Shohini Kundu, University of California-Los Angeles
Francis Longstaff, University of California-Los Angeles
Abstract: We develop a formal fixed-income framework to value sticky deposits. This framework provides closed-form expressions for deposit values and allows us to study the impact of stickiness on deposit interest-rate and runoff risks. The duration of a bank deposit can be either positive or negative, which has important implications for hedging the interest-rate risk of bank balance sheets. Banks that maximize deposit value by following optimal deposit beta strategies may significantly increase their interest-rate and deposit runoff risks. We test the empirical implications of the valuation model using market deposit premia observed in bank merger and acquisition transactions. The results provide strong empirical support for the model’s predictions.
Abstract: I study the impact of government debt on bond yields and fiscal capacity when there is uncertainty about who will bear the burden of debt repayments. A trade-off emerges when future taxes reduce households’ exposure to income risks but expose them to unanticipated tax changes and policy un- certainty. Households’ consumption volatility, and so precautionary asset demand, scales with debt levels, but the relation is non-monotonic if there is uncertainty about relative tax incidence that is unrelated to income risks. I characterize a threshold above which further debt issuance erodes fiscal insurance and hurts welfare, and show that this threshold declines with the level of foreign demand and increases when taxation is more progressive. Negative β assets such as long-term debt can pro- vide better insurance than short-term debt by lowering consumption volatility when it is needed the most. In a dynamic production economy, fiscal insurance raises interest rates, compresses risk premia, and reduces investment. I show that even in incomplete markets, a version of Ricardian neutrality holds if taxes are lump-sum. Ruling out bubbles, my results indicate that debt alone does not improve risk sharing and that supply effects will persist even if government bonds lose their specialness.
Discussant: Lorenzo Garlappi, University of British Columbia
