Essays on banking, financial markets, and macroeconomics

In this dissertation, I study the optimal decisions of financial market participants such as households, banks, and countries in different kinds of financial markets. In the first chapter, I study the optimal contract and portfolio decisions of banks in an opaque banking system in which consumers have limited information about each bank's asset portfolio and its ability to repay debt. I develop a banking model that is able to explain the bank asset portfolio heterogeneity observed in the 2007-2009 financial crisis, in which some banks incurred large losses from risky assets while other banks had abundant liquidity and made profitable purchases and acquisitions. In this banking system, inefficient risk-taking is undetectable by consumers until a bank incurs losses. Upon learning about such losses, consumers run on the affected bank, which becomes bankrupt and begins to liquidate assets. In equilibrium, risk-taking and potential bankruptcies of a small number of banks are generally unavoidable. However, these bankruptcies indirectly prevent more banks from engaging in risk-taking and therefore the banking sector is endogenously divided into risk-taking and healthy banks. In the second chapter, I study the impact of capital requirements on bank risk-taking and the welfare of depositors using the banking model developed in the first chapter. I find that in the existence of financial opacity, there always exists an optimal level of capital requirement. A capital requirement that is too high or too low is not optimal for welfare. In the third chapter, I study the impact of funding from public institutions on consumption smoothing and sovereign debt default using a dynamic macroeconomic model with endogenous default risk. In the model, a country has access to sovereign bond market where interest rate depends on the default risk in the next period. In addition, the country has access to low interest rate funding from a public institution, where fiscal austerity, represented by an involuntary reduction of consumption, is attached to the use of funding. When deciding whether and how much to use public funding, the country weighs the benefit of low-rate funding and the cost of downward consumption distortion. When the model is calibrated to the Argentine economic crisis in the late 1990s, the model can account for the negative correlation of IMF funding and output and match the volatility of IMF funding.