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Systemic Risks, Financial Intermediaries, and Asset Markets

  • Author(s): Gandhi, Priyank
  • Advisor(s): Longstaff, Francis A.
  • Lustig, Hanno N.
  • et al.
Abstract

The credit crisis of 2007-2009 has sparked an enormous interest in the role that financial intermediaries play in our economy. Recent literature examines how financial intermediaries affect not only macro-economic variables but also asset markets such as the stock and the bond markets. The underlying theme in this recent literature is that the function of financial intermediaries in our asset markets is not yet completely understood and requires further study. This dissertation is based on three chapters that examine the interaction between systemic risks, financial intermediaries, and asset markets.

The first chapter is titled 'Counterparty Credit Risk and the Credit Default Swap Market'. This chapter is a version of a forthcoming paper in the Journal of Financial Economics by the same title. This paper is coauthored with Navneet Arora and Francis Longstaff. Counterparty credit risk has become one of the highest-profile risks facing participants in financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. In this chapter I examine this issue empirically. I find that counterparty

credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.

The second chapter is titled 'Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation'. This chapter is a version of a UCLA Anderson working paper. This paper is coauthored with Hanno Lustig. I show that the largest commercial bank stocks, measured by book value, have significantly lower risk-adjusted returns than small- and medium-sized bank stocks, even though large banks are significantly more levered. I find a size factor in the component of bank returns that is orthogonal to the standard risk factors. This size factor, which has the right covariance with bank returns to explain the average risk-adjusted returns, measures size-dependent exposure in banks to bank-specific tail risk. The variation in exposure can be attributed to differences in the financial disaster recovery rates between small and large banks. A general equilibrium model with rare bank disasters can match these alphas in a sample without disasters provided that the difference in disaster recovery rates between the largest and smallest banks is 35 cents per dollar of dividends.

In the final chapter of this dissertation I document a new stylized fact regarding aggregate bank credit growth and the excess returns of bank stocks. I find that a 1% increase in bank credit growth rate implies that excess returns on bank stocks over the next one year are lower by nearly 3%. Unlike most other forecasting relationships, credit growth tracks bank stock returns over the business cycle and explains nearly 14% of the variation in bank stock returns over a 1-year horizon. I show that this predictive variation in returns reflects the representative agent's rational response to a small time-varying probability of a tail event that impacts banks and bank-dependent firms. Consistent with this hypothesis I show that the predictive power, as measured by the absolute magnitude of the coefficient on credit growth and the adjusted-R2 at the the 1-year horizon, depends systematically on variables that regulate exposure to tail risk. Historically, the probability of a tail event increases in a

recession, therefore this mechanism also explains the observed correlation between variation in aggregate bank credit level and business conditions.

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