Knowledge that Transforms

Why do banks fund loans embodying considerable borrower-specific information with liquid deposits? I address this question by examining the disciplinary effect of liquid deposits in a framework where banks' production of nontransferable borrower information is explicitly considered. I show that deposit liquidity motivates banks to provide greater monitoring of their loan applicants despite the general lack of observability of bank monitoring and bank loan quality. The analysis provides an important link between the two activities in which banks are viewed as “special”—their liquidity provision through demand deposits and their lending to information-intensive borrowers.Journal of Economic LiteratureClassification Numbers: G21, G28.

Previous research questions the use of best-efforts offering methods for IPOs since firm-commitment offerings have lower direct issue costs. This paper attempts to explain the choice of best-efforts methods by focusing on an indirect offering cost: the possibility that an offering will be unsuccessful. Determinants of offering success, including offering size, price, underwriter reputation and the clustering of filings, have different impacts on the likelihood of success for these offering methods. Unsuccessful offerings are also found to be costly. Issuers select the offering method that provides the greater ex ante probability of success, all else equal, consistent with cost minimization.Journal of Economic LiteratureClassification Numbers: G24, C25.

The increased fragility of the banking industry has generated growing concern about the risks associated with payment systems. Although in most industrial countries different interbank payment systems coexist, little is really known about their properties in terms of risk and efficiency. How should payment systems be designed? We tackle this question by comparing the two main types of payment systems, gross and net, in a framework where uncertainty arises from several sources: the time of consumption, the location of consumption, and the return on investment. Payments across locations can be made either by directly transferring liquidity or by transferring claims against the bank in the other location. The two mechanisms are interpreted as the gross and net settlement systems in interbank payments. We characterize the equilibria in the two systems and identify the trade-off in terms of safety and efficiency.Journal of Economic LiteratureClassification Numbers: G21, E51.

This paper proposes and implements a security design framework to assess why corporate managers issue convertible debt. We examine three theories that make predictions about the design of convertible debt. Our results suggest that some issuers design convertible debt to mitigate asset substitution problems, while others design it to reduce adverse selection problems. We also find that issuers vary convertible debt security design over the business cycle in response to time variation in asset substitution and adverse selection problems. Overall, the results indicate that corporate managers actively alter convertible debt security design to mitigate costly external finance problems. Journal of Economic Literature Classification Number: G32

This paper examines the impact of reducing the tick size on market-making behavior on The Toronto Stock Exchange. The results indicate a significant decrease in the percentage of trades of fewer than 10,000 shares involving the upstairs traders and a significant increase in the percentage of trades of fewer than 1,000 share involving the designated market makers. Consistent with this finding, the upstairs traders earn significantly lower returns on non-block trades and the designated market markers earn lower returns on trades smaller than 1,000 shares. We conclude the tick size reduction benefits the trading public.Journal of Economic LiteratureClassification Numbers, G20, G24.

I use both the depth of the buyers' market and the trading volume to measure asset liquidity in the contract drilling industry and I find that drilling rigs are less liquid than oil wells. The results indicate that managers avoid selling illiquid assets unless they face high costs for alternative sources of funds. The evidence also suggests that managers follow a “pecking order” of asset sales, selling liquid assets before illiquid assets. Finally, I find evidence that the liquidity of a firm's asset portfolio increases its debt capacity. I conclude that asset liquidity is an important consideration in investment and capital structure decisions.Journal of Economic LiteratureClassification Numbers: G3, G31, G32, G33, L71.

In this paper we investigate empirically the relative advantages of floor and screen trading systems. We judge the systems by their ability in providing a high degree of market integration. The main result is that a closer integration of underlying and derivative markets occurs when both instruments are screen traded, but the difference is significant only for short return intervals. In active trading periods the superiority of screen systems is even more pronounced.Journal of Economic Literature Classification Numbers:G15, G20.

The existing banking literature leaves largely unanswered the question: what is the viability of bank liquidity provision if investors can dynamically readjust their portfolios? To address this question, I analyze the problem of optimal liquidity provision through bank deposit contracts in a simple continuous-time equilibrium model under uncertainty. My model introduces the possibility of investors' directly investing in the market, which gives rise to a moral hazard problem in the use of deposit contracts. I argue that this can severely restrict liquidity provision and characterizes incentive-compatible deposit contracts as second-best mechanisms to provide liquidity. The analysis shows that at the optimum, liquidity provision is negatively correlated with the degree of irreversibility of the market investment opportunity. In particular, when the market investment opportunity is completely reversible, deposit contracts cannot provide any insurance against liquidity risks.Journal of Economic LiteratureClassification Numbers: D 51, D 92, G 20, G 21.

I explore the functioning of inside money competition in an overlapping generations model to address the question of whether the base of currency supply should be a monopoly. In such an economy, banks enhance allocative efficiency by offering short-term contracts (banknotes) in order to finance long-term investments since wealth has to be transferred between the generations prior to the fruition of the high-yielding long-term investments. Liquidity is created by offering agents favorable short-term contracts for funds that are earmarked for long-term investments. I study how issuance of banknotes, liquidity creation, and payment processes interact in competitive and monopolistic banking industries. I show that neither free banking (banking with free entry) nor monopoly banking achieves a first-best (Pareto-efficient) allocation. However, free banking is Pareto-inefficient compared to monopoly banking. This inefficiency arises from the overissuance incentives of competing banks. Additional liquidity needs are distributed among all banks through the payment system provided that households are indifferent to which banknotes they use to satisfy their liquidity needs. Hence, the issuer of banknotes creates a negative externality since other banks must invest more in short-term investments in order to balance liquidity needs. Under free banking, the first holders of banknotes receive an implicit return, so they can profit from funds earmarked for long-term investments. The monopoly does not provide implicit returns, but the first holders get returns from their banks' shares. Monopoly banking Pareto-dominates free banking since it has to devote a smaller portion of resources to less profitable short-term investments.Journal of Economic LiteratureClassification Numbers: E42, E50, E51, G21.

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.