RESEARCH STATEMENT

    Thomas Paul Gehrig

    GENERAL STATEMENT

    •My research focuses on information acquisition and information aggregation in market economies. Accordingly, I analyse individual incentives to produce information and to transform this information into market strategies. Markets are institutions that aggregate heterogenous information of (largely) uncoordinated individual transactions and translate those into market prices and quantity allocations. Thus, markets typically provide feedback about information of others, and thus produce signals that can also be used beneficially by others (see for example F.A.v. Hayek on "Knowledge in Society", AER 1945). The value of market information, however, is limited by market frictions, which abound in real world applications even in the (seemingly) most efficient and (seemingly) best organized markets (such as e.g. financial markets): limits to arbitrage, limits to knowledge (or complexity), coarse communication, information imperfections, delay, errors, lack of synchronicity of decisions/trades, taxes, .... Therefore, my research centers on market incompleteness. It attempts to understand better the inner working of market economies under real market conditions as opposed to idealistic conditions analysed under the complete market paradigm.
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    •In particular, my research focuses on incomplete financial markets. Financial markets are the best to analyse, both theoretically and empirically because of data abundance and since incompleteness adds additional layers of fascination such as market participation and liquidity, for example. While my work is primarily guided by theoretical benchmark models to test consistency of arguments, it builds on empirical phenomena both in markets (e.g. such as domestic bias in global portfolio investments) as well as from experimental labs. The advantage of the experimental lab is that almost any hypothetical conditions can be synthetically generated in the lab and the variables of interest can be controlled by the designer of the experiment, which is good for internal validity. Real world data on the other hand are good for external validity but notoriously limit investigations, because not all relevant variables can be observed, or controlled for in the real world, and, hence, are not available for detailed analysis. Both sources of information - field and lab - are useful to guide judgement, but theory is key to improve judgement and knowledge.
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    • Below are a classification and a selective summary of typical research questions I have been - and continue to be - contributing to in my work.

    ASSET PRICING IN INCOMPLETE MARKETS

    The universe of asset prices provides a unique real world laboratory to identify the sources of "market anomalies". In incomplete markets asset prices are not only determined with respect to market expectations about future payoffs and associated risk but also by market participation, risk bearing capacity and market liquidity. Moreover market participation may depend on the realization of aggregate risk factors; the willingness to bear risk may decline in and after a financial crisis adding to the price pressures during a crisis. Simple models that ignore time variation in liquidity may not perform well especially in periods of market stress. Typical topics are:
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    • the role of information on portfolio allocation (e.g. domestic bias, small firm effect, ...).
    • the role of liquidity factors for asset prices.
    • momentum and liquidity
    • ambiguity aversion and time-varying risk
    • multi-market trading and price discovery

    BANKING, TRADING AND FINANCIAL INTERMEDIATION

    "Banking versus Trading" (Boot, Ratnovsky, RF, 2016) is the title of a recent authoritative study about the changing role of banks. The authors argue that long-term oriented relationship banking is increasingly replaced - at a quick pace - by more short-term oriented business models such as originate-to-distribute. To the extent that banks sell asset-backed securities to the markets, how does their trading affect their long-term incentives for screening and monitoring clients and loans? How does this substitution process affect "bank-oriented" countries (such as Continental Europe or Japan) differently relative to more market-oriented countries (UK and U.S.) with inherently larger markets for corporate bonds? How does this change in business models affect the conditions for long-term investment financing in Europe? Typical topics are:
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    • drivers of systemic risk in banking
    • a strategic role for bank equity
    • regional banks and local information provision
    • loan sales and screening incentives
    • fast trading and price volatility

    INFORMATION ACQUISITION AND PRICE DISCOVERY

    The distinctive strength of markets is their ability to aggregate and communicate heterogenous information. Typically, such information is sparsely distributed in society and typically highly imperfect. By aggregating the choices of many individuals that are based on such imperfect and potentially even erroneous information signals, markets contribute to generating informative signals, and under ideal conditions even sufficient statistics for the underlying information. While perfect markets are prone to the information paradox, frictional markets are key in providing incentives for individuals to produce relevant information that can be aggregated by the price mechanism. Moreover, market participants (firms) can exploit market frictions to produce information, for example by cross-listing their stocks. Paradoxically, to the extent that competition increases market fragmentation it enhances incentives for information production, and as such the adverse selection component in bid-ask spreads. Regulation may counteract this increase in trading costs by curbing informed trading. This, however, generally comes at the cost of less societal price discovery.
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    In experimental work I also analyse individual behaviour with respect to costly information acquisition. While individuals tend to herd in a market context, thus economizing on information (presumably) produced by others, their behaviour may change dramatically in a strategic context. In simple experimental bargaining settings, where information about outside options of the bargaining partner can be elicited by investing resources, we find a number of challenging insights: in more opaque environments individuals seem to coordinate more easily on some fairness norms resulting in more efficient bargaining outcomes, while in less opaque environments individuals tend to behave more opportunistically generating more instances of inefficient break down of negotiations. Overall, however, both, under the (more) opaque as well as the (more) transparent settings individuals tend to grossly overweight the value of information; they are ready to pay a price far higher than the strategic value of that information. This is true both, if the value is determined by some notion of equilibrium play, or if is determined by optimal play against the empirical populations.
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    Typical topics are:
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    • cross listings and price discovery
    • price discovery in exchanges when traders can trade directly in OTC markets
    • crossing networks, proprietary trading and price discovery
    • dark pools, price volatility and price discovery
    • fast trading and price discovery
    • over-confidence versus excessive information production
    • literacy versus nudging

