Knowledge that Transforms

We develop a model to examine the impact of international cross-listing on domestic market liquidity and trading volume to determine when domestic market development is likely to follow. Greater information transparency between markets increases domestic market liquidity and volume, resulting in market development. Conversely, post-listing order flow migration away from the domestic market reduces its liquidity and volume, resulting in retardation. The net impact is positive and greater when market professionals acquire rather than reveal information, for smaller previously restricted markets, and for cross-listings in larger more transparent markets that have a greater potential to expand the shareholder base.Journal of Economic LiteratureClassification Numbers: D44, D82, F36, G15.

When monitoring is not contractible—so investors monitor only when, at that time, they expect to benefit from doing so—efficient contracts sometimes induce managers to makefalsereports to investors. Because of monitoring discretion, management misrepresentation can produce Pareto improvements by reducing monitoring costs. When costs of renegotiation are small, optimal contracts necessarily induce misrepresentation. Discretionary monitoring also generates an equilibrium role for multiple-security capital structures. When an optimal contract has two investors, securityholder conflict arises endogenously as a means of reducing monitoring costs. It is efficient to write the contract so that one investor's decision to monitor hurts the other investor.Journal of Economic LiteratureClassification Number: G32.

This paper develops a model of price determination in insurance markets. Insurance is provided by firms that are subject to default risk. Demand for insurance is inversely related to insurer default risk and is imperfectly price elastic because of information asymmetries and private information in insurance markets. The model predicts that the price of insurance, measured by the ratio of premiums to discounted losses, is inversely related to insurer default risk and that insurers have optimal capital structures. Price may increase or decrease following a loss shock that depletes the insurer's capital, depending on factors such as the effect of the shock on the price elasticity of demand. Empirical tests using firm-level data support the hypothesis that the price of insurance is inversely related to insurer default risk and provide evidence that prices declined in response to the loss shocks of the mid-1980s.Journal of Economic LiteratureClassification Numbers: G22, G32, G33.

This paper reviews and analyzes the legal and economic aspects of the duty of best execution. Although a well-established principle of securities trading, we show that the dual problems of definition and enforcement make best execution both unwieldy and unworkable as a mandated legal duty. We examine the impact of several market practices on best execution, in particular payment for order flow, preferencing and internalization practices, and price improvement and order execution protocols. We suggest three possible directions for the future rule and interpretation of the duty of best execution.Journal of Economic LiteratureClassification Numbers: G10, G18, K22, K23.

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.

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 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.

We develop a model of trading volume when agents have different valuation and face transaction costs. In particular, the differential valuation is induced by differential tax status which generates trading around the distribution of cash dividends. Our model predicts that trading volume is negatively affected by idiosyncratic risk of dividend-paying stocks. Volume is negatively affected by the systematic risk of these stocks only in the presence of transaction costs.Journal of Economic LiteratureClassification Numbers: G11, G12, H20.

This paper examines cross-subsidy, moral hazard, and bank liability issues related to the provision of federal deposit insurance by "rerunning" its implementation, i.e., determining fair premium values, over the period 1927-1932. The pre-1933 period was characterized by historically high asset-price volatility, a large number of bank failures, and a weak federal safety net. In this economic context, we find a high degree of self-insurance on the part of the banks in our sample, both in terms of higher overall capital levels and a strong correlation between capital levels and asset volatility. Potentially large, regional cross-subsidies among banks were also found. Journal of Economic Literature Classification Number: G21.

This paper considers a standard monetary economy with indivisible primary assets and transaction costs. When assets are indivisible, if a steady-state equilibrium with positive savings exists, there necessarily exists a very large set of equilibria. The intermediation of indivisible assets substantially reduces the set of competitive equilibria, and enhances the "flexibility" of prices. We state sufficient conditions for intermediaries to form and hold all primary assets directly. We define and analyze various measures of the consumer surplus created by intermediaries. We show that conventional measures of intermediary output bear no obvious relation to the consumer surplus created by intermediation. Journal of Economic Literature Classification Numbers: E40, G20.