| The efficiency of financial markets cannot be taken for granted. Asymmetric information, government intervention, and psychological biases can significantly affect their operation. This dissertation focuses on two of these factors: government intervention in banking markets and psychological biases in asset pricing. In particular, I examine how: (i) non-performing loans can be used to support state enterprises, (ii) directed credit impacts bank competition, and (iii) narrow framing affects securities prices.; First, I examine the role of non-performing loans in supporting state enterprises. According to conventional wisdom non-performing loans indicate bad economic policy. But non-performing loans may be part of an optimal policy if governments wish to maintain employment. I present a model where non-performing loans reduce the transfers required to support state enterprises. Because transfers involve substantial deadweight losses, non-performing loans are superior to subsidies. I show that moral hazard and corruption do not alter this result. The model helps to explain the evolution of banking and state enterprise reform in China.; Second, I examine the impact of policy lending on bank competition. Many countries use directed credit to support favored industries. Economists have urged countries to eliminate directed credit, viewing it as inefficient allocation of capital. However, using a model of imperfect competition in banking, I show that directed credit may enhance competition by reducing the market power of private sector banks. The exact effect of directed credit on bank competition depends on market structure and how the government intervenes. I extend the model to show that when directed credit is inefficient, its elimination may cause banks to gamble.; Third, I evaluate the impact of narrow framing on asset pricing. The Capital Asset Pricing Model (CAPM) predicts that in pricing assets investors care only about assets' covariance with the market portfolio as measured by beta. However, recent research in behavioral economics indicates that individuals frame choices narrowly, that is, they assess risks in isolation. I show that narrow framing implies that investors price the volatility of individual assets. Data from the US stock market confirm this prediction. Moreover, once this factor is included beta is no longer statistically significant. |
