Three essays on financial innovation
This dissertation concerns financial innovation in credit instruments. The implications of three of these new instruments---securitized assets, secondary market syndicated loans, and credit derivatives--for participating institutions and the macroeconomy are examined from two different approaches. Two essays explore their impact on the credit and interest rate channels of the monetary policy transmission mechanism, and the third essay analyzes security design features to signal instrument value. The first essay considers the effects of all three credit risk transfer (CRT) instruments on the two credit channels of the transmission mechanism. Evidence of the channels is tested for in a factor-augmented vector autoregression (FAVAR) model. Impulse response functions show no support for the existence of a narrow credit channel, which focuses on hank supplied credit, but demonstrate broad credit channel effects faced by all borrowers in financial markets. Banks active in these markets can insulate themselves from monetary policy actions, weakening the narrow credit channel with wider access to CRT for both borrowers and lenders of all types. The results suggest that transferred credit risk does not reduce the overall amount of risk in financial markets allowing for effective monetary policy. The second essay investigates what influence securitization has on the interest rate channel of the transmission mechanism. Emphasis is placed on differences among the mortgage, consumer credit, and business loan markets and between agency and private-label deals. The empirical framework consists of an interest rate pass-through and aggregate demand model augmented to account for securitization. For both markets and types, securitization tends to increase the speed of adjustment of lending rates to changes in the policy rate, reduce the size of the pass-through for all but the business loan market, and decrease the interest rate elasticity of output. More available funding and liquidity from securitization may weaken the response of financial market rates to monetary policy actions, which may result in less influence on real activity. The results suggest that private-label securitization deals make the adjustment process more efficient than agency transactions, and, for the business loan market, other channels such as the narrow credit channel may no longer be operative. The final essay develops a signaling model of asset-backed security issuance to analyze the role of the principal paydown structure as a signal of the value of the securities offered to investors. A securitizing firm has an information advantage over an investor about asset value. It is shown that a high-type firm can separate from a low-type counterpart with a sequential payment structure that repays principal based on the priority of the securities rather than in proportion to the amount invested in the securities under a pro rata payment structure. The model offers an explanation for how a majority of the securitization deals in markets are structured, and the predictions from the model offer suggestions for the design of future securitization transactions given the recent experience in these markets.