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- Volume 9, 2017
Annual Review of Financial Economics - Volume 9, 2017
Volume 9, 2017
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Do the Effects of Accounting Requirements on Banks’ Regulatory Capital Adequacy Undermine Financial Stability?
Vol. 9 (2017), pp. 1–20More LessDuring the 2007–2009 financial crisis, many parties criticized aspects of accounting requirements for banks as undermining financial stability. These criticisms generally reflect the view that these requirements primarily affect stability through their effects on banks’ regulatory capital adequacy. I criti-cally evaluate whether this idea can be sustained on logical and evidential grounds. I explain how accounting requirements typically have quite small effects on banks’ regulatory capital adequacy. I discuss the plausibility of the alternative view that accounting requirements primarily affect stability by improving banks’ understanding of their risks and their transparency to markets and regulators. Because securitization is the setting in which banks’ regulatory capital adequacy is most likely to be significantly affected by accounting requirements, I describe empirical research on significant changes in securitization accounting effective in 2010. I explain how even in this setting regulatory capital adequacy incompletely explains how accounting requirements for banks affect stability.
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What to Do About the GSEs?
Vol. 9 (2017), pp. 21–41More LessFannie Mae and Freddie Mac, the two large government-sponsored enterprises (GSEs) that are at the center of US residential mortgage finance, are “elephants in the room” that are being ignored as part of broad-brush financial sector reform. Neither the Dodd–Frank Act nor recently proposed overhauls of Dodd–Frank have addressed reform of the GSEs’ structures, although the GSEs were placed in government conservatorships in early September 2008 and have remained in that state since then. In this article, we review what the GSEs do and how they got themselves into financial difficulties, and we provide an overview of some of the major proposals for reforming the US residential mortgage finance system. We conclude with our own ideas and suggestions for how housing finance, as well as housing policy more generally, should be reformed.
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Market Liquidity After the Financial Crisis
Vol. 9 (2017), pp. 43–83More LessThis article examines market liquidity in the postcrisis era in light of concerns that regulatory changes might have reduced dealers’ ability and willingness to make markets. We begin with a discussion of the broader trading environment, including an overview of regulations and their potential effects on dealer balance sheets and market making, but also considering additional drivers of market liquidity. We document a stagnation of dealer balance sheets after the financial crisis of 2007–2009, which occurred concurrently with dealer balance sheet deleveraging. However, using high-frequency trade and quote data for US Treasuries and corporate bonds, we find only limited evidence of a deterioration in market liquidity.
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Agent-Based Models for Financial Crises
Vol. 9 (2017), pp. 85–100More LessThis article describes the agent-based approach to modeling financial crises. It focuses on the interactions of agents and on how these interactions feed back to change the financial environment. It explains how these models embody the contagion and cascades that occur owing to the financial leverage and market concentration of the agents and the liquidity of the markets. This article also compares agent-based models to the standard economic approach to crises and shows the ways in which agent-based models overcome limitations of economic models when dealing with financial crises. In particular, this article demonstrates how agent-based models replace homogeneous, representative agents with heterogeneous agents and optimization with heuristics, and how such models move away from a focus on equilibrium, allowing non-ergodic dynamics that are manifest during financial crises to emerge.
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Information Disclosure in Financial Markets
Itay Goldstein, and Liyan YangVol. 9 (2017), pp. 101–125More LessInformation disclosure is an essential component of regulation in financial markets. In this article, we provide a cohesive analytical framework to review certain key channels through which disclosure in financial markets affects market quality, information production, efficiency of real investment decisions, and traders’ welfare. We use our framework to address four main aspects. First, we demonstrate the conventional wisdom that disclosure improves market quality in an economy with exogenous information. Second, we illustrate that disclosure can crowd out the production of private information and that its overall market-quality implications are subtle and depend on the specification of information-acquisition technology. Third, we review how disclosure affects the efficiency of real investment decisions when financial markets are not just a side show, as real decision makers can learn information from them to guide their decisions. Last, we discuss how disclosure in financial markets affects investors’ welfare through changing trading opportunities and through beauty-contest motives. Overall, our review suggests that information disclosure is an important factor for understanding the functioning of financial markets and that there are several trade-offs that should be considered in determining its optimal level.
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What Shapes Consumer Choice and Financial Products? A Review
Vol. 9 (2017), pp. 127–146More LessCentral to the field of consumer finance is that consumers make financial decisions that do not always coincide with the financial decisions ideally depicted in optimal economic models. In this review, we discuss developments in the field of household finance, focusing on how consumers make suboptimal financial decisions across different types of settings and factors that affect their decisions. Rather than conducting a comprehensive survey, we focus specifically on consumer choice in the context of research on credit card borrowing, housing and mortgage debts, investment and savings decisions, and spending and consumption. We also discuss financial product design and marketing, as well as the regulatory landscape of lenders of consumer financial products. We present five future research directions and considerations for researchers and policymakers.
