August 22, 2023

Darrell Duffie (Stanford), Yichao Zhu (ANU) and I just completed a new version our the paper "The Decline of Too Big To Fail".

For globally systemically important banks (GSIBs) with US headquarters, we find significant reductions in market-implied probabilities of government bailout after the Global Financial Crisis (GFC), along with roughly 170\% higher wholesale debt financing costs for these banks after controlling for insolvency risk.  Since the GFC, bank creditors appear to expect much larger losses in the event that a GSIB approaches insolvency. In this sense, we estimate a decline of ``too big to fail.''

Mentions: FSB report "Evaluation of the Effects of Too-Big-To-Fail Reforms"

November 6, 2022

Bruce Grundy (ANU), Yue Wang (ANU) and I recently completed a new paper titled More Debt More Leverage? In the paper we investigate whether the primary purpose of raising debt levels was to finance growth opportunities. If so, then higher debt levels would signal greater post-payout returns on assets but contain no information about firm risk. Using annual data for more than 5,500 public US non-financial firms from 1971 to 2021, we reject this hypothesis by showing that the return channel accounts for only 30% of the variation in debt levels, with the risk channel accounting for much of the remainder. We show that the link between greater debt growth and higher firm risk is particularly pronounced during accommodative monetary policy regimes. The paper was previously titled "What Changes in Corporate Debt Levels Reveal about Firms' Risk, Returns and Payouts"

July 5, 2022

In the note Valuation of Bank Assets with Early Government Intervention, Mick Schaefer, Alexander Szimayer (University of Hamburg) and I solve a dynamic structural model for valuing bank debt and equity that allows for the possibility of government intervention both prior to and at insolvency.

May 12, 2022

A new paper titled Risk Aversion in Corporate Bond Markets, jointly written with Ilya Dergunov (ANU) and Jean Helwege (UC Riverside), is now available.

In this paper, we examine risk aversion in corporate bond markets, and its relationship with monetary policy. While policy measures tend to restore confidence, extremely accommodative policy may engender excessive risk-taking. We measure temporal variation in risk aversion over 1974-2020 with a new methodology that isolates the elasticity of risk aversion to macro shocks from other components of credit spreads. Our theoretical framework extends habit-based pricing models by incorporating potential bailouts of systemic firms through cohort effects. We find risk aversion rises with tight monetary policy, but, contrary to popular belief, no evidence of excessive "Reaching for Yield" in the ultra-low-for-long post-GFC period.

July 28, 2020

Across-the-Curve Credit Spread Indices 

This note, prepared jointly with Darrell Duffie and Yichao Zhu, presents a preliminary approach to the design of an across-the-curve credit spread index (AXI). The index is a measure of the recent average cost of wholesale unsecured debt funding for publicly listed U.S. bank holding companies and their commercial banking subsidiaries. This may be a useful benchmark for bank lending and related derivatives risk management applications. The index is a weighted average of credit spreads for unsecured debt instruments with maturities ranging from overnight to five years, with weights that reflect both transactions volumes and issuance volumes.