Working Papers

Regulatory Model Secrecy and Bank Reporting Discretion 

Job Market Paper (November 2023)

This paper studies how banking regulators should disclose the regulatory models they use to assess banks that have reporting discretion. In my setting, such assessments depend on both economic conditions and the fundamentals of banks' assets. The regulatory models provide signals about economic conditions, while banks report information about their asset fundamentals. On the one hand, disclosing the models helps banks understand how their assets perform in different economic environments. On the other hand, it induces banks with socially undesirable assets to manipulate reports in order to obtain favorable assessments. While regulators can partially deter manipulation by designing the assessment rule optimally, the disclosure decision of the regulatory models remains necessary. The optimal disclosure policy is to disclose the regulatory models when the assessment rule is more likely to induce manipulation and keep them secret otherwise. In this way, disclosure complements the assessment rule by reducing manipulation when it harms the regulators more. These analyses speak directly to supervisory stress tests and climate risk stress tests.

Banks Incentive Pay, Diversification and Systemic Risk

joint with Fabio Castiglionesi (Accepted at Journal of Banking and Finance)

This paper analyzes the effects of bank manager’s incentive pay on financial stability. Two banks are owned by risk-neutral principals and run by risk-averse managers that determine the level of leverage and how much to diversify into the other bank’s asset. Diversification and leverage in turn determine both idiosyncratic and systemic insolvency risk. We first characterize the optimal incentive pay contract under the assumption that a planner maximizes the total value of the banks. The optimal contract features both absolute and relative performance evaluation, and it pins down the optimal diversification and leverage. In equilibrium, even if the principal represents the interest of all stakeholders of an individual bank, the contract relies too much on relative performance evaluation, which induces an inefficiently high level of diversification, leverage, and systemic risk. We show that regulations on managerial pay and leverage in place are ineffective at best, and only regulating the relative performance evaluation may restore efficiency.

Work in Progress

Information Regime and Portfolio Choice for Inattentive Investors

joint with Peicong (Keri) Hu (September 2023)

We examine how fund managers make use of two tools--portfolio choice and information regime choice--to attract capital from investors. In this paper, the investors are rationally inattentive and have different preferences for portfolio companies compared to the fund managers. To attract more investment, the fund managers can align portfolio choices with the investors' preference and/or provide information in a way that reduces the processing cost for the investors. Both choices impact how investors allocate their attention, which in turn influences their investment decisions. To serve as a benchmark, we show that the choice of information regime is irrelevant when the investors are attentive. This is because the fund managers can adjust the portfolio composition to ensure that the investors always provide the same level of investment. However, when the investors are inattentive, both the information regime and the portfolio composition matter for their investment decisions. We show that, when the fund managers choose the information regime alone, they may prefer providing either detailed or aggregated information to the investors, depending on the investors' information processing capacity and preference. We also explore scenarios where the fund managers choose the portfolio alone or both tools simultaneously.

Bank Capital Requirement and Market Discipline

joint with Lucas Mahieux (June 2023)

Basel regulations enable banks to use internal risk models to report their risks to regulators and markets. However, banks may strategically understate risks. This paper aims to study the optimal bank regulations, taking into account the role of market discipline. We show that, when banks' risks are observable, capital requirement alone can restore efficiency. However, in cases where banks' risks are unobservable, the regulator must combine capital requirements with audits to discourage banks' misreporting. Market discipline serves as an important complementary mechanism, further reducing banks' incentives for misreporting. Consequently, regulators can reduce audit frequency to lower auditing costs and implement more lenient capital requirements. This study offers insights into the interplay between regulatory tools and market discipline.