Knowledge that Transforms

This paper examines why we have marketmakers (specialists in stock markets, used-car dealers) in some markets and matchmakers (real-estate brokers, employment agencies) in others. Using a bilateral search model, it is shown that when the valuations of the agents are private information, marketmaking might yield higher or lower profits and welfare effects than matchmaking, depending on the efficiency and the cost of search and on the distribution of valuations of the agents. This is in contrast to an earlier result that when the agents' valuations are common knowledge marketmaking yields higher profits and greater welfare effects than matchmaking.

Standard models of panics do not allow for trade between banks and assume that a run bank's liquidation costs are determined exogenously. We develop a model in which banks trade with each other and liquidation costs are determined endogenously in a strategic environment. The model reproduces a panic's characteristic fall in stock prices, rise in interest rates, and wave of bank runs. It also accounts for the seasonal timing of panics, the change in interest rates across panics, and international differences in panic frequency. The roles of withdrawal suspension, lender of last resort, and deposit insurance are also investigated.

We analyze the value to firms of being able to renegotiate covenants in their debt contracts. Covenants control agency problems, but also reduce firms' flexibility to pursue profitable investments. Initial covenants will be more severe for renegotiable contracts, because they can be relaxed selectively when the lender believes they pose an inefficient constraint. We show firms with high ex ante credit risk find the option to renegotiate most valuable. The model is used to explain why bank loans and privately placed debt typically have harsher covenants than public debt and to predict which firms will borrow using closely held debt. Journal of Economic Literature Classification Numbers: D82, G21, G32.

In our model risk-neutral shareholders need to motivate a manager to select among projects with different risks, and to work hard in implementing the chosen project. Curvature of the manager's compensation contract as a function of profit affects his attitude toward project risk. The optimal curvature depends on the trade-off between controlling project risk and motivating effort. The analysis predicts greater option-based compensation when there are desirable risky growth opportunities (proxied by Tobin's q or R&D expenditures) and less option compensation when there are effective monitoring institutions (such as outside directors and bank lenders).

In this paper we analyze how depositors can employ both monitoring and capital requirements to control the risk of bank assets. We also analyze how monitors should be compensated if their actions are not directly observable and if there are binding limits on their liability. Second-best capital and monitoring levels (with unobservable actions) will be distorted away from their respective first-best levels. We derive some results about the nature of these distortions and characterize the optimal incentive scheme for monitors.

A model with private information that supports conventional arguments for a government monopoly in supplying circulating media of exchange is constructed. The model also yields rate-of-return and velocity predictions which are consistent with observations from free banking regimes and fiat money regimes. In a laissezfaire banking equilibrium, fiat money is (essentially) not valued, and the resulting allocation is not Pareto optimal. However, if private agents are restricted from issuing circulating notes, there exists an equilibrium with valued fiat money that Pareto dominates the laissez-faire equilibrium and is Pareto optimal within a restricted class of allocations. Journal of Economic Literature Classification Numbers: 020, 310.

This paper studies distinctions between fixed-price and Dutch auction self-tenders for common stock. We find that fixed-price tenders pay higher premiums to retire greater equity fractions than Dutch offers yet generate similar total returns to stockholders. Accordingly, total returns are significantly higher in Dutch auctions after controlling for tender and firm characteristics. In addition, wealth transfers to owners of repurchased shares are significantly higher in fixed-price offers. The Dutch mechanism thus appears to induce increases in firm value with smaller disbursals of cash. These cost savings to investors who maintain their ownership may explain the popularity of the new technique.

This paper analyzes the optimal financial structure for a firm in which the top manager must provide incentives to a subordinate in addition to exerting directly productive efforts. Optimal capital structure is shown to involve a moderate level of debt with a substantial penalty for default, and passive shareholders. In a two- or three-layer hierarchy, optimal leverage is shown to decrease as either the number of hierarchical levels or the importance of agents further down the hierarchy increases. This and other implications of the model square well with existing evidence and suggest new directions for empirical work.