ESSAYS ON REPURCHASE AGREEMENTS, BAILOUTS, AND THE MACROECONOMIC ...

112 Pages·2015·0.67 MB·English

ESSAYS ON REPURCHASE AGREEMENTS, BAILOUTS,
AND THE MACROECONOMIC EFFECTS
OF BANK FAILURES

by
DANIEL LEE OTTO
ROBERT R. REED, COMMITTEE CHAIR
WALTER ENDERS
HARRIS SCHLESINGER
GREGORY GIVENS
WILLIAM JACKSON III
ROBERT BROOKS

A DISSERTATION

Submitted in partial fulfillment of the requirements
for the degree of Doctor of Philosophy
in the Department of Economics,
Finance, and Legal Studies
in the Graduate School of
The University of Alabama

TUSCALOOSA, ALABAMA

2015
Copyright Daniel Lee Otto 2015
ALL RIGHTS RESERVED
ABSTRACT

In this dissertation, I study different aspects of the financial system within
times of crisis with special attention paid to money market mutual funds (MMMF)
and their use of repurchase their agreements ("repos").
Repos play a significant role in global credit market activity. Yet, research
regarding the underlying components of repos remains nascent. In the first chapter,
I examine the role of risk tolerance on lending and collateral within these
agreements.
In the second chapter, I study a model in which a risk-pooling intermediary
engaging in the repo market, such as a MMMF, is exposed to runs. Inspired by
events during the financial crisis, I show that bailouts are part of an efficient social
insurance scheme in the event that a run emerges. However, this result does not
imply that optimal intervention completely isolates shadow-banking intermediaries
from a crisis. In fact, optimal public sector intervention imposes costs on money
market funds by requiring them to liquidate some collateral. On the other hand, a
commitment to no bailouts contributes to financial instability as the repo market
collapses in the wake of a run without a public safety net.
Chapter three expands my analysis of financial stress into the realm of
traditional depository institutions. This chapter examines the effects of exogenous
bank failures in the United States from 1973 - 2006. My results support the previous
literature which suggests that real economic activity is lower following a shock.
However, in addition to a linear model, I consider the possibility of a threshold
value within banking shocks. Upon examination, I find that the effects of exogenous
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failures become asymmetric around $3 billion. Larger shocks are shown to impact
the economy significantly. By comparison, smaller shocks have a completely
ambiguous effect.

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DEDICATION
This dissertation is dedicated to my friends and family. To my friends,
Nicholas John Pihakis and John Bernard Halbert III, I want to say thanks for
always challenging me intellectually. You both continue to set the bar high and I do
my best to keep up and challenge you back. To my parents, Larry Lee Otto and
Dawn Charlotte Otto, thank you for your constant love and support. You are
always there to lend me your ear and a helping hand – both of which I take for
granted far too often. It is truly a privilege to be a part of your lives.

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ACKNOWLEDGMENTS
I wish to thanks all of my committee members for offering their time and
talents. A very special thanks needs to go out to my committee chair, Dr. Robert
Reed. Your guidance over the past 4 years has been invaluable. I owe much of my
academic success to you and I look forward to a many future collaborative works. In
addition, thank you to Dr. Walter Enders, Dr. Gregory Givens, Dr. Williams
Jackson III, and Dr. Robert Brooks for agreeing to serve on my committee.
In conclusion, I also want to note the help of Dr. Harris Schlesinger. Thank
you for pushing me to my intellectual limits.

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CONTENTS

ABSTRACT .................................................................................................................. ii
DEDICATION .............................................................................................................. iv
ACKNOWLEDGMENTS ............................................................................................. v
LIST OF TABLES ....................................................................................................... ix
LIST OF FIGURES ...................................................................................................... x
CHAPTER 1: Repos, Risk Aversion, and Haircuts ..................................................... 1
1 Introduction ................................................................................................................ 1
2 The Model ................................................................................................................... 5
2.1 Endowments, Preferences, and Technologies .................................................... 5
2.2 Timing of Actions ............................................................................................... 6
3 Optimal Choices .......................................................................................................... 8
3.1 Repo Solutions .................................................................................................. 12
4 Numerical Analysis ................................................................................................... 14
4.1 Leverage Elasticity ........................................................................................... 19
5 Conclusion ................................................................................................................. 20
References ..................................................................................................................... 21
CHAPTER II: Repos, Bailouts, and Instability in the Shadow Banking System .... 23
1 Introduction .............................................................................................................. 23
2 The Model ................................................................................................................. 27
2.1 Preferences and Technologies ........................................................................... 28
2.2 Unexpected Shocks and Financial Instability ................................................. 30
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3 The Planner’s Allocation .......................................................................................... 31
3.1 Period 2: Settlement (Repurchase of Collateral) ............................................ 34
3.2 Period 1: Collateral Liquidation and Bailout Funding ................................... 36
3.2.1 Optimizing Consumption in the Good Aggregate State ........................ 37
3.2.2 Optimizing Consumption in the Bad Aggregate State........................... 39
3.3 Period 0: The Planner’s Investment in the Repo Market, Short-Term
Returns, and Taxes ................................................................................................ 42
3.4 Fragility ............................................................................................................. 43
4 Bailouts and Collateral Liquidation ......................................................................... 45
5 Equilibrium under Discretion ................................................................................... 46
5.1 Intermediaries’ Decisions .................................................................................. 48
5.2 Fiscal Authority’s Tax Decision ....................................................................... 48
5.3 Bailouts vs. No Bailouts ................................................................................... 49
6 Comparing Bailout Cases ......................................................................................... 51
7 Conclusion ................................................................................................................. 52
References ..................................................................................................................... 54
Appendix ...................................................................................................................... 56
CHAPTER III: The Macroeconomic Effects of Bank Failures ................................. 75
1 Introduction .............................................................................................................. 75
2 The Basic Model ....................................................................................................... 78
2.1 The Data ........................................................................................................... 78
2.2 The Methodology .............................................................................................. 79
3 Aggregate Effects of Bank Failure Shocks ............................................................... 81
A. Building the Framework ................................................................................... 81
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B. Durable and Non-Durable Goods Markets ...................................................... 83
C. Interest Rates and Credit Extension ................................................................ 84
D. Private Saving ................................................................................................... 85
4 Asymmetric Shocks ................................................................................................... 86
4.1 Threshold Testing ............................................................................................. 86
4.2 Small vs. Large Shocks: The Macroeconomic Effects ..................................... 88
5 Conclusion ................................................................................................................. 89
References ..................................................................................................................... 91
Appendix ...................................................................................................................... 93

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LIST OF TABLES
1.1 Benchmark Repo Market ...................................................................................... 14
1.2 Benchmark Repo Market as 𝛾 Changes ............................................................... 15
0
1.3 Benchmark Repo Market as 𝜋 Changes ............................................................... 16
0
1.4 Repo Market under 𝛾 as 𝜋 Changes .................................................................... 17
1 0
1.5 Benchmark Repo Market as 𝑝 Changes................................................................ 18
1.6 Leverage Elasticity, Case 1 .................................................................................... 19
1.7 Leverage Elasticity, Case 2 .................................................................................... 19
3.1 Bank Failure Statistics (Normalized Failures in Levels) ...................................... 78
3.2 F-Test on 𝜙 ........................................................................................................... 88
1

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