Knowledge that Transforms

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.

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.

We examine aftermarket transactions for closed-end fund IPOs and document large sell-to-buy imbalances (“flipping”), extensive price stabilization, and sharp subsequent price drops. The timing of the price drop is related to both the amount of initial flipping, and use of the over-allotment options. The extent of the flipping activity is related to the composition of the syndicate. Moreover, aftermarket buys (sells) are mainly small (large) trades. These findings suggest that lead underwriters price stabilize and manage the supply of shares in the aftermarket, and that closed-end fund IPOs are marketed to a poorly informed public.

This paper models an economy in which risk-averse savers and risk-neutral entrepreneurs make investment decisions. Aggregate investment in high-yielding risky projects is maximized when risk-neutral agents bear all nondiversifiable risks. A role of banks is to assume nondiversifiable risks by pledging their capital in addition to diversifying risks. Banks, however, do not completely eliminate risks when monitoring by depositors is imperfect. Government deposit insurance that uses tax revenue to repay depositors transfers remaining risks to entrepreneurs. Deposit insurance can improve welfare because imperfect monitoring by the government largely results in income transfer among risk-neutral agents rather than lower production.Journal of Economic LiteratureClassification Numbers: G21, G28.

The variances of pricing errors (transitory changes in prices) at the NYSE open and the close are analyzed for U.S. stocks that are traded in London or Tokyo, British and Japanese stocks that are listed on the NYSE, and U.S. stocks that are not traded abroad. The variance of pricing errors is significantly greater at the open than at the close for U.S. stocks, but not foreign stocks. These differences are explained by differences in order flow at the open and the close, a relation that is the same whether stocks are foreign or domestic and whether they trade abroad or notJournal of Economic LiteratureClassification Numbers: G10, D23.

This paper presents an analytical model of underwriting capacity and insurance market equilibrium under an asymmetric corporate tax schedule characterized by incomplete tax-loss offsets. We show that reinsurance causes tax shields to be reallocated to those insurers that have the greatest capacity for utilizing them. Reinsurance is therefore used as an efficient short-run mechanism to yield the optimal allocation of tax shield benefits. In equilibrium, asymmetric taxes cause insurance prices to be actuarially unfair, and the expected return on capital invested in insurance reflects the probability of paying taxes.Journal of Economic LiteratureClassification Number: G22.

When banks act as delegated monitors of borrowing firms in a finite economy, two factors help banks dominate direct lending: portfolio diversification, which increases with bank size, and bank capitalization, which diminishes with size. With free entry into banking, intermediated equilibria are possible even when direct lending cannot overcome autarky. There are usually multiple intermediated equilibria; these may not be Pareto-ranked by bank size, since smaller banks are better captialized and may Pareto-dominate larger banks. Even when one large bank would be most efficient, assigning a monopoly bank charter to coordinate beliefs on the single bank equilibrium may be unattractive: in some cases, a monopoly bank cannot overcome autarky even though free-entry banking can, and in other cases, the monopoly bank reduces production from the direct lending level. Journal of Economic Literature Classification Numbers: G21, L13, O16.

We show that the pattern of short-term negative serial covariances for stock returns over different return measurement intervals is consistent with the implications of inventory-based microstructure models. We develop different testable implications of these models and document supporting evidence. Our findings indicate that to a large extent the short-horizon return revearsals can be explained by dealer-inventory-related market microstructure effects. Journal of Economic Literature Classification Numbers: G14, G20.