UC Berkeley

Financial intermediaries are arguably the backbone of every economy, engaged in a multitude of activities, for instance, capital allocation, liquidity provision, insurance and information production and dissemination. Frictionless financial intermediation is the key to developing an efficient and robust financial system. However, frictions exist and identifying and carefully assessing their potential remedies is critical in preventing market failures. This dissertation aims to further the understanding of frictions in financial intermediation performed by banking organisations and their affiliates while channeling savings of households and businesses to fund profitable opportunities.

Chapters 1 and 2 focus on the interactions of hedge funds and prime brokers in short-term debt markets where the former rely on prime brokerages for leverage. In Chapter 1, "Hedge Fund Leverage: The Role of Moral Hazard and Liquidity Insurance", we build a model of hedge fund securing financing from a prime broker to invest in hard-to-value assets. We introduce a novel form of moral hazard - "fraudulent transfers", whereby a distressed fund may utilize its discretion in valuation of hard-to-value assets to transfer them to affiliates to avoid repaying its obligations. These actions may exacerbate liquidity risk for the prime broker and may also lead to a costly legal recourse to enforce contracts. The model provides several new insights. First, it uncovers a new channel for funding liquidity that can explain why illiquid funds fare worse in times of stress and why better governed funds fared better during the financial crisis. Second, the model provides a new testable hypothesis that systematic or idiosyncratic shocks to fundamentals of bank holding companies may spillover to connected hedge funds through internal capital markets. It also offers an identification strategy to distinguish between possible competing hypotheses. Third, strong governance at hedge funds may reduce incentives to invest in profitable opportunities. Fourth, banking reforms such as Supplementary Leverage Ratio, Liquidity Coverage Ratio and Standing Repo Facility intended to improve resilience of banks may also make hedge funds less vulnerable to shocks in the banking sector. Fifth, the model offers a possible reconciliation for the mixed evidence on the impact of leverage on hedge fund survival documented in the literature.

In Chapter 2, "Multi-Prime Financing by Hedge Funds: A Common Agency Perspective", we extend the model studied in Chapter 1 to a model of nonexclusive contracting with a hedge fund raising secured debt from multiple prime brokers for investment in hard-to-value assets. Multi-prime financing makes it harder for prime brokers to manage counterparty risk due to lack of position transparency of the client. In our model, fund positions are transparent. However, as before, the fund may utilize discretion in valuation of these assets to avoid repaying its obligations. The model highlights that "high-quality" funds in the sense of low probability of default may suffer a loss in aggregate funding in comparison to single-prime level. "Low-quality" funds may also suffer a loss in funding, unless they decrease investment in hard-to-value assets thus constraining investment strategy. Together, these results highlight that multi-prime financing in the presence of position transparency may result in reduced investment in illiquid, hard-to-value assets which arguably also have a high rate of return. This provides a new rationale for why funds are reluctant in improving position transparency among their prime brokers. Furthermore, prime brokers may also be worse-off, highlighting that while improving position transparency may ease counterparty risk management for prime brokers, it may not necessarily make them better-off.

In contrast to our focus on inefficient actions on part of the borrower in the first two chapters, Chapter 3, "Board Conduct in Banks" (co-authored with Krishnamurthy Subramanian, Saipriya Kamath and Prasanna Tantri) focuses on inefficient actions that may be taken within banking organizations themselves. Specifically, motivated by several multinational and national reports on the failure of boards of banks in providing risk oversight preceding the financial crisis of 2008, we examine the minutes of Indian banks’ board meetings and offer insights on board conduct on the kind of issues tabled and discussed in bank boards. We find that risk issues account for only 10% of the issues tabled with regulation and compliance accounting for the most (41%), followed by business strategy (31%). Majority of the issues are not deliberated in detail. We interpret the evidence as suggestive of under-investment in risk and over-investment in regulation and compliance by bank boards.