Information loss over the business cycle
The number of active mutual funds is pro-cyclical: net entry is negative in downturns and positive in upturns. The effect of this firm turnover on welfare depends on a key-trade off: the business cycle replaces low quality exiting funds with entrants that may on average be higher quality, but about whom investors have a less precise signal as they have no returns history (where this "information loss" leads to misallocation that harms welfare). We 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. We estimate this model using data on US mutual funds. We find that the impact of the business cycle on welfare depends on its depth and frequency: a business cycle that is deep and infrequent harms welfare, whereas a business cycle that is shallow and frequent improves welfare. This is because a deep business cycle causes a smaller marginal improvement in average fund quality than a shallow cycle (because in deep recessions high quality funds exit as well as low quality funds) and an infrequent business cycle means that the funds that do exit have longer returns histories, such that a greater volume of socially valuable information is lost.
Squeezing dealers: bank regulation and market liquidity, with Jamie Coen (LSE)
Post-crisis regulation has increased the costs of market-making for dealers, but traditional measures of market liquidity have not deteriorated. To explain this empirical puzzle, we estimate an equilibrium search-and-matching model of an over-the-counter market. We build on existing models of this type by allowing dealers to: (1) endogenously select their search intensity, (2) face heterogeneous search costs, and (3) decide to exit the market. We estimate this model based on transaction-level data on Sterling corporate bonds, making use of a natural experiment in which capital regulation was introduced differentially across banks. We find that higher capital requirements cause high-cost dealers to exit the market and the remaining dealers to increase their search intensity, such that in equilibrium liquidity does not deteriorate. We run counterfactual analyses to reach novel conclusions about how the equilibrium effect of capital regulation on liquidity varies across markets depending on their characteristics and across time depending on financial stress.