Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms that have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds to the formation of a "reputation," a valuable asset that provides an incentive for firms not to choose risky projects. The second hypothesis is that prior to the establishment of a reputation, new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838-60). The presence of a reputation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for the notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period because of technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre-Civil War system of private money issuance by banks was not plagued by problems of overissuance ("wildcat banking").

The ownership structures of firms are endogenous. This makes it difficult to produce direct evidence on the Berle and Means [Berle, A.A., Means, G.C., 1932. The Modern Corporation and Private Property, New York.] hypothesis that corporate governance becomes less efficient as the degree of separation of ownership and control increases. We address this issue by studying Austrian cooperative banking, an organizational form in which the ownership structure is exogenous. We show that firm performance declines as the number of cooperative members increases, corresponding to a greater separation of ownership and control. We also provide direct evidence on another theory that is difficult to test, namely, the efficiency wage hypothesis. We show that the decline in firm performance as the number of shareholders increases is due to an increase in efficiency wages.

The unique characteristics of bank loans emerge endogenously to enhance efficiency in a model of renegotiation between a borrower and a lender in which there is the potential for moral hazard on each side of the relationship. Firm risk is endogenous and renegotiated interest rates on the debt need not be monotone in firm risk. The initial terms of the debt are not set to price default risk but rather are set to efficiently balance bargaining power in later renegotiation. Loan pricing may be nonlinear, involving initial transfers either from the borrower to the bank or from the bank to the borrower.

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Timothy Geithner's memoir of the financial crisis of 2007–08—Stress Test: Reflections on Financial Crises—is an important historical document offering details of how policies were formed and implemented during the crisis, showing the political constraints, and offering lessons for future crises. Walter Bagehot's classic rule for fighting crises— that the central bank should lend against good collateral at a high rate—is passive and incomplete. Geithner argues for the use of overwhelming force to reestablish confidence. Also, although the Federal Reserve's new crisis lending programs needed to be anonymous so as not to reveal weak banks' identities—“stigma”—the stress tests during the crisis did reveal information that may have been useful in reestablishing confidence. (JEL B31, E44, E63, G01, G21, G28)

In the 1980s, U.S. banks became systematically less profitable and riskier as nonbank competition eroded the profitability of banks' traditional activities. Bank failures rose exponentially during this decade. The leading explanation for the persistence of these trends centers on fixed-rate deposit insurance: the insurance gives bank equityholders an incentive to take on risk when the value of bank charters falls. The authors propose and test an alternative explanation based on corporate control considerations. They show that managerial entrenchment played a more important role than did the moral hazard associated with deposit insurance in explaining the recent behavior of the banking industry.

Trading losses associated with information asymmetries can be mitigated by designing securities that split the cash flows of underlying assets. These securities, which can arise endogenously, have values that do not depend on the information known only to informed agents. Bank debt (deposits) is an example of this type of liquid security that protects relatively uninformed agents, and the authors provide a rationale for deposit insurance in this content. High-grade corporate debt and government bonds are other examples, implying that a money market mutual fund based payments system may be an alternative to one based on insured bank deposits.

The credit crisis was sparked by a shock to fundamentals, housing prices failed to rise, which led to a collapse of trust in credit markets. In particular, the repurchase agreement market in the U.S., estimated to be about $12 trillion, larger than the total assets in the U.S. banking system ($10 trillion), became very illiquid during the crisis due to the fear of counterparty default, leaving lenders with illiquid bonds that they did not want, believing that they could not be sold. As a result, there was an increase in repo haircuts (the initial margin), causing massive deleveraging. I investigate this indirectly, by looking at the breakdown in the arbitrage foundation of the ABX.HE indices during the panic. The ABX.HE indices of subprime mortgage-backed securities are derivatives linked to the underlying subprime bonds. Introduced in 2006, the indices aggregated and revealed information about the value of the subprime mortgage-backed securities and allowed parties to buy protection against declines in subprime value via credit derivatives written on the index or tranches of the index. When the ABX prices plummeted, the arbitrage relationships linking the credit derivatives linked to the index and the underlying bonds broke down because liquidity evaporated in the repo market. This breakdown allows a glimpse of the information problems that led to illiquidity in the repo markets, and the extent of the demand for protection against subprime risk.