RESEARCH STATEMENT

    Thomas Paul Gehrig

    GENERAL STATEMENT

    •My research focuses on information acquisition and information aggregation in decentralized 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 individuals and their transactions and translate those into market prices and quantity allocations. Thus, markets typically provide feedback about information from 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 you will find a selection of typical research questions together with some typical and/or pioneering contributions:

    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.
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    • Gehrig, SJE 1993, is the pioneering paper to provide an explanation of the domestic bias based on local geographic information. In frictional markets managers can learn from geographically dispersed markets, about local market conditions and adjust their investment plans accordingly. This feedback effect from prices to investments has been pioneered by Foucault and Gehrig, JFE 2008 in the context of cross-listing decisions. Typical further topics are:
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    • the role of liquidity factors for asset prices.
    • ambiguity aversion and time-varying risk
    • multi-market trading and price discovery
    • asset pricing with externalities: liquidity, ESG, climate risk, network factors

    TRADING INTERMEDIARIES

    Prices in asset markets are determined by the strategic actions of market participants and intermediaries, such as brokers and dealers. Their behaviour and contribution to price discovery has become the topic of market microstrucure, a literature that essentially emerged in the 1990s. In this literature Gehrig, JEMS 1993 is the first paper to model coexistence and competition between organized dealer and less organized OTC markets in securities trading. Gehrig's contribution to the (then) nascent field of market microstructure analyses indirect competition between frictional markets and established markets. Walrasian outcomes emerge in the limit when frictions vanish. In a recent application to HFT-markets in joint work Gehrig, Ritzberger, JET, 2022 frictions will be amplified under ultrafast trading and fast intermediation turns into an independent source of price volatility and risk. With an empirical focus Gehrig et al., JF 2024 provides a field experiment on big data available in high frequency with 164 independent research teams. The paper demonstrates the sensitivity of research results with respect to the research design. Further typical market microstructure topics are:
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    •dark trading and price discovery
    •big data, fast trading and price discovery
    •toxic arbitrage

    BANKING INTERMEDIARIES AND SYSTEMIC RISK

    "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?
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    • Gehrig, Stenbacka, EER 2007 point out a potential drawbacks of information sharing on competition in banking markets by implicitly fostering collusion. The welfare consequences of switching costs and history-based discrimination in banking are discussed in Gehrig, Stenbacka, Shy, EER 2011. Typical further topics are:
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    • Early contributions to aims and scope of the Basel process of capital regulation are Gehrig, SJES 1995 and Gehrig, SJES 1996. The self-regulatory option discussed intensively by regulators in the run-up to Basel II has motivated the analysis of Gehrig, Jost, JRegEc 1995 about the role of self-regulation in a banking context. Gehrig, Iannino, JFS 2021 provides the first data-based evaluation of the Basel process of capital regulation for European banks. The evidence in the cross-section is rather mixed: while the stability and safety of the three lower quintiles of European banks has been affected only minimally, the capital shortfall of the most systemic banks has increased significantly. Gehrig, Iannino, JFEP 2018 identify similar parallel developments in the European insurance sector. While the insurance sector is lagging the banking sector in the build-up of systemic risk exposure (capital shortfall), the authors observe important spill-over effects from banking to insurance, adding to systemic riskiness in the insurance sector. Current work of Gehrig, Iannino, Unger, forthcoming JFS 2024 documents a causal link from bank investments into socially responsible activities to enhanced bank resiliency. Transatlantic differences in banks'systemic risk exposure is analyzed in Gehrig, Iannino and Unger, Handbook of Financial Integration, 2024. Further typical topics are:
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    • ESG drivers of systemic risk in banking
    • a strategic role for bank equity
    • common ownership and systemic risk
    • regional banks and local information provision

    LIQUIDITY IN INCOMPLETE MARKETS

    In complete markets the notion of liquidity is irrelevant as is known from standard work-horse models in asset pricing (like the standard CAPM). Liquidity, however, plays a role as soon as markets are incomplete, or in the presence of frictions. This is true, both in a trading context as well as in models of liquidity provision by financial intermediaries.
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    •In a trading context Gehrig, Jackson, JFM 1998 pioneer the strategic properties of liquidity trades in a multi-market context. They find that in addition to asset correlation also the structure of asset holdings, as well as the nature of the liquidity events determine to what extent trades are strategic complements or substitutes. In particular, the strategic properties can be reversed depending on whether trades are basket trades (as typically is the case or passive funds) or individual stock picking trades. Their theory predicts that the long-term trend from stock picking to passive investments deeply affects the strategic properties of trading behaviour. In other words, the sources of liquidity demand matter even in the absence of informed trading.
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    •Similarly, in a banking context Dietrich, Gehrig, CEPR 2021 show that the sources of liquidity demand have quite different implications on the potential services of liquidity provision offered by banks in competitive markets. They argue that the basic Bryant-Diamond-Dybvig paradigm needs to adjusted in order to guide regulatory policies for real world banking markets.
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    Typical topics are:
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    • price discovery in exchanges when traders can trade directly in OTC markets
    • momentum and liquidity
    • crossing networks, proprietary trading and price discovery
    • dark pools, price volatility and price discovery
    • liquidity and insurance contracts

    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).
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    • Gehrig, IJIO 1996 provides a pioneering network model for intermediation which explains the concentrated and vertically differentiated industrial structure in banking and trading markets. Similar vertically differentiated structures arise from agglomeration economies, such as liquidity externalities in search markets. This idea is developed in Gehrig, EER 1998 and applied to the notion of competitiveness of markets.
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    •The role of organizational form for acquisition of coarse information is pioneered by Gehrig, Regibeau and Rockett, RED 2000 and Gehrig, JITE 2004 in a non-Bayesian setting. Gehrig, Stenbacka, EL 2023 characterize optimal subsidies for research and development, i.e. the production of information about novel products and production processes.
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    Typical further topics are:
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    • Two at the top? Financial structure in the certifications industries
    • Information sharing and collusion in banking
    • 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 (Gehrig, Iannino, JFS 2021). 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 (Gehrig, Iannino, JFEP 2018), 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 (Gehrig, 2008) and competition between them. 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 in Gehrig, 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