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Mutual Funds in Equilibrium
Vol. 9 (2017), pp. 147–167More LessHistorically, the literature on money management has inconsistently applied the rational expectations equilibrium concept. We explain why and summarize developments in the money management literature that do apply this concept correctly. We demonstrate that the rational expectations equilibrium approximates the observed equilibrium in the money management space at least as well as it does in the stock market. Recent work reveals that there is little support for the common conclusion that, as a group, investors in the money management space are naive and that mutual fund managers are charlatans. Even today, equilibrium thinking is not nearly as prevalent in mutual fund research as it is in the rest of asset pricing. This state of play provides a multitude of opportunities for future research in the area.
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Exchange-Traded Funds
Vol. 9 (2017), pp. 169–189More LessOver nearly a quarter of a century, exchange-traded funds (ETFs) have become one of the most popular passive investment vehicles among retail and professional investors because of their low transaction costs and high liquidity. By the end of 2016, the market share of ETFs exceeded 10% of the total market capitalization traded on US exchanges, representing more than 30% of overall trading volume. ETFs revolutionized the asset management industry by taking market share from traditional investment vehicles such as mutual funds and index futures. Because ETFs rely on arbitrage activity to synchronize their prices with the prices of the underlying portfolio, trading activity at the ETF level translates to trading of the underlying securities. Researchers have found that although ETFs enhance price discovery, they also inject nonfundamental volatility into market prices and affect the correlation structure of returns. Furthermore, ETFs impact the liquidity of the underlying portfolios, especially during events of market stress.
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An Overview of China's Financial System
Vol. 9 (2017), pp. 191–231More LessWe provide a review of China's financial system and consider the challenges it faces and future reforms. The formal sectors of the financial system, which include a fast-growing stock market and are dominated by a banking sector with large state-owned banks, have played a critical role in financing the state sectors and the investment-driven economic growth model. However, the formal sectors have not served the needs of the private sectors or of households; these dynamic sectors have been financed by alternative finance sectors operating largely outside the markets and formal institutions. Going forward, financial markets need to be further developed to provide more support for the private sectors, including technology and services industries; the formal and alternative sectors should work together to improve the efficiency of resource allocation to better support the new model of consumption- and innovation-driven growth. Finally, the financial system needs to reduce the likelihood of damaging financial crises, which have included a real estate crisis, a banking crisis triggered by defaults on corporate and local government debt, and a twin crisis in the currency market and the banking sector.
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The Development of China's Stock Market and Stakes for the Global Economy
Vol. 9 (2017), pp. 233–257More LessThe rise of China and fivefold growth of its stock market over the past decade have fueled a growing literature on this market in financial economics. On the corporate side, researchers have evaluated the progress of China's stages of privatization, analyzed biases in the selection of firms for listing, and documented massive underpricing of initial public offerings. On the asset pricing side, researchers have studied the price premium of domestic A shares over their foreign-share counterparts, analyzed the firm-specific information content of prices, provided new evidence on informational and behavioral effects in prices, and begun to identify systematic cross-sectional patterns in returns. Numerous areas are ripe for future research as China's stock market continues to grow in global influence and as ongoing reform provides new natural experiments. Challenges for the field will be to gain familiarity with China's distinctive financial system and to avoid overapplying research paradigms developed for the US setting.
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A Firm's Cost of Capital
Vol. 9 (2017), pp. 259–282More LessTo create value, a firm must invest in projects that provide a return greater than the cost of capital. The cost of capital is not observed and its estimation requires assumptions on investors’ consumption, savings, and portfolio decisions. We review the academic literature on firms’ cost of financial capital and the estimation of the different components: cost of equity, cost of debt, and their relative weights. We also review various approaches to estimating the cost of capital and the assumptions justifying these approaches.
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The Fundamentals Underlying Oil and Natural Gas Derivative Markets
Vol. 9 (2017), pp. 283–300More LessWhat determines the range and boundaries of energy derivative markets? Why is the oil futures trade dominated by contracts on two grades and locations when the global trade encompasses many grades and locations? Should we expect change in the near future? We review research on the establishment and performance of energy derivative markets, focusing on the two major energy commodities: oil and natural gas. For both commodities, trade in derivatives arose at the conclusion of a historical process in which production along the value chain that had been coordinated by vertically integrated companies or similar institutional structures switched to being coordinated through markets. Consequently, much of the research reviewed here is about the structural changes that made it possible for markets to assume this role. This review encompasses research into the price discovery function, which determines how many successful futures contracts are needed for each commodity.
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A Primer on Portfolio Choice with Small Transaction Costs
Vol. 9 (2017), pp. 301–331More LessThis review is an introduction to asymptotic methods for portfolio choice problems with small transaction costs. We outline how to derive the corresponding dynamic programming equations and how to simplify them in the small-cost limit. This allows one to obtain explicit solutions in a wide range of settings, which we illustrate for a model with mean-reverting expected returns and proportional transaction costs. For more complex models, we present a policy iteration scheme that allows one to numerically compute the solution.
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Forward-Looking Estimates of Interest-Rate Distributions
Vol. 9 (2017), pp. 333–351More LessThis article reviews methods for extracting both risk-neutral and physical density forecasts for interest rates. It presents some applications, with particular focus on issues pertaining to forward guidance and the zero lower bound. Several important applied questions in macroeconomics and monetary economics can be very directly addressed using the wealth of information in interest-rate derivative securities.
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