Behavioral Finance and Financial

Stability
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SECULAR STAGNATION
IN THE OPEN ECONOMY

Eggertson, Mehrotra, and Summers develop a two country model to examine how capital markets
transmit secular stagnation across countries More Info

About This Research

The Behavioral Finance and Financial Stability Project, founded at the Harvard Business School,
supports research collaborations between faculty and students across Harvard University to
understand, predict, and prevent financial instability. The BFFS project also maintains an ongoing real-
time database of financial stability and investor sentiment measures that it makes available to
researchers and the broader public. Please visit our About page for more information about the
project.

Proceed to Data Section

Research Highlights
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Credit Cycle Feedback Loop
A Model of Credit Market Sentiment (BFFS WP #002)
Robin Greenwood, Samuel G. Hanson, and Lawrence Jin
AUG 2016

Over the past decade, it has increasingly been recognized that investor beliefs play an important role
in driving the credit cycle. In "A Model of Credit Market Sentiment", Robin Greenwood, Sam Hanson
and Lawrence Jin (of Caltech) develop a model to explore the feedback between credit market
sentiment and credit market outcomes. Their model is able to capture many documented features of
credit booms and busts, including the the link between credit growth and future returns, and the "calm
before the storm" periods in which fundamentals have deteriorated but the credit market has not yet
turned.

See Robins other research here, Samuels other research here, and Lawrences other research here
Related Themes: Measuring Sentiment & Expectations, Credit Markets
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Monetary Policy and Global Banking (BFFS WP #004)
Falk Bruning and Victoria Ivashina
JUN 2016

Global banks primarily receive funding in their domestic currencies, but operate and invest in multiple
foreign currencies. These cross country lending/borrowing operations create demand for currency
hedges. A tightening of domestic monetary policy may drive a bank to lend more in a foreign currency
by its effect on the these currency hedges. Falk and Victoria show evidence supporting this channel of
cross border shock transmission from data sets of country level firm-claims and individual level
syndicated loans.

See Falk's other research here. See Victorias other project-related financial stability research here, or
her homepage here.
Related Themes: Credit Markets, Monetary Policy and Money Markets
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The figure shows the return on assets of highly levered (dashed line) and low leverage (solid line)
banks from 2003-2015. Contrary to popular opinion, highly levered banks were less profitable than
low leverage banks pre crisis.
The Private Costs of Highly Levered Banks
Juliane Begenau and Erik Stafford
JUN 2016

The choice of relatively high leverage as a means to reduce the overall cost of capital by many banking
practitioners is interpreted as folly by some, and defended by others as a clever decision given the
capital markets apparent failure to appreciate the associated risks. Begenau and Stafford suggest and
provide evidence for an additional consideration: that high leverage signals an excessive focus on
financing decisions over good management, specifically over value-relevant investment and operating
decisions.

See Eriks other research here and Julianes other research here.
Related Themes: Global Crisis and Debt Data
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Does Reserve Accumulation Crowd Out Investment
Carmen Reinhart, Vincent Reinhart, and Takeshi Tashiro
MAY 2016

In this paper, Reinhart, Reinhart, and Tashiro study nine Asian economies in an effort to understand
why much of the decrease in investment that occurred during the 1997-1998 crisis has persisted in
the years between 1998 and 2014. Unlike Latin American economies during the mid- to late-1980s,
investment in these economies does not appear to be suffering at the expense of private consumption
or capital flight. For this reason, the authors contend that the traditional concepts of crowding out and
leakages must be redefined to be more encompassing.

See Carmens other research here and Vincents other research here.
Related Themes: Global Crisis and Debt Data, Monetary Policy and Money Markets
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Connectedness and Contagion
Hal Scott
MAY 2016

Systematic runs on financial institutions were the main culprits of the financial meltdown of 2008, not
over-exposure in connected balance sheets. Hal Scott argues this insight in his new book,
"Connectedness and Contagion." In fact, contagion, as caused by these systematic runs of short-term
creditors, still imposes great risks on the global financial system. Hal warns that recent legislative
efforts by the US congress have weakened the ability of regulatory bodies to adequately combat
contagion.

