The industrial organisation of financial intermediation

Abstract

This thesis consists of three chapters on the industrial organization of financial intermediation. The first chapter, which is co-authored with Jamie Coen, considers the interbank market and how it should be regulated. The interbank network, in which banks compete with each other to supply and demand financial products, creates surplus but may also result in risk propagation. We examine this trade-off by setting out a model in which banks form interbank network links endogenously, taking into account the effect of links on default risk. We estimate this model based on novel, granular data on aggregate exposures between banks. We find that the decentralised interbank network is not efficient, primarily because banks do not fully internalise a network externality in which their interbank links affect the default risk of other banks. A social planner would be able to increase surplus on the interbank network by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains. The second chapter considers the effect of the business cycle on outcomes in the mutual fund industry. The business cycle induces turnover in mutual funds: they exit in recessions and enter in recoveries. The effect of this firm turnover on welfare depends on a key trade- off: on the one hand, the business cycle \cleanses the market of low quality exiting funds and replaces them with entrants that may on average be higher quality. On the other hand, the entrants have no returns history and so investors have less precise beliefs about their ability, where this \information leads to misallocation that harms welfare. I examine this trade-off by estimating a structural model in which rational investors form and update beliefs about competing mutual funds that endogenously choose to enter and exit the market. I estimate this model using data on US mutual funds. I find that the business cycle has material, persistent effects that are negative in the short-term but turn positive as the effect of information loss decays over time. The third chapter considers local competition between mutual funds. Mutual funds with similar investment strategies compete with each other for investment opportunities. I set out a model of demand for mutual funds in which (i) funds are located within a network depending on similarities in their investment strategies and (ii) funds impose negative spillovers on each other through this network. I structurally estimate this model using data on US equity 4 mutual funds. I identify these network spillovers based on how investors in a given mutual fund respond to the returns performance of its competitors. I find that local competition has a material impact on fund size, in that absent competition the median fund would be 20% bigger, and on cross-sectional variation in size. I perform counterfactual simulations in which I demonstrate that luck can play an important role even when funds are skilled and investors are rational: I find that luck accounts for 9% of cross-sectional variation in mutual fund size.