Knowledge that Transforms

Exploiting the analogy with the private provision of a public good, this paper studies debt restructuring with an arbitrary number of creditors using mechanism design. Creditors differ in the value they expect to receive in bankruptcy, and this value is private information. As with public goods, too little debt forgiveness is granted in equilibrium relative to the first best. Creditors are more willing to make concessions under common values than under pure private values, an opposite phenomenon to the “winners' curse” in auctions. Exchange offers are an optimal restructuring scheme for the debtor, because they allow creditors to contribute to debt forgiveness at different levels.Journal of Economic LiteratureClassification Numbers: G34, G33.

Many recommendations for reforming securities markets are predicated on the belief that providing information on order flow and other market variables to traders (i.e., increasingmarket transparency) will increase liquidity and improve price efficiency. This paper demonstrates that market transparency can actually increase price volatility and lower market liquidity. This occurs even though transparency increases the precision of traders' predictions about the asset's value. In a sufficiently large market, transparency always reduces volatility and improves market quality. We use these results to assess various policy proposals concerning the disclosure of trading information.Journal of Economic Literature Classification Numbers:D82, D83, G12, G14.

In the presence of economies of scale, depositors' expectations are shown to give rise to vertical differentiation and to yield multiple market equilibria, some of which exhibit institutional or systemic collapse. This fragility is due to a coordination problem among depositors and not to bank competition. Nevertheless, failure perceptions do influence rivalry which in turn affects the failure probability in particular equilibria. Deposit insurance improves welfare by preventing collapse, extending the market, and minimizing frictions. However, deposit insurance also may induce fiercer competition for deposits and increase the deadweight losses associated with failing institutions. The welfare impact of deposit insurance is shown to depend on market structure, and is thus ambiguous even in a world of full liability and no moral hazard in bank investments.Journal of Economic LiteratureClassification Numbers: G21, G28.

The AMEX changed the tick size from[formula]to[formula]for low-price stocks on September 3, 1992. Consistent with the prediction of L. E. Harris (1994, Minimum price variations, discrete bid–ask spreads, and quotation sizes,Rev. Finan. Stud.7,149–178), the change has reduced both quoted and effective spreads, although the magnitude of the reduction is much smaller than predicted. However, we fail to find evidence of a significant increase in trading volume. Our cross-sectional regressions show that stocks with greater trading activity, lower prices, and stronger competition from the regional exchanges experienced greater spread reductions.Journal of Economic LiteratureClassification Numbers: G10, G18, G20.

This paper models inside trading regulation with a well-defined objective and introduces an explicit measure of regulatory strictness. The regulator's objective is to minimize the trading loss of liquidity traders. With market professionals whose information-based trading is not regulated, the objective of regulation can be achieved by promoting competition between these market professionals and the insider. When stricter regulation induces improvement in the precision of the market professionals' information, tolerating some insider trading can be the optimal regulatory policy. It is also shown that allowing more market professionals to enter the market and disclosing information to them are as effective in achieving the regulatory objective as the direct restriction of insider trading.Journal of Economic LiteratureClassification Numbers: D82, G10, L13.

This paper empirically examines contagion effects of bank failures by analyzing the behavior of deposit flows in a sample of failed and healthy banks over the 1929–1933 period. We find evidence of contagion for 1930–1932, while none seems to have existed in 1929 or 1933. In addition, the pace of contagion accelerated over 1930–1932. We find that even during 1930–1932, failing-bank deposit outflows exceeded those at a matched control sample of nonfailing banks. This finding is consistent with the presence of a significant number of informed depositors who distinguished among ex ante failing and nonfailing banks.Journal of Economic LiteratureClassification Number: G21.

We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank's equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses following a required recapitalization. Given the increase in the regulator's exposure that would accompany a reduction in the bank's market value of equity, the regulator may choosenotto enforce the regulation. Hence, capital regulation may be time-inconsistent in this situation and consequently not have its intended risk-mitigating incentives.

We analyze the interrelationships among the corporate organization structure, the capital structure, and the ownership structure of a firm with multiple projects, when incumbent management derives control benefits. The choices made by firm management are: (1) Whether to set up projects as a joint firm or as separate firms (spin-off), (2) the amount of debt financing to use, (3) the structure of the debt contract (e.g., straight debt on the joint firm, limited-recourse project financing, or spin-off with straight debt), and (4) the fraction of equity to hold in each firm (ownership structure). Differences in managerial ability across projects, benefits of control, and the probability of loss of control through a takeover or through bankruptcy are driving factors in this model. We relate the project characteristics to the optimality of spin-offs and limited-recourse project financing arrangements, and derive implications for the allocation of debt and the ownership structure across projects.Journal of Economic LiteratureClassification Numbers: G32, G34, D21.

This paper addresses a fundamental trade-off in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex ante, which regime would they choose? We show that dealers prefer incomplete transparency (meaning marketwide order flow is observed with noise). Slower price adjustment provides time for nondealers to trade, thereby sharing risk otherwise borne by dealers. At some point, however, further reduction in transparency impedes risk sharing: too noisy a public signal provides nondealers too little information to induce them to trade.Journal of Economic LiteratureClassification Numbers: F31, G15.

This paper analyzes dual trading on futures contracts restricted by Chicago Mercantile Exchange Rule 552. Using floor trader data, several categories of traders are identified, and differences in strategies and profitability are examined. When unrestricted, dual traders execute most customer orders and few personal trades. The evidence supports the hypothesis that dual traders are superior brokers. However, there is no evidence of informational advantages in dual traders' personal trading. Dual traders are shown to provide liquidity with their personal trades. Finally, Rule 552 does not appear to have increased trading costs.Journal of Economic LiteratureClassification Numbers: G12, G13, D82.