This paper models the optimal choice of shareholder liability. If investors want managers to be monitored, the monitors should be residual claimants (shareholders), and monitoring and firm value will increase as shareholders commit more of their wealth to the firm. When liquidating wealth is costly, contingent liability dominates direct investment as a wealth commitment device; however, if wealth is unobservable, under this regime only relatively poor investors will hold shares in equilibrium. This may be prevented at a cost by verifying shareholder wealth and restricting stock transfers. Comparative statics on various liability regimes are used to motivate actual contractual arrangements.

An institution holding shares in a firm can use information about the firm both for trading (“speculation”) and for deciding whether to intervene to improve firm performance. Intervention increases the value of the institution's existing shareholdings, but intervention only increases the institution's trading profits if it enhances the precision of the institution's information relative to that of uninformed traders. Thus, the ability to speculate can increase or decrease institutional intervention. We examine key factors that affect the intervention decision, the usefulness of “short-swing” provisions and restricted shares in encouraging institutional intervention, and implications for ownership structure across different firms.

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.

This paper models the optimal choice of shareholder liability. If investors want managers to be monitored, the monitors should be residual claimants (shareholders), and monitoring and firm value will increase as shareholders commit more of their wealth to the firm. When liquidating wealth is costly, contingent liability dominates direct investment as a wealth commitment device; however, if wealth is unobservable, under this regime only relatively poor investors will hold shares in equilibrium. This may be prevented at a cost by verifying shareholder wealth and restricting stock transfers. Comparative statics on various liability regimes are used to motivate actual contractual arrangements.

This paper models the optimal choice of shareholder liability. If investors want managers to be monitored, the monitors should be residual claimants (shareholders), and monitoring and firm value will increase as shareholders commit more of their wealth to the firm. When liquidating wealth is costly, contingent liability dominates direct investment as a wealth commitment device; however, if wealth is unobservable, under this regime only relatively poor investors will hold shares in equilibrium. This may be prevented at a cost by verifying shareholder wealth and restricting stock transfers. Comparative statics on various liability regimes are used to motivate actual contractual arrangements.

Banks and related financial institutions often have two separate subsidiaries that make loans of similar type but differing risk, for example, a bank and a finance company, or a “good bank/bad bank” structure. Such “bipartite” structures may prevent risk shifting, in which banks misuse their flexibility in choosing and monitoring loans to exploit their debt holders. By “insulating” safer loans from riskier loans, a bipartite structure reduces risk‐shifting incentives in the safer subsidiary. Bipartite structures are more likely to dominate unitary structures as the downside from riskier loans is higher or as expected profits from the efficient loan mix are lower.

An institution holding shares in a firm can use information about the firm both for trading (“speculation”) and for deciding whether to intervene to improve firm performance. Intervention increases the value of the institution's existing shareholdings, but intervention only increases the institution's trading profits if it enhances the precision of the institution's information relative to that of uninformed traders. Thus, the ability to speculate can increase or decrease institutional intervention. We examine key factors that affect the intervention decision, the usefulness of “short‐swing” provisions and restricted shares in encouraging institutional intervention, and implications for ownership structure across different firms.

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.

Theory suggests that banks' private information about borrowers lets them hold up borrowers for higher interest rates. Since hold‐up power increases with borrower risk, banks with exploitable information should be able to raise their rates in recessions by more than is justified by borrower risk alone. We test this hypothesis by comparing the pricing of loans for bank‐dependent borrowers with the pricing of loans for borrowers with access to public debt markets, controlling for risk factors. Loan spreads rise in recessions, but firms with public debt market access pay lower spreads and their spreads rise significantly less in recessions.