with limited access to credit. Banks' branch networks can reduce some of these frictions and increase the flow of funding to geographic locations where credit is in greater demand. However, local market power and economies of scope between deposits and loans at the local level may have a negative impact on the geographic flow of credit. Aguirregabiria, Clark, and Wang study the extent to which deposits and loans are geographically segregated and the contribution of branch networks, local market power, and economies of scope to this segregation using data at the bank-county-year level from the US banking industry for the period 1998-2010. The researcher's results are based on the construction of an index which measures the geographic segregation of deposits and loans, and the estimation of a structural model of bank oligopoly competition for deposits and loans in multiple geographic markets. The estimated model shows that a bank's total deposits have a very significant effect on the bank's market shares in loan markets. The researchers also find evidence that is consistent with significant economies of scope between deposits and loans at the local level. Counterfactual experiments show that multi-state branch networks contribute significantly to the geographic flow of credit but benefit especially larger/richer counties. Local market power has a very substantial negative effect on the flow of credit to smaller/poorer counties.

Ralph Koijen, New York University and NBER, and Motohiro Yogo, Princeton University and NBER

The Fragility of Market Risk Insurance

Insurers sell retail financial products called variable annuities that package mutual funds with minimum return guarantees over long horizons. Variable annuities accounted for $1.5 trillion or 34 percent of U.S. life insurer liabilities in 2015. Sales fell and fees increased after the 2008 financial crisis as the higher valuation of existing liabilities stressed risk-based capital. Insurers also made guarantees less generous or stopped offering guarantees entirely to reduce risk exposure. Koijen and Yogo develop a supply-driven theory of insurance markets in which financial frictions and market power determine pricing, contract characteristics, and the degree of market incompleteness.

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