    INDUSTRIAL STRUCTURE IN FINANCIAL MARKETS

    While economies of scale are a potent source of concentration, product differentiation and switching costs are offsetting sources of fragmentation. This question also particularly applies to the financial industry. Concentration tends to be worrisome because besides lack of alternatives for individual choices, it typically implies that key players grow large and systemic. This does not only apply to commercial and investment banks but also to financial intermediaries and certification intermediaries (e.g. rating agencies, auditing firms). Typical topics are:
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    • Two at the top? Financial structure in the certifications industries
    • concentration versus fragmentation in stock trading
    • sustainable market structures in the banking industry

    FINANCIAL REGULATION

    How could the Great Financial Crises happen after so many decades of fine-tuning the frameworks of prudential regulation in the western world? In 2006 the regulatory framework of Basel II was finalized and most Western countries were in the middle of the process of implementing the Basel II accord, when crisis struck and Western banking systems appeared badly prepared for the subprime crisis. How could it happen, that the existence of major, so-called systemic European banks was threatened by the U.S. subprime crisis despite the fact that capital regulation was intended to increase the safety and soundness of the global banking system? Why was it precisely those banks that supervisors should worry most about were exposed to the highest risk, and why did the crisis not strike smaller banks (saving banks, cooperative banks, credit unions, etc.) to the same extent? Why was Scandinavia largely unaffected; what did Scandinavian banks learn from their own crisis in the early 1990's that other European banks (seemingly) did not? In our empirical work we find the worrisome result that the Basel process of capital regulation did contribute to de-capitalize the upper quintile of systemic European banks in an unprecedented way. Moreover we find that taking over supervisory power by the ECB within the new supervisory concept of Banking Union did not contribute to a meaningful recapitalization of those banks, at least up to November 2016. Moreover, the systemic banks are engaging in the business of stock repurchases again as they did in the run-up to the Great Financial Crisis in 2007, seemingly unchecked by their respective supervisors. This work is largely about unintended consequences of regulation. This also applies to the migration of former banking activities such as long-term lending to the insurance sector. Consequently, basically since the imposition of Basel II, a considerable increase in systemic risk can be witnessed in the (life-)insurance sector, as has been independently emphasized by the IMF in its Global Stability Report 2016. Typical topics are:
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    •bank capital regulation
    •evaluating banking union
    •optimal supervisory structure in integrated banking markets
    •short sale bans, price discovery and systemic risk
    •the implications of MiFID II for price discovery in European trading places

    FINANCIAL GEOGRAPHY

    The economic activity in geographic space is determined by the interplay between centrifugal and centripetal forces. This work concentrates on the centrifugal forces of liquidity and the centripetal forces of certain types of regulation. Interestingly, Regulation NMS was a major driver of market fragmentation in the "national market" of the U.S. by implicitly subsidizing speed advantages and high-frequency trading. This is an example of unintended consequences of possibly misplaced regulation, or simply the reflection of the political economy of regulation. This research also contributes to a better understanding of the evolution of financial centers. Typical topics are:
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    • geography of financial centers
    • geography of financial trading places
    • MiFID II and the structure of European trading places

    FINANCIAL HISTORY

    History is the only laboratory that allows the analysis of unfettered markets prior to regulatory activity. Moreover, by comparing market behaviour during historical crises with modern crises, the role of the prudential regulation can be assessed. Interestingly, in joint work with Caroline Fohlin and Marlene Haas we find that the Panic of 1907 that triggered the foundation of the Federal Reserve System in the U.S. in 1913, exhibits many commonalities with the Great Financial Crisis 2007/8 about a hundred years later. We find that evidence for the funding-illiquidity - market-illiquidity nexus already worked in the early crisis. Moreover, we find that asset prices in the early markets did display liquidity premia, which can be largely attributed to information risk. In earlier work with Caroline Fohlin (RF, 2006) we also analyse transaction costs in early European markets and compare them with those of the early NYSE. Interestingly, and counter-intuitively, we find that bid-ask spreads were significantly lower in the early Berlin market relative to NYSE. We also find that the Aktiengesetz in Germany was a major break in the development of the German financial system, which up to 1896 had been far more flexible and innovative than the US system. The Aktiengesetz did channel significant amounts of market liquidity from smaller to larger companies and stifle innovation in the "Finanzplatz Germany" for a long period to follow (until 1994). Typical topics are:
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    • price discovery and crises in the early European exchanges
    • rumors, runs and price discovery in the US stock exchanges prior to regulation
    • regulation and the performance of the early stock exchanges