Research

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In Progress
Banks' Non-Interest Income and Systemic Risk, Brunnermeier, Markus K., Dong Gang, and Palia Darius , (In Progress) AbstractBanks and Systemic Risk

This paper documents that banks with higher non-interest income (noncore activities like investment banking, venture capital and trading activities) have a higher contribution to systemic risk than traditional banking (deposit taking and lending). After decomposing total non-interest income into two components, trading income and investment banking and venture capital income, we find that both components are roughly equally related to systemic risk. These results are robust to endogeneity concerns when we use a difference-in-difference approach with the Lehman bankruptcy proxying for an exogenous shock. We also find that banks with higher trading income one-year prior to the recession earned lower returns during the recession period. No such significant effect was found for investment banking and venture capital income.

Computational Complexity and Information Asymmetry in Financial Products, Arora, Sanjeev, Barak Boaz, Brunnermeier Markus K., and Ge Rong , (In Progress) AbstractComplexity and Derivatives.pdf

Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.

CoVaR, Adrian, Tobias, and Brunnermeier Markus K. , Number http://ideas.repec.org/p/fip/fednsr/348.html, (In Progress) CoVaR.pdfCoVaR Slides.pdf

Predicting and measuring a financial institution's contribution to systemic risk that internalizes externalities and avoids procyclicality.

A Crash Course on the Euro Crisis, Brunnermeier, Markus K., and Reis Ricardo , (In Progress) 01b EuroCrashCourse_slides.pdf
The I Theory of Money, Brunnermeier, Markus K., and Sannikov Yuliy , (In Progress) Abstracti_theory.pdfi_theory_slides.pdfi_theory2.pdf

A theory of money needs a proper place for financial intermediaries. Intermediaries create money by taking deposits from savers and investing them in productive projects. The money multiplier depends on the size of intermediary balance sheets, and their ability to take risks. In downturns, as lending contracts and the money multiplier shrinks, the value of money rises. This leads to a Fisher deflation that hurts borrowers and amplifies shocks. An accommodative monetary policy in downturns, focused on the assets held by constrained agents, can mitigate these destabilizing adverse feedback effects. We devote particular attention to interest rate cuts, and study the potential for such policies to create moral hazard.

Measuring and Allocating Systemic Risk, Brunnermeier, Markus K., and Cheridito Patrick , (In Progress)
Optimal Time-Inconsistent Beliefs: Misplanning, Procrastination, and Commitment, Brunnermeier, Markus K., Papakonstantinou Filippos, and Parker Jonathan A. , (In Progress) Time-inconsistent Beliefs.pdf
A Welfare Criterion for Models with Biased Beliefs, Brunnermeier, Markus K., Simsek Alp, and Xiong Wei , (In Progress) AbstractWelfare Biased Beliefs Slides.pdfWelfare Biased Beliefs.pdf

This paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs. Instead of taking a stand on whose belief is correct, our criterion asserts an allocation to be belief-neutral inefficient if it is inefficient under any convex combination of agents' beliefs. While this criterion gives an incomplete ranking of social allocations, it can identify negative-sum speculation in a broad range of prominent models with distorted beliefs.

In Press
Liquidity Mismatch, Brunnermeier, Markus K., Gorton Gary, and Krishnamurthy Arvind , Risk Topography, Chicago, (In Press) Liquidity Mismatch.pdfliquidity_mismatch_slides.pdf
A Macroeconomic Model with a Financial Sector, Brunnermeier, Markus K., and Sannikov Yuliy , American Economic Review, (In Press) Abstractmacro_finance_slides.pdfmacro_finance.pdfReadme for Matlab code.pdf

This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly nonlinear amplification effects, the economy is prone to instability and occasionally enters volatile crisis episodes. Endogenous risk, driven by asset illiquidity, persists in crisis even for very low levels of exogenous risk. This phenomenon, which we call the volatility paradox, resolves the Kocherlakota (2000) critique. Endogenous leverage determines the distance to crisis. Securitization and derivatives contracts that improve risk sharing may lead to higher leverage and more frequent crises.

Predatory Short Selling, Brunnermeier, Markus K., and Oehmke Martin , Review of Finance, (In Press) Predatory Short Selling.pdf
2013
Redistributive Monetary Policy, Brunnermeier, Markus K., and Sannikov Yuliy , Jackson Hole Symposium, 1 September 2012, Jackson Hole, p.331-384, (2013) AbstractRedistributive Monetary Policy.pdfJackson Hole 2012 Presentation.pdfThree Stability Concepts.pdf

Liquidity and deflationary spirals self-generate endogenous risk and redistribute wealth. Monetary policy can mitigate these effects and help rebalance wealth after an adverse shock, thereby reducing endogenous risk, stabilizing the economy, and stimulating growth. The redistributive channel differs from the classic Keynesian interest rate channel in models with price stickiness. Central banks assume and redistribute tail risk when purchasing assets or relaxing their collateral requirements. Monetary policy (rules) can be seen as a social insurance scheme for an economy beset by financial frictions. As with any insurance, it carries the cost of moral hazard. Redistributive monetary policy should be strictly limited to undoing the redistribution caused by the amplification effects and by moral hazard considerations.

Bubbles, Financial Crises, and Systemic Risk, Brunnermeier, Markus K., and Oehmke Martin , Handbook of the Economics of Finance, Amsterdam, (2013) AbstractBubbles, Financial Crisis and Systemic Risk.pdf

This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.

