While bank capital requirements permit a bank to freely substitute between equity and subordinated debt, lenders and investors view debt and equity as imperfect substitutes. It follows that, after controlling for the level of regulatory capital, the mix of debt in capital isolates the role that the market plays in disciplining banks. I document that the mix of debt in capital affects bank behavior, but only when investors can impose real constraints. In particular, the mix of debt reduces the probability of failure and future distress for BHC-affiliated institutions (where the investor has control rights through an equity position) and for stand-alone banks before the Basel Accord (when debt issues included restrictive covenants). However, substituting equity for subordinated debt at the bank holding company level or in stand-alone banks since the Basel Accord (where the investor has few protections) only increases the probability of distress and failure.

This paper offers a model of intermediation in the Diamond-Dybvig tradition in which both fiat currency and bank deposits are present. The behavior of the economy's price level, deposit-currency ratio, and money supply is compared across equilibria in which bank runs do and do not occur. It is shown that the behavior of these variables in the presence and absence of runs is consistent with that observed in the United States during the period from 1929 to 1933.

Projects with negative expected value cannot obtain financing in competitive capital markets if all potential investors are risk neutral and have identical beliefs about the distribution of the project′s net revenue. We present a series of examples with heterogeneous beliefs in which it is possible for a project to obtain financing even though all investors in the project believe, conditional on the project being undertaken, that the project has negative expected value. An important feature of the examples is that the differences in beliefs are due only to differences in information, and are not simply arbitrary unexplained differences in opinions. Journal of Economic Literature Classification Numbers:D8, G1.

I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

This paper illustrates how non-contractual legal rules sometimes alleviate contractual incompleteness. A serious incompleteness in debt contracts is the borrower's ability to fraudulently transfer assets to third parties, rendering the borrower insolvent. The incompleteness arises because contractual remedies are ineffective against third-party transferees who are not bound by the debt contract, while the borrower has no assets to recover. Fraudulent conveyance law is a non-contractual legal rule allowing recovery against these transferees. This increases debt capacity most dramatically for borrowers with highly liquid assets. Without non-contractual legal rules, high liquidation value implies low debt capacity. Journal of Economic Literature Classification Numbers: G32; G38.

The subprime crisis highlights how little we know about bank governance. This paper addresses a long-standing gap in the literature by analyzing the relationship between board governance and performance using a sample of banking firm data that spans 34years. We find that board independence is not related to performance, as measured by a proxy for Tobin’s Q. However, board size is positively related to performance. Our results are not driven by M&A activity. But, we provide new evidence that increases in board size due to additions of directors with subsidiary directorships may add value as BHC complexity increases. We conclude that governance regulation should take unique features of bank governance into account.

The debate over the potential procyclicality of bank capital requirements under Basel II has focused overwhelmingly on peak-to-trough variation in minimum regulatory requirements. In this paper, we re-examine the problem from the perspective of market discipline. First, we show that the marginal impact of introducing Basel II depends strongly on the extent to which market discipline leads banks to vary lending standards procyclically in the absence of binding regulation. Second, we evaluate policy options not only by their efficacy in dampening cyclicality in capital requirements, but equally by how well the information value of Basel II market disclosures is preserved.

We examine the effect of credit default swaps (CDSs) on debt specialization. We argue that reference firms in CDS contracts, seeking to minimize creditor conflicts and bankruptcy costs, exhibit higher debt concentration than firms on which no CDSs are traded. Our results show that firms engage in greater debt specialization and are more likely to specialize following the inception of CDS trading. Additionally, we find that, while lender concentration in firms increases, the number of bank lenders drops, lead arranger share rises, and the probability that lead arrangers and lenders are repeated increases following the onset of CDS trading. Our results are robust to instrumental variable estimation, propensity-score matching, different model specifications, and different subsamples.

Using a panel data set (1997–1999) for 235 publicly listed companies in the People's Republic of China (PRC), this study tests empirically whether the purchase of property insurance mitigates principal-agent (agency) incentive conflicts. In contrast to prior studies, we first estimate a probit insurance participation decision model and then a fixed-effects insurance volume decision model (with Heckman's sample selection correction) in order to shed light on the determinants of both property insurance participation and volume decisions. Our results suggest that a major motivation for the corporate purchase of insurance in China appears to be the mitigation of agency conflicts. Additionally, various ownerships seem to have different impacts on the corporate purchase of insurance in China. Moreover, the results show that the same factor can have different impacts on the insurance participation and volume decisions, and that binding financial conditions may be a key factor accounting for such observed differences.

We examine the impact of geographical proximity on the acquisition decisions of US public firms over the period 1990–2003. Transactions where the acquirer and target firms are located within 100 km of each other are classified as local transactions. We find that acquirer returns in local transactions are more than twice that in non-local transactions. The higher return to local acquirer is not explained by related, either horizontal or vertical, industry transactions, and appears to be related to information advantages arising from geographical proximity. These information advantages facilitate acquisition of targets that, on average, create higher overall return. The higher return to local acquirers is preserved by the use of target termination fee contracts.