Essays on financial fragility and resolutions

Abstract

This thesis examines issues on financial fragility and possible resolutions. The key focus of three essays is to investigate how to implement both ex ante and ex post methods to avoid or mitigate the impact of financial fragility. The first essay explores the optimal reorganization bankruptcy choice for those firms experiencing financial difficulties. The second essay examines the role of creditor diversity on financial stability and its potential regulation implications. The third essay studies the role of information sharing on financial fragility induced by possible valuation runs. The first essay finds pre-packaged reorganization (prepack) takes ex ante better firms through a shorter and less costly bankruptcy procedure compared to traditional Chapter 11 but leads to more refiling. To explain this phenomenon, I propose an information acquisition model where creditors trade higher bankruptcy costs under traditional reorganization with higher accuracy in filtering inefficient from efficient firms. The prepack decision is governed by the value of the signal that a firm can acquire under traditional Chapter 11. Empirically, firms with better information and higher downside risks choose traditional reorganization. These firms subsequently have a lower rate of emergence but a higher survival rate. The second essay examines the effectiveness of bank regulation in the light of creditor diversity. We focus on a bank's value generation through the interaction of its issuance of securities with different risk levels, matching between securities and creditors, and capital buffer. Our calibration and evidence suggest even a well-capitalized bank cannot eliminate financial fragility in the absence of creditor diversity. We find capital regulation is only effective when a bank can save financing costs by matching the riskiness of securities and the risk tolerance of diverse creditors. If financial fragility is persistent, we suggest liquidity regulation can mitigate excessive risk-taking. In the presence of multiple equilibria, financial market may experience valuation shock which shifts the market from high credit supply equilibrium to low credit supply equilibrium, causing sharp declines in financing and welfare. The third essay studies the impact of information sharing to this financial fragility. I find information sharing can mitigate the magnitude of the credit supply reduction; meanwhile increases market's fragility, i.e. the likelihood of such reduction. Since information sharing encourages valuation and discourages unsophisticated investments, sophisticated investors would strictly prefer information sharing, which could lead to a suboptimal social outcome. From a social planner's perspective, optimal choice of information sharing should be countercyclical.