Leadership, Coordination and Corporate Culture, Bolton, Patrick, Brunnermeier Markus K., and Veldkamp Laura , Review of Economic Studies, Volume 80, Issue 2, p.512-537, (2013) Abstractleadership.pdf

Overconfident leaders make more precise mission statement which enhances coordination among the followers by reducing the leaders' time-inconsistency problem.

What makes a good leader? A good leader is able to coordinate his followers around a credible mission statement, which communicates the future course of action of the organization. In practice, leaders learn about the best course of action for the organization over time. While learning helps improve the organization's goals it also creates a time-consistency problem. Leader resoluteness is a valuable attribute in such a setting, since it slows down the leader's learning and thus improves the credibility of the mission statement. But resolute leaders also inhibit communication with followers and leader resoluteness is costly when followers have sufficiently valuable signals.

Macroeconomics with Financial Frictions: A Survey, Brunnermeier, Markus K., Eisenbach Thomas, and Sannikov Yuliy , Advances in Economics and Econometrics, Tenth World Congress of the Econometric Society, New York, (2013) Abstractslides.pdfsurvey_macrofinance.pdf

This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification e ects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate the downturn. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained ecient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.

The Maturity Rat Race, Brunnermeier, Markus K., and Oehmke Martin , Journal of Finance, Volume 68, Issue 2, p.483-521, (2013) AbstractMaturity Rat Race.pdfMaturity Rat Race Slides.pdf

We develop a model of endogenous maturity structure for financial institutions that borrow from multiple creditors. We show that a maturity rat race can occur: an individual creditor can have an incentive to shorten the maturity of his own loan to the institution, allowing him to adjust his financing terms or pull out before other creditors can. This, in turn, causes all other lenders to shorten their maturity as well, leading to excessively short-term financing. This rat race occurs when interim information is mostly about the probability of default rather than the recovery in default, and is most pronounced during volatile periods and crises. Overall, firms are exposed to unnecessary rollover risk.

Reviving 'Money and Banking', Brunnermeier, Markus K., and Sannikov Yuliy , Is Inflation Targeting Dead?, (2013)
2012
Risk Topography, Brunnermeier, Markus K., Gorton Gary, and Krishnamurthy Arvind , NBER Macroeconomics Annual 2011, Volume 26, p.149-176, (2012) Abstractrisk_topography.pdfrisk_topography_slides.pdf

The aim of this paper is to conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policymakers, researchers and market participants about systemic risk. Our approach emphasizes that systemic risk (i) cannot be detected based on measuring cash instruments, e.g., balance sheet items or ratios such as leverage and income statement items; (ii) typically builds up in the background before materializing in a crisis; and (iii), is determined by market participants’ endogenous response to various shocks. Our measurement system asks that regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities (our response indicator) with respect to major risk factors and liquidity scenarios. General equilibrium responses and economy-wide system effects can be calibrated using this panel data set.

2010
Clock games: Theory and experiments, Brunnermeier, Markus K., and Morgan John , Games and Economic Behavior, Volume 68, Number 2, p.532 - 550, (2010) Abstractclock_games_slides.pdfclock_games.pdf

Timing games with pre-emption and waiting motive as well as information clustering.

In many situations, timing is crucial—individuals face a trade-off between gains from waiting versus the risk of being preempted. To examine this, we offer a model of clock games, which we then test experimentally. Each player's clock starts upon receiving a signal about a payoff-relevant state variable. Since the timing of the signals is random, clocks are de-synchronized. A player must decide how long, if at all, to delay his move after receiving the signal. We show that (i) delay decreases as clocks become more synchronized, and (ii) when moves are observable, players “herd” immediately after any player makes a move. Our experimental results are broadly consistent with these two key predictions of the theory.

Economists' Perspectives on Leadership, Bolton, Patrick, Brunnermeier Markus K., and Veldkamp Laura , Handbook of Leadership Theory and Practice, Boston, MA, (2010) Leadership Survey.pdf
Optimizing the Currency Area, Brunnermeier, Markus K. , The Great Financial Crisis: Lesssons for Financial Stability and Monetary Policy, Frankfurt, p.14-22, (2010) ECB Colloquium 2010.pdfslides.pdf
2009
Complexity in Financial Markets, Brunnermeier, Markus K., and Oehmke Martin , (2009) Abstractcomplexity.pdf

Should we regulate complex securities, subject them to an FDA-style approval process, or limit who can invest in them? To answer these questions, one first needs to establish why complexity matters, and what defines a complex security. Complexity is an important concept in financial markets with boundedly rational agents, but that finding a workable definition of complexity is difficult. For example, while CDOs are viewed by most as highly complex, equity shares of financial institutions, whose payoff structures are even more complicated, are often seen as less complex. We point out three different ways in which boundedly rational investors can deal with complexity: (i) by dividing up difficult problems into smaller sub-problems or by using separation results, (ii) by using models – simplified pictures of reality, (iii) through standardization and commoditization of securities. Importantly, simply increasing the quantity of information disclosed to investors does not resolve complexity, since in the presence of bounded rationality it leads to information overload..

Deciphering the Liquidity and Credit Crunch 2007-2008, Brunnermeier, Markus K. , Journal of Economic Perspectives, Volume 23, Number 1, p.77-100, (2009) Abstractliquidity_credit_crunch.pdfliquidity_crunch_2007_08_slides.pdfliquidity_credit_crunch_nber.pdf

This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.