The Origins of Financial Instability and Policy Responses

• Applicant: Professorin Dr. Ester Faia, Ph.D.
• Subject Area: Economic Theory
• Term: from 2019 to 2023
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 415866087

Several years after a major financial crisis, financial instability is still pervasive in several sectors of the economy. In Europe non-performing loans are still high particularly in countries like Italy, Spain and France, indicating that incomplete information on borrowers and over-valued collateral still need corrective actions. Various macro-prudential measures are being implemented to control the emergence of instability on credit growth. Second, fragility in the banking sector is also pervasive whereby in many countries bank runs and bank defaults are still frequent. Against this background the new European supervisory architecture is advancing on the design and implementation of liquidity regulation, whose efficacy and possible consequences are still unknown. Beyond instability in credit markets and in the traditional banking sector, new digital markets (notably those for crypto-currencies) are posing challenges in that in many cases they exhibit bubble-prone dynamics. Given the above this project aims at examining the origins of financial market instability, and its possible prevention, in three sectors of the economy, namely in households’ borrowing decisions, whereby heterogeneity might foster amplifications, in the banking sector subject to bank runs, which possibly call for liquidity regulation, and in new digital markets (notably crypto-currencies) where trading and prices are often driven by exuberant investors more than by fundamentals. While on the academic side it has been argued that macroeconomic models lack key ingredients to understand the complex interaction with the financial side, policy makers also call for new models to guide macro-prudential policy. Against this background, in this project we focus on building models which can also be used for policy analysis in the above-mentioned areas. The first aims at building a heterogeneous agents model with contractually founded credit frictions to study the distributional consequences of macro-prudential policy. A second sub-project aims at building a macro model with banks subject to runs and holding optimal contractual agreements with outside financiers to assess the role of liquidity regulation in containing banking panics. A third sub-project aims at studying the determinants of prices and the conditions for the emergence of instability in new digital markets.

• DFG Programme: Research Grants
• Co-Investigator: Giuliano Curatola, Ph.D.