Knowledge that Transforms

We analyze the optimal contract to finance the series of investments of a growing firm. The analysis is based on the need to repeatedly raise funds when informed insiders can expropriate outside investors. The optimal contract can be implemented by a sequence of one-period debt contracts and equity ownership by outsiders. Debt is optimal, as it reduces the expected cost of auditing, while partial equity ownership by insiders is optimal, as it mitigates the need for auditing in the presence of valuable growth opportunities. The model yields time-series implications regarding capital structure, investment and its fraction financed externally, and profitability.

This paper explores the pricing of debt in a financial system where the assets that borrowers hold to meet their obligations include claims against other borrowers. Assessing financial claims in a system context captures features that are missing in a partial equilibrium setting, such as liquidity spillovers across financial institutions resulting from expansions and contractions of balance sheets. Aggregate liquidity can be seen as the rate of growth of financial sector balance sheets.

We analyze the interaction between bank and market finance in a model where bankers gather information through monitoring and screening. We show that if a market characterized by a disclosure law is established such that entrepreneurs wishing to raise market finance can credibly disclose their sources of financing, this might undermine bankers' incentive to screen, even when screening is efficient. Correspondingly, other things being equal, the change from a bank-based system to one in which market-finance and bank-finance coexist might have an adverse affect on economic growth. Consistent with this result, our empirical findings suggest that both bank and stock market development have a positive effect on growth, but the growth impact of bank development is lower the higher is the level of stock market development.

We analyze the potential competitive effects of the proposed Basel II capital regulations on US bank credit card lending. We find that bank issuers operating under Basel II will face higher regulatory capital minimums than Basel I banks, with differences due to the way the two regulations treat reserves and gain-on-sale of securitized assets. During periods of normal economic conditions, this is not likely to have a competitive effect; however, during periods of substantial stress in credit card portfolios, Basel II banks could face a significant competitive disadvantage relative to Basel I banks and nonbank issuers.

Financial institutions, especially large banks, have reached beyond their traditional activities in recent years and have become more homogeneous as a result. Even though this brings about diversification gains, we show that their stability may fall as consequence since institutions' incentives for taking on risk and supplying liquidity deteriorate. Optimal regulation should hence not provide a relief for diversification. However, we also identify an important benefit of this development. When financial institutions become more homogeneous, there is less need for risk sharing among them. This in turn mitigates the impact of any imperfections such risk sharing may be subject to.