See Hal's other research here

Related Themes: Global Crisis and Debt Data, Stabilization Policy & Regulation

(click image to enlarge)

The figure shows the fraction of cov-lite loans by quarter
Covenant-Light Contracts and Creditor Coordination
Bo Becker and Victoria Ivashina
31 MAR 2016

Leveraged loan markets go through episodes in which the typical new loan is issued with far fewer
protections to the lender, known as cov-lite. Many have pointed to cov-lite issuance as a proxy for
credit market overheating. In the first empirical analysis of this topic, Bo and Victoria evaluate
whether this development can be attributed to market overheating, increased borrower demand for
cov-lite loans, or a rise in creditor coordination costs.

See Victorias other project-related financial stability research here, or her homepage here. Data
related to this study is publicly available here.
Related Themes: Measuring Sentiment & Expectations, Credit Markets

(click image to enlarge)

Global Cycles: Capital Flows, Commodities, and Sovereign Defaults, 1815-
2015
Carmen Reinhart, Vincent Reinhart, and Christoph Trebesch
FEB 2016

Empirical works exploring the relationship between capital flows and economic crisises have been
limited by data to several episodes in the modern era. Reinhart, Reinhart, and Trebesch explore the
rich history of booms and busts in capital flow by uncovering data from sources going back to 1815.
The pattern uncovered by the authors have strong implications on the vulnerabilities of many
emerging economies today.

See Carmens other research here, Vincents other research here, and Christophs other research
work here.
Related Themes: Measuring Sentiment & Expectations, Global Crisis and Debt Data
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Forward Guidance and the Yield Curve: Short Rates versus Bond Supply
Robin Greenwood, Samuel G. Hanson, and Dimitri Vayanos
07 DEC 2015

The term forward guidance when the central bank guides market expectations is normally used in
reference to central bank policy on short rates. However, quantitative easing (or QE) the other
primary monetary policy tool being used since 2008 also involves some degree of forward guidance
as well. In this paper, Greenwood, Hanson, and Vayanos build a no-arbitrage model of the yield curve
that allows for a characterization and comparison of the effects of forward guidance on short rates and
forward guidance on quantitative easing.

See Robins other research here, Samuels other research here, and Dimitris other research here.
Related Themes: Monetary Policy and Money Markets, Stabilization Policy & Regulation
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Extrapolation and Bubbles
Nicholas Barberis, Robin Greenwood, Lawrence Jin, and Andrei Shleifer
SEP 2015

At the heart of standard narratives of historical asset bubbles is a high degree of extrapolation the
formation of expected returns based on past returns by investors. Yet, nearly all bubbles are also
defined by very high trading volume, a feature that excessive extrapolation cannot explain alone.
Barberis, Greenwood, Jin, and Shleifer develop a novel model of bubbles, wherein extrapolative
investors weigh two opposing signals, in an effort to reconcile these two defining features of bubbles.

See Nicholass other research here, Robins other research here, Lawrences other research here, and
Andreis other research here.
Related Themes: Measuring Sentiment & Expectations
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Dollar Funding and the Lending Behavior of Global Banks
Ivashina, Victoria, David S. Scharfstein, and Jeremy C. Stein
AUG 2015

Foreign banks play large roles in the US domestic funding market. However, unlike domestic banks,
which are funded by insured deposits, these institutions are funded either by uninsured domestic
commercial papers or by insured foreign denominated deposits which are then swapped in the FX
market. A shock that forces these banks to switch from commercial papers to deposits can have large
consequences on the covered interest rate parity relationship given limited arbitrage capital.

