Equilibrium and welfare in markets with financially constrained arbitrageurs

Gromb, Denis; Vayanos, Dimitri

doi:10.1016/s0304-405x(02)00228-3

Cited by 988 publications

(661 citation statements)

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“…Given our findings on bank capital and securities trading, our results are consistent with models of financial intermediation where the capital level of banks affects asset demand (Xiong, 2001;Gromb and Vayanos, 2002;Brunnermeier and Pedersen, 2009;Adrian and Shin, 2010;He and Krishnamurthy, 2013;Brunnermeier and Sannikov, 2014).…”

supporting

confidence: 85%

Securities Trading by Banks and Credit Supply: Micro-Evidence

et al. 2015

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Reproduction permitted only if source is stated.ISBN 978-3-95729-1 -(Printversion) Non-technical summary Research questionThe role of securities trading by banks has assumed significant importance in the modern financial system. Commercial banks today hold a significant amount of securities in their asset portfolio.In the aftermath of the recent financial crisis, there is considerable debate both in academic and policy circles about the implications of security trading by banks' for credit supply and securities markets. A recurrent argument has been that securities trading activities by banks in the crisis have led to a reduction in credit supply. Moreover, there have been several policy initiatives to impose some restrictions on banks' trading activities as there are claims that weak banks take excessive risk through securities trading (Volcker rule in USA, the Liikanen Report in the European Union and the Vickers Report in the UK).However, empirical analysis is scant due to the lack of comprehensive micro datasets. ContributionIn this paper, we empirically analyze securities trading by banks, and the associated spillovers to the supply of credit to the real sector. We use the German securities' register that contains information on investments made by German banks at the security level as well as the German credit register with information on the credit given by German banks to each firm. The main testable hypothesis, which we examine is that banks with trading expertise will increase their investments in securities during the crisis, especially in those securities that had a (larger) drop in price, to profit from the trading opportunities, thereby withdrawing funds from lending. ResultsWe find that, during the crisis, banks with trading expertise increase their overall investments in securities, especially in those that had a larger price drop. The quantitative effects are largest for trading banks with higher capital and in securities with lower rating and longer maturity. In fact, there are no differential effects for triple-A securities. Moreover, banks with trading expertise reduce their overall supply of credit in crisis times -i.e., for the same borrower at the same time, trading banks reduce lending relative to other banks. The credit reduction is stronger for trading banks with higher capital and is binding at the firm level. All these differential effects for trading banks are not present outside the crisis period. The use of detailed micro data allows us to control for a number of characteristics that deal with several other interpretations, which makes our results robust. Our results suggest that during a crisis, security-trading activities can crowd out lending. However, at the same time, we also find that banks buy securities that have a larger drop in price, especially in long-term and low rated securities, in turn acting as risk absorbers. Nichttechnische Zusammenfassung Forschungsfrage AbstractWe analyze securities trading by banks and the associated spillovers to the supply of credit. Empir...

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confidence: 85%

Securities Trading by Banks and Credit Supply: Micro-Evidence

et al. 2015

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“…Typically, skilled investors will seek to expand their profitable positions either through trading leverage (short positions funding long positions) or by soliciting outside capital from less skilled investors. However, in theoretical models such as Aiyagari and Gertler (1999), Gromb and Vayanos (2002), Geanakopolis (2003), Fostel and Geanakopolis (2008), Brunnermeier and Pedersen (2009) and Kondor (2009) leverage constraints can result in sudden reversals if idiosyncratic declines lower the value of collateral and force correlated liquidations. Fear of forced liquidations limit the leverage arbitrageurs are willing to employ and therefore the capital these arbitrageurs can devote to eliminating anomalies.…”

Section: Stock Price Momentum During Crsp and Victorian Eras: Abnormamentioning

confidence: 99%

Momentum Trading, Return Chasing and Predictable Crashes

2014

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte.

