Knowledge that Transforms

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.

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.

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.

Controversial econometric studies of mortgage data show that mortgage loan applications by some minorities are denied more frequently than are applications by whites with similar observable default risk factors. But recent evidence indicates that minority borrowers also default more frequently than whites with similar observable risk. This paper presents a simple equilibrium model of discriminatory credit rationing and finds parametric restrictions consistent with both these empirical findings. However, in this model, proposed antidiscrimination policies have surprising side effects. Thus, policy analysts accepting this empirical evidence should not expect to derive model-free conclusions about the effects of proposed policies. Journal of Economic Literature Classification Numbers: G21, G28, D63.

I show that dual trading reduces the net order flow and market depth. Trading volume and gross (of commission fees) profits of informed traders are lower with dual trading, while trading volume and gross losses of uninformed traders are unaffected. When the broker′s commission income is independent of the customer′s trading volume, the competitive commission fee is lower with dual trading. The utility of uninformed traders (net of commission fees) increases with dual trading, while the net profits of informed traders decrease. Journal of Economic Literature Classification Numbers: G12, G13, D82.

We develop an integrated model in which a risk-neutral informed trader optimally chooses any combination of a market buy, a market sell, a limit buy including the limit buy price, and a limit sell including the limit sell price. Limit orders undercut the market maker and generate transactions inside the bid-ask spread. The informed trader exploits limit orders by submitting market orders even when the terminal value is inside the spread. When the terminal value is above the bid, a combined market buy-limit sell is more profitable than a market buy only. We obtain an analytic solution. Journal of Economic Literature Classification Numbers: D40, D82, G12, G14.