See Victorias other project-related financial stability research here, or her homepage here. See
Jeremys other research here.
Related Themes: Credit Markets
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The figure shows the average premium of short-term T-bills, by week-to-maturity. Short-maturity T-
bills have very low yields.
A Comparative Advantage Approach to Government Debt Maturity
Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein
AUG 2015

Using a novel model that incorporates monetary benefits that investors derive from holding riskless
securities, Greenwood, Hanson, and Stein examine how a government should optimally determine the
maturity structure of its debt. They explore the results of their model under multiple scenarios
depending on whether a government can directly internalize these monetary benefits and on the
presence of private sector competition in the production of riskless, money-like claims.

See Robins other research here, Samuels other research here, and Jeremys other research here.
Related Themes: Credit Markets, Monetary Policy and Money Markets, Stabilization Policy &
Regulation
 (click image to enlarge)
The authors recommend opting for treasury rates over the LIBOR as the reference rate for many
interest rate derivatives
Reforming LIBOR and Other Financial Market Benchmarks
Darrell Duffie and Jeremy C. Stein
JAN 2015

Duffie and Stein review the history and the role of LIBOR and similar benchmarks used in the modern
financial market. The authors argue that the incentive to distort these benchmarks is severe given the
benchmarks' polling nature and the sheer volume of the derivative market linked to these rates. The
authors make several recommendations on how changes to benchmark definition and the adoption of
new overall regulatory policies, can reduce the susceptibility of reference rates to manipulation.

Related Themes: Credit Markets, Stabilization Policy & Regulation, Size and Growth of the Financial
Sector

Finance

Finance is a featured research topic at Harvard Business School.

Our intellectual roots are based in a long line of scholars from Robert Merton whose collaborative work
on risk management and option pricing won him the Nobel Prize in Economics in 1997, to John Lintner
who co-created the Capital Asset Pricing Model and made significant contributions to dividend policy,
and Gordon Donaldson whose work helped shape the field of corporate finance. We strive to
understand how managers and firms make value-enhancing decisions; and how financial institutions,
markets, and instruments contribute to this process. Our approach to research is distinguished by its
unique combination of theory, empirical analysis, mathematical modeling, and field observations at
companies.

Featured Works
Monetary Policy Drivers of Bond and Equity Risks

John Y. Campbell, Carolin E. Pflueger and Luis M. Viceira

HBS Working Paper Series 2015

How do monetary policy rules, monetary policy uncertainty, and macroeconomic shocks affect the risk
properties of US Treasury bonds? The exposure of US Treasury bonds to the stock market has moved co

Playing Favorites: How Firms Prevent the Revelation of Bad News

Lauren Cohen, Dong Lou and Christopher J. Malloy

2016

We explore a subtle but important mechanism through which firms can control information flow to the
markets. We find that firms that cast their conference calls by dispr

Dynamics of Demand for Index Insurance: Evidence from a Long-Run Field

Experiment

Shawn A. Cole, Daniel Stein and Jeremy Tobacman

American Economic Review: Papers and Proceedings May 2014

This paper estimates how experimentally-manipulated experiences with a novel financial product, rainfall
index insurance, aff

Expectations of Returns and Expected Returns

Robin Greenwood and Andrei Shleifer

Review of Financial Studies 2014

We analyze time-series of investor expectations of future stock market returns from six data sources
between 1963 and 2011. The six measures of expectations are highly positively corr

Mortgage Convexity

Samuel G. Hanson

Journal of Financial Economics August 2014

 Most home mortgages in the United States are fixed-rate loans with an embedded prepayment option.
When long-term rates decline, the effective duration of mortgage-backed securities (MBS) falls due to
heightened refinancing expectations. I show that thes

Financial Repression in the European Sovereign Debt Crisis

Victoria Ivashina and Bo Becker

2014

By the end of 2013, the share of government debt held by the domestic banking sectors of Eurozone
countries was more than twice its 2007 level. We show that this type of increasing reliance on the
domestic banki

Recent Publications

1. CASE | HBS CASE COLLECTION | NOVEMBER 2016

Financing Astroscale

Ramana Nanda and Matthew C. Weinzierl

Keywords: Entrepreneurial Finance; Entrepreneurship; Finance

CITEEDUCATORS RELATED

2. CASE | HBS CASE COLLECTION | NOVEMBER 2016

Deutsche Bank: Structured Retail Products

Boris Valle and Jrme Lenhardt

Describes how Deutsche Bank, a leading bank in Europe, is deciding whether or not to launch a new
structured retail product in Germany: an auto callable note. Will this product find a market and how
does it fit into the banks product portfolio? The case investigates how Deutsche Bank manufactures
and distributes its structured retail products, and more broadly explores the opportunities and
challenges of offering financial products to households. The case also dwells on the scale and scope of
business of retail banking in an increasingly regulated environment.

