Essays on Credit Spreads, Bank Risk-Taking, and Flight-to-Safety

Abstract

This dissertation consists of three independent chapters in financial economics. Chapter 1 studies the dynamics of US corporate bond credit spreads. Post-2008, corporate bond credit spreads decline when long-term interest rates increase, particularly for lower-rated bonds. This is true unconditionally but also conditional on monetary policy announcements. In the cross-section, this negative co-movement between long rates and credit spreads is more pronounced for bonds predominantly held by life insurers. I develop a quantitative framework that rationalizes these findings. In the model, life insurers with long-duration liabilities face duration mismatch and, therefore, realize equity gains when long rates increase. As a result, their effective risk aversion declines, driving down equilibrium credit spreads. The model also shows that life insurers' duration mismatch can dampen or even reverse the transmission of unconventional monetary policy to bond markets. Chapter 2, co-authored with Jihong Song, studies the risk-taking of US banks. Banks with high deposit market power take on significantly less credit risk. The loan portfolios of high-market-power banks are much safer than those of low-market-power banks. This persistent relationship is not driven by the size, funding structure, loan market power, or geography of banks. Consequently, high-market-power banks earn higher profits, are less pro-cyclical, and sustain smaller losses in recessions. We propose a model where deposit market power increases banks' franchise value and induces them to take on less risk to avoid defaults. Chapter 3, co-authored with Sebastian Merkel, studies the interaction between flight-to-safety behavior and nominal rigidity. We build a New Keynesian model with idiosyncratic risk, incomplete markets, and nominal safe assets to study the transmission of uncertainty shocks through investors' portfolio decisions. In response to an unexpected increase in uncertainty, investors reallocate their resources from productive to safe assets for precautionary reasons. When prices are sticky, the real value of nominal safe assets cannot flexibly adjust. Instead, the adjustment pressure leads to an aggregate demand recession and undershooting in the price of productive assets. Conventional interest rate policy alone has limited power in influencing household portfolios. Instead, fiscal policy is crucial in price stabilization and optimal policy.