Essays in financial intermediation

• Main Author: Liu, Zijun
• Published: London School of Economics and Political Science (University of London) 2011
• Subjects: 332.7; HG Finance
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.550714

The thesis consists of three papers. Credit Rating and Competition (co-authored wth Pragyan Deb and Nelson Camanho) studies the behaviour of credit rating agencies in a competitive framework with the presence of conflicts of interest. We show that competition for market share through reputation is insufficient to discipline rating agencies in equilibrium. More importantly, our results suggest that, in most cases, competition will aggravate the lax behaviour of rating agencies, resulting in greater ratings inflation. This result has important policy implications since it suggests that enhanced competition in the ratings industry is likely to make the situation worse. Credit Default Swaps - Default Risk, Counter-party Risk and Systemic Risk examines the implications of CDS on systemic risk. I show that CDS can contribute to systemic risk in two ways: through counter-party risk and through sharing of default risks. A central clearing house, which can only reduce counter-party risk, is by no means a panacea. More importantly, excessive risk taken by one reckless institution may spread to the entire financial system via the CDS market. This could potentially explain the US government's decision to bail out AIG during the recent financial crisis. Policies requiring regulatory disclosure of CDS trades would be desirable. Investor Cash Flow and Mutual Fund Behaviour (co-authored with Zhigang Qiu) analyzes the trading incentives of mutual fund managers. In open-ended funds, investors are only willing to invest in the fund when the share price of the fund is expected to increase, i.e. the fund is expected to make profits in the future.We show that the fund manager may buy the asset even when he perceives the asset to be over-valued, given that his portfolio choices are disclosed to the investors and that he is paid a fixed fraction of the terminal value of the fund.