Annual Review of Financial Economics - Current Issue

We assess the efficacy of market-based systemic risk measures that rely on US financial firms’ stock return comovements with market- or sector-wide returns under stress from 1895 to 2023. Stress episodes are identified using corporate bond spread widening and narrative dating, spanning from the Panic of 1907 to the Banking Stress of 2023. Measures observed prior to the onset of stress episodes predict market outcomes (realized volatility and returns), balance sheet outcomes (lending, profitability, and run risk), and bank failures. Specifically, the measures are: (a) particularly effective in capturing the cross-sectional ranking of institutions conditional on a stress episode, rather than aggregate outcomes; (b) more informative when stress episodes are severe; and (c) relevant for both banks and nonbank financial institutions, although measures incorporating market leverage are especially informative for banks. A comparative analysis shows that market-based indicators offer information that is distinct from, and complementary to, traditional balance sheet metrics used in supervisory and macroprudential risk assessment.

Fragility of financial markets arises when market prices exhibit amplified reaction to underlying shocks, either fundamental or nonfundamental. The history of financial markets features many examples of such episodes, market-wide or asset-specific, which have generally been of great concern. Using a canonical framework of trading in financial markets, we provide an overview of forces generating fragility. These forces include learning by investors from the price as they make trading decisions and various channels for strategic complementarities among investors that act against price-induced strategic substitutes. We analyze the informativeness and volatility of prices and how they are related to the fragility concept.

This article examines US Treasury securities market functioning from the global financial crisis through the COVID-19 pandemic given the ensuing market developments and associated policy responses. We describe the factors that have affected intermediaries, including regulatory changes, shifts in ownership patterns, and increased electronic trading. We also discuss their implications for market functioning in both normal times and times of stress. We find that alternative liquidity providers have stepped in as constraints on dealer liquidity provision have tightened, supporting liquidity during normal times, but with less clear effects at times of stress. We conclude with a brief discussion of more recent policy initiatives that are intended to promote market resilience.

In financial crises, a period of overheated credit markets turns into a credit crunch accompanied by a systemic breakdown in the financial intermediary sector. Without a deep understanding of their roots, designing policies to decrease the probability of suffering from them or to avoid the worst consequences is like flying blind. In this review, I survey the recent development of the theory of financial crises. I focus on the answers these theories provide to four fundamental questions. What makes the booming phase fragile, and what are the incentives and frictions leading to that fragility? What triggers the crisis? Why is the downturn persistent? Should policy intervene, and if so, how?

This article examines the evolution and challenges of model-based capital regulation in banking, discussing its impact on banking system resilience and financial stability. Introduced with Basel II, model-based regulation sought to link capital requirements to asset risk but encountered practical issues like discretion in banks’ risk reporting, complexity, and procyclicality, weakening its effectiveness. Large banks often exploited modeling discretion to reduce capital requirements, lowering equity levels and amplifying systemic risk, as evidenced in the global financial crisis of 2008. While greater distance between banks and supervisors limits discretion, the findings underscore the advantages of simpler frameworks, such as leverage ratios, for enhancing transparency and stability. Political economy considerations, however, complicate international regulatory alignment, as national regulators balance stability objectives with considerations about domestic competitiveness. The article concludes that streamlined regulation paired with strong and robust equity standards would bolster financial stability and calls for further research on regulatory frameworks and systemic risk.

Fiscal dominance refers to situations in which monetary policy is constrained by the public sector's budget constraint. Large shifts in the dynamics of sovereign debts, surpluses, and central banks’ balance sheets since the great financial crisis have created the perception of a heightened risk of such fiscal dominance in major jurisdictions. This article reviews the theoretical and empirical literature on fiscal dominance. We offer a simple theory in which fiscal dominance arises as the outcome of strategic interactions between the government and the central bank.

Market macrostructure studies the broad organization of financial markets into key players and institutional features and how this organization affects the level and dynamics of asset prices. We present a simple model to discuss when, why, and how market macrostructure matters for asset prices. We then review work on three specific examples: the rise of passive investing in the stock market, the increased role of central banks in bond markets through asset purchase programs, and the role of levered financial intermediaries in financial markets. We highlight various approaches to tackling macrostructure questions including quasi-natural experiments, equilibrium models, and the use of detailed quantity data on asset positions.

Governments have often used two policy instruments to lower financing costs: the money supply to generate seigniorage and regulation of the financial system to increase demand for their interest-bearing bonds. Both involve trade-offs. This article marshals historical evidence and economic theories about how the US federal government has arranged monetary, financial, and fiscal systems since 1800 to lower its financing costs. In doing so, we infer evolving priorities of different US administrations.

This article provides an overview of the regulation of market microstructure, particularly in equity and option markets. We emphasize the motives for regulation and restrictions on the trading process, including the distinctive regulatory environments (and regulators) for different financial instruments as well as the role of brokers in routing trades, and market makers who intermediate trade. Our article highlights such central features of the design of markets as best execution responsibilities; order protection (trade-through) restrictions (Regulation NMS); payment for order flow, tick size, and access fees; and the role of auctions, transparency, and short-selling restrictions. We point to some of the distinctive features of fixed-income trading and market design and the emerging role of litigation in determining regulatory outcomes.

This article surveys the literature on the historical growth and transformation of the US financial sector. The sector expanded rapidly between 1980 and 2006, during which its contribution to GDP rose from 4.8% to 7.6%. After the global financial crisis, the size of the sector stabilized at approximately 7% of GDP. After reviewing this literature, we examine recent developments, including the continued growth of high-fee alternative asset management and the shift away from banks to lending by nonbank financial intermediaries. We interpret both the growth and recent evolution of the sector as reflecting a continued transition to a more market-based financial system, with risk migrating away from banks and into markets.