Keywords: Structured Products; Structured Retail Products; Germany; Auto Callable Note; Financial
Product; Financial Product Development; Financial Product Marketing; Financial Product
Launch; Financial Product Positioning;Finance; Assets; Asset Pricing; Asset Management; Capital
Markets; Financial Institutions; Banks and Banking; Commercial Banking; Financial
Instruments;Annuities; Bonds; Stocks; Financial Management; Financial Markets; Financial
Strategy; Interest Rates; Investment
 CITEEDUCATORS RELATED

3. BOOK | 2016

Why They Do It: Inside the Mind of the White-Collar Criminal

Eugene F. Soltes

From the financial fraudsters of Enron, to the embezzlers at Tyco, to the Ponzi schemer Bernie Madoff,
the failings of corporate titans are regular fixtures in the news. But what drives wealthy and powerful
people to white-collar crime? I draw from extensive personal interaction and correspondence with
nearly fifty former executives as well as research in psychology, criminology, and economics to
investigate how once-celebrated executives become white-collar criminals.

Keywords: Crime and Corruption; Corporate Finance

CITEFIND AT HARVARDPURCHASE RELATED

4. WORKING PAPER | HBS WORKING PAPER SERIES | 2016

Sovereign Risk, Currency Risk, and Corporate Balance Sheets

Wenxin Du and Jesse Schreger

Nominal debt provides consumption-smoothing benefits if it can be inflated away during recessions.
However, we document empirically that countries with more countercyclical inflation, where nominal
debt provides better consumption smoothing, issue more foreign-currency debt. We propose that
monetary policy credibility explains the currency composition of sovereign debt and nominal bond risks
in the presence of risk-averse investors. In our model, low credibility governments inflate during
recessions, generating excessively countercyclical inflation in addition to the standard inflationary bias.
With countercyclical inflation, investors require risk premia on nominal debt, making nominal debt
issuance costly for low credibility governments. We provide empirical support for this mechanism,
showing that countries with higher nominal bond-stock betas have significantly larger nominal bond
risk premia and borrow less in local currency.

Keywords: Sovereign Finance; Business Cycles; Currency

CITESSRNREAD NOW RELATED

5. CASE | HBS CASE COLLECTION | SEPTEMBER 2016 (REVISED NOVEMBER 2016)

Western Technology Investment

Ramana Nanda, William A. Sahlman and Nicole Keller

Based in Portola Valley, California, WTI specialized in this hybrid form of debt and equity financing for
early-stage companies. Like traditional venture capital and private equity firms, WTI raised funds from
institutional investors and evaluated deals. However, instead of making initial investments in the form
of equity, WTI focused primarily on lending money to start-ups, charging them interest and receiving
 warrants that could later be converted to stock in the case of a liquidity event. Most initial investments
usually in the range of $3-$5 millionwere made in tandem with or following a companys early
rounds of venture capital equity financing. In addition, like more traditional venture capital investors,
WTI hoped to participate in follow-on debt and equity investments in its successful portfolio
companies.

Keywords: Entrepreneurial Finance; Venture Capital; Entrepreneurship;Equity; Finance; California

CITEEDUCATORS RELATED

6. CASE | HBS CASE COLLECTION | SEPTEMBER 2016 (REVISED SEPTEMBER 2016)

MyTime

Juliane Begenau and Robin Greenwood

Ethan Anderson, the CEO of San Francisco-based e-commerce company MyTime, must decide on the
company's growth strategy. MyTimes first product was a website and mobile app that offered
consumers a convenient way to book appointments with local merchants throughout the United
States. Student must assess the company's growth strategy and develop a model to value a
prospective customer to the company's website.

