Knowledge that Transforms

In this paper, we examine the role that institutions may play in enabling banks to write contracts whereby sovereign debt is not forgiven ex post. Our model provides a rationale for the emergence of a centralized forum for debt renegotiation, such as the London Club, as well as for bank syndicates. These bank syndicates arise as part of a pre-commitment device rather than for risk sharing purposes. We propose a debt contract under which only involuntary default is forgiven ex post. Our main findings are that under this contract, debt forgiveness after voluntary (strategic) default is avoided. When voluntary default occurs, access to the credit market is denied only for a limited number of periods, rather than forever. In contrast to a voluntary default, involuntary default is forgiven immediately.

When should regulators close a financially ailing bank? FDIC practice in the US has moved in the direction of early closure. In contrast, banking regulators in Japan continue to follow a more patient approach. This paper analyses a series of models in which closure rules and bailout policies arise endogenously through the interaction of (i) regulators' attempts to minimize discounted, expected bankruptcy costs, and (ii) equity-holders' incentives to recapitalise banks. We characterize subsidy policies for distressed banks that implement socially optimal closure rules at minimum financial cost to regulators and which reduce moral hazard.

This article applies finite mixture distributions to the estimation of cost functions for financial firms through time. The mixture approach allows the estimation of multiple technologies when firms' technology choices are unobservable. Technology switching (‘diffusion’) and underlying technical change are simultaneously evaluated. An application to large samples of U.S. banks for the years 1982–1986 illustrates the approach. Results suggest banks switch to lower cost production technologies when unburdened by strict branching regulations.

Over the past several years, substantial research effort has gone into measuring the efficiency of financial institutions. Many studies have found that inefficiencies are quite large, on the order of 20% or more of total banking industry costs and about half of the industry's potential profits. There is no consensus on the sources of the differences in measured efficiency. this paper examines several possible sources, including differences in efficiency concept, measurement method, and a number of bank, market, and regulatory characteristics. We review the existing literature and provide new evidence using data on US banks over the period 1990–1995.

This paper provides a global asset pricing perspective on the debate over the relation between predetermined attributes of common stocks, such as ratios of price-to-book-value, cash-flow, earnings, and other variables to the future returns. Some argue that such variables may be used to find securities that are systematically undervalued by the market, while others argue that the measures are proxies for exposure to underlying economic risk factors. It is not possible to distinguish between these views without explicitly modelling the relation between such attributes and risk factors. We present an empirical framework for attacking the problem at a global level, assuming integrated markets. Our perspective pulls together the traditional academic and practitioner viewpoints on lagged attributes. We present new evidence on the relative importance of risk and mispricing effects, using monthly data for 21 national equity markets. We find that the cross-sectional explanatory power of the lagged attributes is related to both risk and mispricing in the two-factor model, but the risk effects explain more of the variance than mispricing.

This paper expands the empirical research on the auctions of failed financial institutions by examining the thrift industry Accelerated Resolution Program as an alternative to the standard auction procedures. Jointly managed by the Office of Thrift Supervision and the Resolution Trust Corporation, the objective of this program was to intervene before insolvency and, thereby, to reduce the regulatory expenditures. Previous research has often found the existence of a wealth transfer to the winning bidders in both commercial bank and thrift auctions. In contrast to this previous research, no evidence is found in this study to conclude that a wealth transfer occurred in standard Resolution Trust Corporation auctions. Furthermore, while the Accelerated Resolution Program yielded positive abnormal returns, there is also no evidence of a wealth transfer.

This paper presents a reputation model of divestiture activity that yields a sharp cross-sectional implication for event studies of sell-off announcements: A decision to divest a division that is known to be successful conveys good news about the division; in contrast, a decision to divest a division that is known for underperformance conveys no news about the division. We test these hypotheses on a sample of sell-off announcements for which we find stories in the Wall Street Journal unambiguously characterizing the division being sold as either a “winner” or a “loser”. The stock price reaction to the sell-off of losers is indistinguishable from zero while the stock price reaction to the sell-off of winners is a statistically significant 2.5%. These results are strengthened when we expand the sample to include divisions whose profitability was announced in the company's annual report. For this expanded sample, the average stock price reaction to the announcements of sell-offs of losers remains indistinguishable from zero, while returns from the sell-offs of winners average a highly significant 3.4%.

This study tests the hypothesis that common stock call options are exercised rationally and in accordance with the commonly used frictionless markets boundary conditions. Using two years of historical early exercise data for common stock call options, the results show that contrary to the frictionless markets boundary conditions, approximately 20 percent of the early call exercise occurs at times other than ex-dividend dates. While most of the non-dividend related early exercise may be explained by transactions costs, a significant number of contracts appear to be exercised irrationally. These results suggest that failure to incorporate market frictions in option pricing models is likely to lead to specification error.

Some of the most recent empirical studies on interest rate derivatives have found humped shapes in the volatility structure of interest rates. In this paper, we propose a simple model that allows for humped volatility structures, and that can be described by one state variable. With the model, American style claims can be priced very efficiently which is very important if the model has to be calibrated daily to market prices of standard American options. Furthermore, the model allows for explicit formulas for European style options. Finally, the computational efficiency of our model in the Li et al. (1995) framework is compared with the efficiency in a typical Hull and White (1993a, 1994, 1996) framework. In fact, we can use both procedures for our model, since we prove that if a deterministic volatility model can be embedded in either of these algorithms, then so it does in the other one. Empirical evidence from option data supporting our model is provided as well.

This paper investigates the role of interest rate risk in explaining security price changes. We develop and test a two-factor linear beta pricing model of security returns in which the factors are the excess returns on the long-term, riskless bond and the equal-weighted equity market index. We find that time-variation in the interest rate and market risk premia influence expected security returns. Furthermore, conditional interest rate volatility affects security returns, particularly during periods of substantial interest rate movements.