Making payments in an efficient manner is critical to a well-functioning economic system. While the direct effect of reducing the cost of payments is an increase in user welfare, changes in the payment system can have broader economic effects. This is because payment systems are characterized by a multisided network externality, as the willingness of consumers to participate in a payment method depends on the number of merchants on the system and operators of a payment system can glean information from the payment flows. We highlight the role that banks have played in the payment system and show how payment innovation can lead to bank disintermediation both in payment services and in the credit market. We highlight some recent innovations in payments—some of these rely on the banking system and others try to bypass it. There are many interesting open questions for researchers to explore in this field.

Safe and liquid assets (convenience assets) are used to make payments, meet unexpected consumption shocks, and facilitate financial transactions. The value of these convenience services is captured by the convenience yield, which is determined by the aggregate demand and supply of convenience assets. US Treasury securities are a prime example of a convenience asset, while bank and nonbank financial institutions also produce claims with varying degrees of safety and liquidity. Repos are safe and liquid securities created from tranching a long-term bond into a risky equity claim and a debt repo claim. Banks and bond mutual funds create liquid assets by pooling across investors’ idiosyncratic liquidity risk. Finally, packaging securities into a composite, as in mortgage-backed securities, also creates liquid and safe assets. Private sector creation of convenience assets involves a number of challenges, including leverage constraints and panic runs. We discuss how to measure convenience yields, convenience asset creation by the private sector, and the equilibrium determination of convenience yields.

We review the literature on the effectiveness of public policies to facilitate firms’ access to finance. The rationale for such policies is to address market failures that cause financial constraints. Using a simple taxonomy, we discuss the current evidence on common interventions to tackle these constraints: public lending through state and development banks, public lending through private banks, subsidized credit, credit guarantee schemes, export credit agencies, publicly backed venture capital, and tax incentives for equity investors. Based on the quantity and quality of the available evidence, we summarize the policies that have proven most effective in helping firms access external financing. In addition, we highlight areas where future research is needed to address current knowledge gaps and to provide more definitive policy guidance.

We survey and extend work on the Federal Reserve's effect on the stock market, focusing on three empirical facts: The effect of monetary policy surprises in a narrow window around announcements from the Federal Open Market Committee (FOMC), the pre-FOMC announcement drift, and the FOMC cycle in stock returns. We discuss the magnitude of the Fed's impact (directional effects or effects on average stock returns), the types of shocks coming from the Fed (pure monetary policy shocks, reaction function news, or information about the Fed's view of the economy), and the asset pricing channels through which effects emerge (equity premia for news from the Fed, or changes to yields, equity premia, or expected dividends). We also consider the information transmission channels. The Fed's effect on the stock market is large, even for average stock returns earned over periods of several decades. Fed-induced changes to both yields and equity premia play substantial roles, with less direct evidence available regarding cash flows. For stocks, reaction function news appears to be more important than Fed information effects. Informal information flows outside announcements windows are important.

I survey work that uses information in derivative and other asset prices to forecast movements in financial markets.

We review the literature on sustainable investing, focusing on financial effects. First, we examine the effects of investor tastes on portfolio tilts and asset prices in a simple equilibrium setting. We establish novel connections, including a direct relation between the green portfolio tilt and the greenium. We also relate our framework to prior modeling of divestment. Finally, we review evidence related to the main concepts from our theoretical analysis, including the greenium, green tilts, climate risk, and investor tastes.

In this review, we explore the economic channels through which net zero banking might be consistent with lender business incentives. We begin with a framework wherein net zero lending may create value differentially from carbon-intensive lending through the channels of (a) credit risk and (b) lending returns conditional on risk (i.e., profit margins and lending book growth). When applying the framework as a lens to survey the literature, we uncover multiple roles for risk characteristics of lending opportunities being influenced by decarbonization. Moreover, decarbonization and green investment are tied to enhanced profitability through bank lending growth. We also highlight gaps in research knowledge and point out opportunities to connect the broader banking literature with climate finance. For instance, bank specialization in sector-specific risk and return advantages in bank lending may already be playing a role in the net zero transition. We conclude that net zero banking is an economic concept.

Since ChatGPT's release in 2022, demand for artificial intelligence (AI)–related skills in finance has grown rapidly, as generative AI drives significant technological changes in both the financial research field and the broader economy. We show that financial occupations are highly exposed to the productivity effects of generative AI, review the literature on the impact of ChatGPT on firm value, and provide directions for future research investigating the impact of this major technology shock. Generative AI also holds great potential as a tool for finance researchers and practitioners: We review and describe innovations in research methods linked to improvements in AI tools, along with their applications. We offer a practical introduction to available tools and advice for researchers in academia and industry interested in using these tools.

This review article highlights what we know from neuroeconomics regarding the effects of context, past experiences, and age on brain processes involved in decision-making and illustrates how finance research has built on these insights, and how it could continue to do so going forward.

Existing evidence shows convincingly that expected cash flows of nonfinancial firms can be negatively affected by their total risk, so that nonfinancial firms can create shareholder wealth by managing their total risk. After reviewing theories that demonstrate links between firm value and total risk, I examine how financial risk management is used to manage firm total risk. I conclude from the evidence that the use of financial risk management is mostly limited to near-term risk in nonfinancial firms. I offer explanations for this limited role of financial risk management. I argue that the limitations of financial risk management make it important for firms to also focus on resilience and call for more research on the costs and benefits of resilience.