When the managers of a firm are not its owners, agency problems result if managers take actions that maximize their own utility rather than the value of the firm. This paper investigates the existence of agency problems in mutual savings and loans. Using a more general approach than in previous studies, I show that mutual S&Ls were operating with an inefficient output mix while stock S&Ls were not, suggesting an agency problem among mutual S&Ls. The results cast doubt on a common argument that mutuals convert to stock S&Ls to capture economies of scale.

We explore the optimal financial contract for a large investor with potential control over a firm's investment decisions. An optimal menu of claims resembles a U.S. version of lender liability doctrine—equitable subordination. This doctrine permits the court to subordinate a controlling investor's claim in bankruptcy, but only under well-specified conditions. It allows a firm to strike an efficient balance between: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts. We provide a partial rationale for a financial system in which powerful creditors do not hold blended debt and equity claims. Journal of Economic Literature Classification Numbers: G20, G33, K22.

We analyze the value to firms of being able to renegotiate covenants in their debt contracts. Covenants control agency problems, but also reduce firms' flexibility to pursue profitable investments. Initial covenants will be more severe for renegotiable contracts, because they can be relaxed selectively when the lender believes they pose an inefficient constraint. We show firms with high ex ante credit risk find the option to renegotiate most valuable. The model is used to explain why bank loans and privately placed debt typically have harsher covenants than public debt and to predict which firms will borrow using closely held debt. Journal of Economic Literature Classification Numbers: D82, G21, G32.

We investigate the effects of technological change, deregulation, and dynamic changes in competition on the performance of US banks. Our most striking result is that during 1991–1997, cost productivity worsened while profit productivity improved substantially, particularly for banks engaging in mergers. The data are consistent with the hypothesis that banks tried to maximize profits by raising revenues as well as reducing costs. Banks appeared to provide additional or higher quality services that raised costs but also raised revenues by more than the cost increases. The results suggest that methods that exclude revenues when assessing performance may be misleading.

This paper investigates the incentives of a regulator to close depository institutions, recognizing that an institution′s risk taking will be influenced by the regulator′s policy regarding bank closure and that there are opportunity costs in closing banks arising from their intermediation function. The regulator focuses not on the current portfolio of the bank, but on the bank′s future portfolio. Even if the regulator seeks to maximize welfare, the first best is not obtainable because the regulator is unable to credibly commit to certain policies regarding closure. Journal of Economic Literature Classification Numbers: G2, L5, G1.

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.

The Great Recession focused attention on large financial institutions and systemic risk. We investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, we estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. We evaluate the costs and competitive implications of breaking up the largest banks into smaller banks.