This paper shows that the contractual arrangement between banks and nonbank lenders (NBLs) is a key source of financial stability. I document that credit lines account for 90% of bank funding to NBLs. NBLs use credit lines to manage investment uncertainties and gain liquidity support, while banks' liquidity advantage makes them natural insurers. I develop a dynamic model of financial intermediation with endogenous credit limits and fees to study the financial stability implications of bank--NBL credit lines. Credit lines allow NBLs to finance uncertain investments and affect their commercial paper funding costs. NBLs therefore trade off liquidity support and asset value gains against higher default risk from increased leverage when requesting limits. When extending limits, banks as large providers of credit lines internalize both NBLs' price schedule for credit line insurance and the cost of drawdown exposure in bad states. This internalization disciplines risk-taking by both banks and NBLs. Rather than simply transferring risk from NBLs to banks, endogenous limits and fees generate general-equilibrium feedback between contingent liquidity provision and safe asset creation. Credit lines' contingent features make them cheaper than cash, and safer but costlier than loans. Quantitatively, credit lines raise welfare by 1.83% relative to loans. Partial guarantees of NBL debt reduce welfare by weakening banks' relative liquidity advantage and restricting credit line supply.
➤Brattle Group Ph.D. Candidate Award For Outstanding Research
➤Jacobs Levy Equity Management Dissertation Fellowship in Quantitative Finance
We develop a model where CLOs are the optimal financial structure for securitizing assets that trade in illiquid markets. As is true empirically, CLOs hold portfolios of risky loans that they actively rebalance and finance themselves with safe, long-maturity debt. CLOs face restrictions on their equity payouts, but these restrictions ignore the market-to-market value of CLO assets. Banks that hold CLOs' safe debt are insulated from fire-sales, and a financial system where CLOs take risk instead of banks is more efficient than traditional banking. CLOs are most useful in moderately illiquid markets with significant gains from trade and fire-sale costs.
This paper studies the welfare implications of accessing centralized versus decentralized over-the-counter (OTC) secondary markets. We develop a model of asymmetric information in the lending market in which borrowers have access to two costly signals. Creditworthy borrowers signal their type by liquidating non-pledgeable assets in a centralized market or exchanging them for collateralizable assets in an OTC market. Equilibrium prices and haircuts determine signaling costs endogenously. In the optimal separating contract, the cheapest market in terms of signaling costs is accessed. We establish conditions for existence of equilibria in which different markets are accessed – CM-only, OTC-only, and dual-market – and rank them by the welfare they provide to borrowers. We show that OTC-only equilibria offer the highest welfare, followed by dual-market and CM-only equilibria.