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“…There is a large body of theoretical literature exploring the effects of arbitrage capital on asset price dynamics based on two slightly different approaches (e.g., Xiong (2001), Kyle and Xiong (2001), Gromb and Vayanos (2002), Pedersen (2009), Kondor (2009), Krishnamurthy (2009), andDanielsson, Shin, andZigrand (2010)). These models commonly show that after arbitrageurs suffer large losses on their current positions, reduced risk appetite can cause them to liquidate positions despite the fact that the positions become even more profitable.…”

Section: Capital Constraintsmentioning

confidence: 99%

“…Kiyotaki and Moore (1997) developed a dynamic model to show that through their role as collateral for loans, durable assets (such as land) can amplify small, temporary shocks to technology or income distribution to generate large, persistent fluctuations in output and asset prices. Gromb and Vayanos (2002) showed that margin constraints can force arbitrageurs to prematurely liquidate arbitrage positions at losses and thus contribute to inefficiency in asset prices. Brunnermeier and Pedersen (2009) highlighted that margin constraints can be destabilizing and market liquidity and traders' funding liquidity can be mutually reinforcing, leading to liquidity spirals.…”

Section: Credit Cyclesmentioning

confidence: 99%

Bubbles, Crises, and Heterogeneous Beliefs

Xiong

2013

Handbook on Systemic Risk

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This paper reviews the quickly growing literature that builds on heterogeneous beliefs, a widely observed attribute of individuals, to explain bubbles, crises, and endogenous risk in financial markets.Wei Xiong Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08450 and NBER wxiong@princeton.edu 1The history of financial markets has been dotted with episodes of bubbles, during which market values of assets vastly exceeded reasonable assessments of their fundamental value. Asset price bubbles can lead to severe economic consequences ranging from wasteful over-investment and frenzied trading during booms to devastating financial crises and depressed real economies during busts. Economists have emphasized many aspects of bubbles and crises. Minsky (1974) advocated the view that excessive expansion of bank credit due to optimism can fuel a speculative euphoria and slowly lead the economy to a crisis. Kindleberger (1978) stressed that irrationally optimistic expectations frequently emerge among investors in the late stages of major economic booms and lead firm managers to over-invest, over-promise, and over-leverage, which sow the seeds for an eventual collapse after they fail to deliver on their promises.Shiller (2000) highlighted a host of psychological biases people use in forming a feedback mechanism, through which initial price increases caused by certain initial precipitating factors such as new technology innovations feed back into even higher asset prices through increased investor confidence and expectations. Allen and Gale (2007) focused on agency problems of professional managers who actively seek unwarranted risk, which leads to bubbles and crises.This chapter reviews a quickly growing body of work that was started by Harrison and Kreps (1978) that studies bubbles and crises based on heterogeneous beliefs, a widely observed attribute of individuals.In a market in which agents disagree about an asset's fundamental and short sales are constrained, an asset owner is willing to pay a price higher than his own expectation of the asset's fundamental because he expects to resell the asset to a future optimist at an even higher price. Such speculative behavior leads to a bubble component in asset prices. This approach does not require a substantial amount of aggregate belief distortions to generate a significant price bubble. Instead, the bubble component builds on the fluctuations of investors' heterogeneous beliefs. Even when investors' aggregate beliefs are unbiased, intensive fluctuations of their heterogeneous beliefs can lead to a significant price bubble through frenzied trading (e.g., Scheinkman and Xiong (2003)). This approach is flexible enough to incorporate several important aspects of bubbles and crises, such as over-investment (e.g., Bolton, ) and crashes (e.g., Abreu and Brunnermeier (2003) and Hong and Stein (2003)). Heterogeneous beliefs can also lead to credit cycles (e.g., Geanakoplos (2010)). The speculation induced by heterogeneous beliefs also lea...

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Equilibrium and welfare in markets with financially constrained arbitrageurs

Cited by 988 publications

References 24 publications

Securities Trading by Banks and Credit Supply: Micro-Evidence

Securities Trading by Banks and Credit Supply: Micro-Evidence

Momentum Trading, Return Chasing and Predictable Crashes

Bubbles, Crises, and Heterogeneous Beliefs

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