The paper investigates the connection between concentration and fragility in over-the-counter (OTC) markets. I argue that the increase in spreads in OTC markets during a crisis reflects an increase in dealer mark-ups and not merely an increase in dealer costs of facilitating trade. Using Regulatory TRACE data on the US Corporate Bonds market, I construct a bond-level HH-index to gauge concentration in the market for each bond. Focusing on the COVID-19 crisis that emerged in the first quarter of 2020, I show that concentrated markets exhibit a greater increase in spreads and a stronger decline in trade volumes during a crisis. I present a model in which trade in a bond is led by dealers who acquire information about it. Systemic distress incentivizes informed dealers to exercise market power more aggressively by submitting low bids that appeal solely to distressed customers. When calibrated to the behavior of spreads across different concentration levels before and during the COVID-19 crisis, the model successfully reproduces the data, including the response of volume to the crisis, which was not targeted. Additionally, the calibration demonstrates that the increased uncertainty during the COVID-19 crisis was key for concentration to exacerbate the severity of the crisis as much as it did.
We develop a search-theoretic model of over-the-counter markets in which customers with arbitrary preferences and asset holdings trade through dealers. Importantly, we assume that when a customer and a dealer meet, dealers can only sell assets that they already own. Within this environment, we derive the equilibrium relationship between dealers’ cost of holding assets as inventory and various measures of liquidity, including dealers’ inventory holdings (or “capital commitment”), bid-ask spreads, trade size, volume, and turnover. Using transaction level data from the corporate bond market, we calibrate the model to quantitatively assess the impact of post-crisis regulations on dealers’ inventory costs, liquidity, and welfare. We also exploit our structural framework to study the effects of other developments in the corporate bond market, including entry by non-regulated banks, the rise of electronic trading platforms, and the shift towards passive investment vehicles.
This paper investigates the impact of transient economic shocks on long-term growth, focusing on their role in shaping the nature of R&D investment. Using US Census survey data, it provides novel evidence indicating that private sector investment in basic research is countercyclical. Specifically, it documents a substantial rise in private basic research expenditure in 2008 (20%), 2009 (35%), during the 2001 dot.com recession (20%), and during the 1991 recession (55%). In line with Schumpeter’s theory, the paper argues that weak demand induces firms to transition towards long-term R&D, prompting them to pursue more fundamental questions, and ultimately fostering technological leaps and long-term growth. Based on these findings, the paper proposes a novel semi-endogenous growth model with two types of R&D activities: creating new knowledge (basic research) and applying existing knowledge (applied research and development). After calibrating the model, it shows that the adverse impact of a recession on the level of R\&D investment is countered by reallocating this investment to activities that have greater social value. When the latter effect dominates, downturns can accelerate long-term growth.
Recent empirical work by Martin et al. (2018) document that banks facing failure compensate for departing depositors by attracting insured deposits. This run-in reduces the bank’s liability cost and enhances its chances of weathering distress. However, it also weakens the discipline imposed by depositors and leads banks to take more risks. This paper introduces a theoretical model assessing the impact of insured deposit flows on the overarching stability of the banking system. The model underscores that sophisticated insured depositors seeking to maximize returns amplify the gravity of a banking crisis. Remarkably, even a minimal fraction of these non-sticky depositors can introduce destabilizing effects. In this context, I argue that regulatory measures limiting insured deposit flows, like strict controls on brokered deposits, are an all-or-nothing game. Unless they drastically reduce the activity of insured depositors, they are ineffective in sustaining the discipline deposits impose on bank risk-taking.