Knowledge that Transforms

Banks can make suboptimal liquidity choices and gamble for lender of last resort (LOLR) support. Endogenous bailout rents are driven by the need to preserve bankers' incentives under uncertain net worth. In equilibrium, banks can herd in risk management, choosing suboptimal liquidity when they expect others to do so. Optimal liquidity can be restored by quantitative requirements, but such regulation is costly. An LOLR policy incorporating bank capital information can reduce distorting rents and allow for a more efficient solution, but may only be possible in transparent economies.

We evaluate the efficacy of price discovery in the round-the-clock U.S. Treasury market. Using a comprehensive intraday database, we explore informational role of trades over the 24-hour day. We find that information asymmetry is generally highest in the preopen period and lowest in the postclose period. Information asymmetry in the overnight period is comparable to that in the regular trading period. However, on days with macroeconomic announcements, information asymmetry peaks shortly after the news release at 8:30. Moreover, information asymmetry is higher on Monday morning and higher immediately before than after the open of U.S. Treasury futures trading. Although volume is low after hours and trading cost is relatively high, overnight trading generates significant price discovery. Results suggest that overnight trading activity is an important part of the Treasury price discovery process.

This paper surveys the growing literature on payments. We begin by presenting a simple model that illustrates the essential function of payments and how this may be implemented through various arrangements. We show how the basic models of payments have been used to address a variety of microeconomic and macroeconomic policy issues. We then discuss the links between payments economics and other fields, including monetary theory, corporate finance, and industrial organization. We conclude with an overview of the empirical literature and directions for future research.

Financial intermediaries often use stress testing to set risk exposure limits. Accordingly, we examine a model with an agent who faces stress testing constraints and another who does not. Three results are obtained. First, when there are K* binding constraints, the constrained agent's optimal portfolio exhibits (K*+2)-fund separation. Second, the effect of the constraints on the optimal portfolio is identical to that of an adjustment in the expected payoffs of the risky securities that tends to lower them. Third, a security's equilibrium expected return depends on both its systematic risk and its idiosyncratic returns in the states where the constraints bind.

We document that chief executive officer (CEO) incentive compensation plays an important role in determining internal capital market (ICM) allocation efficiency. Our results suggest that CEO equity-based compensation can be effective in ameliorating inefficiencies in internal capital allocation decisions. We find that while stock grants play an important role in motivating CEOs to make more efficient internal capital allocation decisions, there is surprisingly no discernible influence of stock options. Our analysis supports the view that private benefits derived by managers are increasing in internal capital misallocation. We also document a strong positive link between CEO incentive compensation and excess value of diversified firms suggesting that the diversification discount can be ameliorated with CEO incentive compensation. The study contributes to the ICM literature and the literature on conglomerate diversification discount.

We study a significant innovation with widespread consequences for the mutual fund industry: the introduction of multiple-class funds that give investors a choice among alternative load and fee structures. The transition to a multiple-class structure represents an important step in the evolution of the mutual fund industry. It also provides a well-controlled setting for research on the structure of funds, on investor clienteles and their impact on fund performance and, more generally, about the manner in which financial innovations tend to be adopted. We develop a simple model of a fund's decision on whether and when to introduce new classes and empirically investigate the model's predictions that: (a) Funds with more skilled management, less sensitivity of flows to performance, smaller size, higher existing loads and membership in larger families are better positioned to benefit and, therefore, more likely to switch to a multiple-class structure earlier; (b) The new classes increase the level and volatility of fund inflow by attracting investors with short and uncertain investment horizons – which, in turn, can negatively impact fund performance. Our empirical results are generally supportive of the model's predictions.

We investigate whether information sharing among banks has affected credit market performance in the transition countries of Eastern Europe and the former Soviet Union, using a large sample of firm-level data. Our estimates show that information sharing is associated with improved availability and lower cost of credit to firms. This correlation is stronger for opaque firms than transparent ones and stronger in countries with weak legal environments than in those with strong legal environments. In cross-sectional estimates, we control for variation in country-level aggregate variables that may affect credit, by examining the differential impact of information sharing across firm types. In panel estimates, we also control for the presence of unobserved heterogeneity at the firm level, as well as for changes in macroeconomic variables and the legal environment.

We examine whether banks better protect themselves against risk-shifting as compared to non-bank lenders by comparing risk management polices across firms that borrow from different lenders using a unique, hand-collected data set of hedging and borrowing practices. Consistent with banks being effective monitors, we find hedging is positively associated with the proportion of bank debt amongst firms with large risk-shifting incentives. We present descriptive evidence showing that banks use covenants as one of the channels to mitigate risk-shifting.