Knowledge that Transforms

We develop a simple model of the housing market in which financial imperfections can serve to stabilize aggregate fluctuations, and not necessarily aggravate them as in much of the previous literature; we term this a financial decelerator. Stabilization can occur in our model because lenders are imperfectly informed as to borrowers' propensity to default. As a result, it is too costly for lenders to impose borrowing constraints that guarantee repayment in every possible eventuality. This allows some borrowers to default when house prices are low, thereby leaving them with more wealth. This then serves as an endogenous stabilizing force.

This paper examines the contribution of investments in Information Technology (IT) and in advertising to the output and profits of Spanish banks, in the period 1983–2003. We find that the growth in the stock of IT capital explains one third of output growth of banks, and that an additional investment in IT of one million euros may be substituted for twenty-five workers. The paper also finds that advertising investments increase the demand for bank services with an elasticity of 0.22 for deposits and 0.11 for loans. For all the assets considered, the null hypothesis that banks use the profit-maximizing amount of services per period cannot be rejected with the data.

Banking crises are usually followed by low credit and GDP growth. Is this because crises tend to take place during economic downturns, or do banking sector problems have independent negative real effects? If banking crises exogenously hinder real activity, then sectors more dependent on external finance should perform relatively worse during banking crises. The evidence in this paper supports this view. The differential effects across sectors are stronger in developing countries, in countries with less access to foreign finance, and where banking crises were more severe. Robustness checks include controlling for recessions, currency crises, and alternative proxies for bank dependence.

Bank runs in the literature take the form of withdrawals of demand deposits payable in real goods, which deplete a fixed reserve of goods in the banking system. That framework describes traditional bank runs based on currency withdrawals as occurred historically in the US and more recently in developing countries. However, in a modern banking system, large withdrawals typically take the form of electronic payments of inside money, with no analog of a depletion of a scarce reserve from the banking system. In a new framework of nominal demand deposits repayable in inside money, pure liquidity-driven bank runs do not occur. If there were excessive early withdrawals, nominal deposits would hedge the bank and flexible monetary prices in the goods market would limit real consumption. The maturity mismatch of short term liabilities and long term assets is not sufficient for multiple equilibria bank runs without other frictions. A key role of the bank is to ensure optimal real liquidity, which allows markets to optimally distribute consumption goods through the price mechanism.

This paper studies the use of incentive contracts in the Bolton–Scharfstein model when some agents in the population are technically constrained from falsifying reports and stealing cash [Bolton, P., Scharfstein, D., 1990. A theory of predation based on agency problems in financial contracting. Amer. Econ. Rev. 80, 94–106]. The original Bolton–Scharfstein contract may not be optimal for a large range of parametric values. The optimal contract may induce falsification and stealing in equilibrium and social welfare may be improved. Moreover, the optimal contract does not screen different types of agents. Empirical implications for various types of staged-contracts are discussed.

We examine the implications of optimal credit risk transfer (CRT) for bank-loan monitoring, and the incentives for banks to engage in optimal CRT. In our model, properly designed CRT instruments allow banks to insure themselves against loan losses precisely in those states that signal monitoring. We find that optimal CRT enhances loan monitoring and expands financial intermediation, in contrast to the findings of the previous literature. Optimal CRT instruments are based on loan portfolios rather than individual loans and have credit-enhancement guarantees, pretty much as banks do in practice. But the extent of credit enhancement needs to be precisely delimited. Above that exact level, monitoring incentives are undermined (loan quality deteriorates) and wealth is transferred from the bank's financiers to the bank. Properly designed risk-based capital requirements are shown to prevent such a wealth transfer and to provide banks with the incentive to engage in optimal CRT.

Fragmented trading is widespread. Chowdhry and Nanda [Chowdhry, B., Nanda, V., 1991. Multimarket trading and market liquidity. Rev. Finan. Stud. 4, 483–511] show that some traders benefit by splitting orders across markets at the cost of small liquidity traders who, for exogenous reasons, only trade locally. We extend their model to analyze British and Dutch stocks with ADRs, which trade on both sides of the Atlantic for one or two hours each day. We predict that, in the presence of sufficient small liquidity trading, traders concentrate their trades in the overlapping period and split orders across markets. We document considerable empirical support. In the cross-section, we find order-splitting only for ADRs with most NYSE small liquidity trading. The evidence is (i) increased volatility, increased volume, and (weakly) higher liquidity supply in the overlap and (ii) positive correlation in order imbalance across markets. We further find that the common component in order imbalance has long-term price impact, which supports the notion that these order-splitters are informed traders.

Over the past decade, the distances between small businesses and their bank lenders have increased substantially, as increasing numbers of bank lenders have implemented credit-scoring models to evaluate the creditworthiness of small businesses. These developments are antithetical to the traditional small business lending process, which emphasizes local proximity, bank–borrower relationships, and qualitative information. We theoretically model and empirically test whether and how these changes have affected the probability that small business loans default, using 1984–2001 data from the SBA's flagship lending program. On average, both distance and credit scoring are associated with higher default probabilities—the former suggests that distance interferes with information collection, while the latter suggests that production efficiencies encourage credit-scoring lenders to expand output by making riskier loans at the margin. The default-increasing effects of distance are substantially dampened at credit scoring banks, however, suggesting that hard-information lending approaches may outperform soft-information, relationship-based lending approaches in long-distance situations.

We test the market timing theory of capital structure using an earnings-based valuation model that allows us to separate equity mispricing from growth options and time-varying adverse selection; thus avoiding the multiple interpretations of book-to-market ratio. We find that equity market mispricing plays a significant, if not dominant, role in the security choice decision. Our results are robust to the inclusion of proxies for time-varying growth options and alternate methods of measuring misvaluation.