Essays on the Financial Sector Inefficiencies

This dissertation investigates the sources of inefficiencies in financial sector and effects of these inefficiencies on the economy. In the first chapter, I analyze the effects of asset prices on financial institutions in a dynamic stochastic general equilibrium model including bank defaults and related agency costs. I find that pecuniary externalities exist in asset prices as decentralized banks do not internalize the effects of their lending on asset price distributions. These externalities lead to excess risk taking and leverage in the financial sector. Excess risk taking behavior deteriorates welfare of both depositors and banks in a stochastic economy. I show that a restricted social planner is able to improve welfare by limiting the leverage in the economy. In planner's problem, robust banking system is more resilient against the shocks. This in turn creates more stable economy with lower bankruptcy costs and increases welfare. Thus, I show that significant economic gains are possible with appropriate regulations in the financial sector. In the second chapter, I examine the welfare effects of pecuniary asset price externalities using a dynamic stochastic general equilibrium model. I show that decentralized financial system is socially inefficient due to pecuniary price externalities. I compare various regulations using quantitative welfare analysis. I find that bailout policies cause moral hazard problems and induce excess risk taking. Therefore, such policies worsen the inefficiency. However, macro-prudential policies limit the leverage and provide resilience against the systemic shocks. Thus, these policies mitigate distortions and improve welfare. Furthermore, I show that combination of bailout and prudential reserve requirement policies is pareto better than other regulations. Finally, I introduce credit default swaps (CDS) into the model and find that CDSs can mitigate the distortions. But the benefits of CDSs are limited to the size of systemic shocks. If systemic shocks are big enough, CDS linkages will make crisis contagious among the financial institutions. In the third chapter, I analyze the impacts of asymmetric information and imperfect monitoring on financial sector using a single period model with agency costs. I solve the model analytically comparing different levels of imperfect monitoring on heterogeneous banks. I find that information asymmetries and noises in monitoring encourage risk taking behaviors among the banks with low loan returns. I also show that these asymmetries cause inefficiently low lending among banks with high loan returns. In the extension of the model, I analyze government's incentive to prevent asymmetric information using regulatory tools such as stress tests. I analytically show that if the government is elected for short term and the rate of low return banks is high in the economy, government won't have incentive to announce real type of the banks.