Xavier Freixas

What should be the role of a public development bank (PDB)? Which projects/firms should the PDB target? What can theory say about the types of loans and ways of delivering them that PDBs around the world use? We analyze these questions in the context of a model where screening is costly to banks. Underprovision of credit results from the inability of banks to (i) appropriate the full benefits of projects they finance, more pronounced for high value projects; and (ii) internalize the benefits of screening in terms of aggregate lending. PDB intervention naturally addresses inefficiencies originating in failures in the private provision of credit. Though lending to commercial banks at subsidized rates or providing credit guarantees are valid alternatives, guarantees are less effective than subsidies at equivalent cost. PDB lending is particularly important in recessions, when liquidity/capital shortages are likely, and risk profiles deteriorate potentially leading to further credit underprovision. Subsidized lending is further preferred to guarantees when banks are facing a liquidity shortage, while a credit guarantees program has additional benefits when banks are undercapitalized.

We provide a microfounded framework for the welfare analysis of macroprudential policy within a model of rational bubbles. For this we posit an overlapping generation model where productivity and credit supply are subject to random shocks. We find that when real interest rates are lower than the rate of growth, credit financed bubbles may be welfare improving because of their role as a buffer in channeling excessive credit supply and inefficient investment at the firms' level, but its sudden price decrease may cause a systemic crisis. Therefore a well designed macroprudential policy plays a key role in improving efficiency while preserving financial stability. Our theoretical framework allows us to compare the efficiency of alternative macroprudential policies. Contrarily to conventional wisdom, we show that (i) macroprudential policy may be efficient even in the absence of systemic risk, (ii) it has to be contingent on productivity shocks and (iii) it must be contingent upon the level of real interest rates.

The global financial crisis and the sovereign debt crisis in Europe have redefined the functions of the lender of last resort (LOLR). First, they have placed the LOLR at the intersection of monetary policy, fiscal policy, supervision, and regulation of the banking industry. Second, they have given regulatory authorities the additional responsibility of monitoring the interbank market. Third, they have extended the LOLR role to cover the possible bailout of non-bank institutions, including sovereign countries. This chapter explores the link between the theoretical models of the banking industry and the unprecedented policies displayed in the aftermath of the crisis. We begin by examining the justification of LOLR in a simplified framework where only liquidity shocks arise, to move to a setting where liquidity shocks cannot be disentangled from solvency ones. We then study contagion in the interbank market and systemic risk, two pathologies due to the imperfections of the financial markets, and we discuss the issues raised by the implementation of the LOLR policy within the safety net.

Which projects/firms should be the target of lending by a Public Development Bank (PDB)? What is the optimal design for the PDB's loans, and the optimal structure for delivering them? We analyze these questions in the context of a model where screening is costly to banks and underprovision of credit results from the inability of banks to appropriate the full benefits of projects they finance, more pronounced for high value projects. PDB intervention arises as a natural alternative to alleviate this inefficiency, since it originates in a failure in the private provision of credit. Lending to commercial banks at subsidized rates or providing credit guarantees, targeting the firms that generate high added value, are valid policy alternatives. Though in normal times PDB lending and credit guarantees are shown to be equivalent, lending is preferred when banks are facing a liquidity shortage, while a credit guarantees program is preferred when banks are undercapitalized. Direct lending by the PDB to the targeted industries could be superior to these subsidies to private lending, but only if the PDB's corporate governance is strong enough for public credit to respond to efficiency considerations rather than political concerns. PDB intervention naturally addresses credit underprovision stemming from failures directly affecting financial institutions, but it can also alleviate that arising from firm's moral hazard or insufficient access to collateral.

We model a systemically important financial institution that is too big (or too interconnected) to fail. Without credible regulation and strong supervision, the shareholders of this institution might deliberately let its managers take excessive risk. We propose a solution to this problem, showing how insurance against systemic shocks can be provided without generating moral hazard. The solution involves levying a systemic tax needed to cover the costs of future crises and more importantly establishing a systemic risk authority endowed with special resolution powers, including the control of bankers’ compensation packages during crisis periods.

We study how relationship lending and transaction lending vary over the business cycle. We develop a model in which relationship banks gather information on the

The collapse of AAA‐rated structured finance products in 2007 to 2008 has brought renewed attention to conflicts of interest in credit rating agencies (CRAs). We model competition among CRAs with three sources of conflicts: (1) CRAs conflict of understating risk to attract business, (2) issuers' ability to purchase only the most favorable ratings, and (3) the trusting nature of some investor clienteles. These conflicts create two distortions. First, competition can reduce efficiency, as it facilitates ratings shopping. Second, ratings are more likely to be inflated during booms and when investors are more trusting. We also discuss efficiency‐enhancing regulatory interventions.

Central banks play an important role as lender of last resort (LOLR) to banks experiencing liquidity problems. This article examines this LOLR function, and its relationship with bank closure policy. It considers the justification of LOLR lending in a simplified framework where only liquidity shocks arise. It then examines contagion in the interbank market. The next section is devoted to the case where liquidity shocks cannot be disentangled from solvency ones. This is followed by a discussion of the issues raised by the implementation and decentralization of the LOLR policy within the safety net.