Keywords: Customer Valuation; Discounted Cash Flow; Software; Valuation;Valuation

Methodologies; Subscriber Models; Financial Management; Corporate Finance; Information Technology
Industry; North and Central America

CITEEDUCATORSPURCHASE RELATED

7. CASE | HBS CASE COLLECTION | SEPTEMBER 2016

Financial Services at Falabella (A)

C. Fritz Foley and Agustin M. Hurtado

In 2010, the board and senior management team of Falabella, a leading retailer with operations
throughout Latin America, faced choices about what to do with its financial services division. More
than 4.5 million customers had CMR credit cards that could be used in Falabella stores, and Banco
Falabella competed with other banks by offering personal banking services. The case covers many of
the key questions the leaders of the firm faced, including whether to allow credit card holders to use
their cards for purchases outside of Falabella stores, whether to develop personal banking services
further, and whether to make substantial changes to the strategy or to exit the business.

Keywords: Consumer Credit; Financial Institutions; Personal Finance; Financial

Management; Financial Strategy; Corporate Strategy; Banking Industry; Retail Industry; Latin
America; Chile; Argentina; Colombia; Peru

CITEEDUCATORSPURCHASE RELATED

8. WORKING PAPER | 2016

 The Stock Market and Bank Risk-Taking

Antonio Falato and David Scharfstein

We present evidence that pressure to maximize short-term stock prices and earnings leads banks to
increase risk. We start by showing that banks increase risk when they transition from private to public
ownership through a public listing or an acquisition. The increase in risk is greater than for a control
group of banks that intended but failed to transition from private to public ownership, a result that is
robust to using a plausibly exogenous instrument for failed transitions. The increase in risk is also
greater than for a control group of banks that were acquired but did not change their listing status. We
establish that pressure to maximize short-term stock prices helps to explain these findings by showing
that the increase in risk is larger for newly public banks that are more focused on short-term stock
prices and performance.

Keywords: Risk and Uncertainty; Financial Markets; Investment; Corporate Finance; Banks and
Banking

CITEFIND AT HARVARDREAD NOW RELATED

9. WORKING PAPER

Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

Wenxin Du, Carolin E. Pflueger and Jesse Schreger

Nominal debt provides consumption-smoothing benefits if it can be inflated away during recessions.
However, we document empirically that countries with more countercyclical inflation, where nominal
debt provides better consumption-smoothing, issue more foreign-currency debt. We propose that
monetary policy credibility explains the currency composition of sovereign debt and nominal bond risks
in the presence of risk-averse investors. In our model, low credibility governments inflate during
recessions, generating excessively countercyclical inflation in addition to the standard inflationary bias.
With countercyclical inflation, investors require risk premia on nominal debt, making nominal debt
issuance costly for low credibility governments. We provide empirical support for this mechanism,
showing that countries with higher nominal bond-stock betas have significantly larger nominal bond
risk premia and borrow less in local currency.

Keywords: Sovereign Finance

10. CASE | HBS CASE COLLECTION | JULY 2016

Blue D Pharmaceuticals

Kevin Schulman, Emma Rasiel and Suresh Balu

Susan Durham has just been hired as the Chief Financial Officer of Blue Devil Pharmaceuticals (BDP).
Her charge is to understand the optimal pathway for the development of a novel molecule, BDP-1, to
understand the cost of drug development, the market opportunity, and the optimal financing strategy
for the development of this technology. The case includes a unique simulation model that examines
key unknowns in making this assessment including the volatility in the financial markets, volatility in
in-licensing markets. Financial strategies include: go-alone, partner with a pharmaceutical company,
receive financing from a private equity firm, or there is an option to sell the molecule. Students can
see how uncertainty in the development and financing strategy can impact the value of the firm to
shareholders.

Keywords: Finance; Entrepreneurship