Three essays on deposit insurance, initial public offerings, and shadow banks
It is generally argued that deposit insurance weakens depositor discipline and therefore introduces a moral hazard for commercial banks. The traditional theory ignores the role of the regulator in bank run models once deposit insurance is enacted. The first essay proposes a new role that the regulator who can declare a bank legally insolvent will play. The regulator, who may or may not be the deposit insurer, makes decisions on the timing and resolution of failing banks based on the least cost of the deposit insurer in the game. Deposit insurance leads to a loss of depositor discipline. However, regulator discipline is built from least-cost commitment. Moreover, the regulator discipline always has a stronger effect than depositor discipline in preventing banks from speculating. Hence, deposit insurance with least-cost commitment will not bring extra moral hazard issues from the monitoring perspective. The first essay supports the least-cost resolution policy in the United States.
During the Great Recession, liquidity did not flow out of the banking sector but was reallocated internally. Deposits increased, but the volumes of all other short-term debt financing instruments, except for T-Bills, decreased. Commercial banks, which have stable funding sources from deposits, did not render liquidity backup to shadow banks but held the increased deposits as cash on hand. The second essay uses deposits and financial commercial paper outstanding as proxies for commercial and shadow banking financing instruments because they are unique liabilities of commercial and shadow banks, respectively. Using vector autoregressive models, I provide evidence that when liquidity falls in shadow banks, commercial banks experience funding inflows. In normal times, commercial banks render liquidity backup to shadow banks in the following weeks using the increased deposits. However, the dynamic correlation breaks down in crisis times, which may have contributed to the collapse of the shadow banking system during the Great Recession.
Using theoretical and simulation tools, the third essay studies how strategic risk among investors can help explain both underpricing and underreaction in initial public offerings (IPOs). We assume the post-IPO value of a firm is higher if the IPO raises more capital for the firm. Hence an IPO subscriber faces strategic risk: the value of subscribing depends on the aggregate subscription rate. As this risk is resolved immediately after the IPO, the IPO itself is underpriced. Moreover, since individual investors have limited wealth, a higher offer price raises the risk of undersubscription. Investors respond by demanding a larger discount: the offer price appears to underreact to public news.