This paper describes the balance sheet adjustments of debt and equity financed firms over time in an economy subject to taste shocks. A model is developed that describes a representative firm with a stochastic diminishing returns technology and a set of financial contracts that resolve a conflict-of-interest problem between differentially risk-averse bondholders and stockholders. The contractual resolution of this conflict-of-interest problem between the two agents is shown to shape certain stylized facts of business cycles ignored in Keynesian and Classical models. Changes in investor risk aversion and equity valuations trigger real investment decisions that can cause business cycles. Bond covenants then have the firm adjusting its financing decisions so as to offset any risk-shifting associated with the investment decisions. Stockholders manage the asset side of the firm’s balance sheet while bondholders (regulators in the case of banks) manage the financing side. In this way the welfare of both investors is coalesced over the business cycle. A similar type of analysis accounts for the age distribution of workers, and the size distribution of firms over the business cycle. Evidence presented here and elsewhere fails to reject these predictions for the U.S. non-financial and financial corporate sectors.

In this paper we show in a thought experiment that in an economy where i) investors hold rational expectations, ii) output is generated by a linear homogeneous production function, and iii) real investment is allocated across sectors according to the CAPM, a fractional reserve banking system is not Pareto efficient and amplifies the business cycle. In developing these results we show that these three well known propositions in economics also imply a new view of the business cycle, one where the business cycle is described in terms of the dispersion of an ex-ante probability distribution. The policy implication of this analysis is that bank regulation should go further than the Volcker rule or the Vickers commission proposal by restricting bank investments to currency and deposit accounts on the central bank. Nonbank financial institutions should then carry out the financial intermediation function now carried out by banks. The paper proposes that post office banking perhaps augmented with blockchain technology sometime in the future is one way to implement the transition from fractional reserve banking to full reserve banking. While little academic work has been done on full reserve banking in the aftermath of the Great Crisis, it is interesting to note that it is part of banking reform proposals now (July 2016) before the parliament in Iceland and a special national referendum in Switzerland.

This article is a review of a 531 page book that in turn is a review and evaluation of the 2319 page Dodd–Frank Wall Street Reform and Consumer Protection Act passed by Congress on July 16, 2010. The overriding theme of the book is to pose two approaches to attaining financial stability in the future. One approach is to establish a council of wise men and women supported by an army of highly skilled professional financial economists to formulate and implement regulations designed to prevent future financial crises that wreak havoc on the real economy and require financial support from taxpayers. This is the approach of the Dodd–Frank Act. The second approach proposed by the authors of this book is to design a taxing system that taxes systemically important financial institutions on the basis of their contribution to systemic risk. Borrowing ideas from the literature on the taxation of negative externalities their view is that financial institutions that create crises should pay for the clean-up. They also argue that requiring the financial polluters to pay for the creation of systemic risk will reduce the supply of systemic risk. The reader is invited to decide which approach is best.

There are numerous aspects concerning financial regulation which the current financial turmoil has high-lighted. These include: (1) the form of deposit insurance; (2) bank solvency regimes, ‘prompt corrective action’; (3) Central Banks’ money market operations; (4) commercial bank liquidity risk management; (5) procyclicality of CARs (and mark-to-market); lack of counter-cyclical instruments; (5) boundaries of regulation, conduits, SIVs and reputational risk; (6) crisis management: (a) within countries, e.g. UK Tripartite Committee; or (b) cross-border, how to allocate the burden of cross-border defaults? This paper describes how the crisis exposed regulatory failings, drawing largely on UK experience, and suggests remedies.

This paper exploits changes in financial subsidy programs to investigate their effect on female employment and firm performance. The identification strategy uses a quasi-experiment from a government policy change that eliminated financial support for exporting plants in the Chilean manufacturing industry. The difference-in-differences methodology shows that the policy change increased the share of total female employment by 3.3%, driven mainly by an increase of female workers in blue-collar occupations. In comparison, male labor experienced a drop of 4.4% in white-collar occupations in the treated plants relative to those in the control group. Plant total factor productivity (TFP) decreased due to the policy change, but both total gross output and sales rose approximately 7% on average. The paper explores two possible mechanisms to explain these findings: the technology adoption channel and changes in the gender composition of labor in the presence of a gender pay gap. The findings are consistent with the international trade and corporate finance literature on firm behavior under high market fixed and sunk costs.

I uncover heterogeneous effects of macroprudential policy on GDP growth distribution by bringing together the literature on the impact of macroprudential policy and recent developments on the use of quantile regressions. I identify important benefits of macroprudential policy on the left-tail of the GDP growth distribution which contrast with the negative effects found in previous studies using conditional mean models. These benefits may offset the deterioration on growth-at-risk produced by the build-up of cyclical vulnerabilities and the materialization of financial crises. I also find that the impact of macroprudential policy is dependent on the position in the financial cycle, the type of instrument, and the time elapsed since its implementation. In particular, tightening capital measures during expansions may take up to two years to show evidence of benefits on growth-at-risk, while the positive impact of borrower-based measures is rapidly observed. Conversely, in downturns the benefits of loosening capital measures are more immediate, while those of borrower-based measures are limited. This suggests the importance of timing in macroprudential policy. Overall, this study provides a useful framework to assess the impact of macroprudential policy in terms of GDP growth and to identify the term-structure of specific instruments.

Emerging market economies have undergone an extraordinary period of turbulence in capital markets during the period 1997–2002, and volatility remains a salient feature of the financial landscape. This paper discusses a number of central issues for the future of the region's financial markets. It starts with a brief summary of the reforms undertaken and shows that financial systems still remain fragile in a number of countries in the region. The paper then advances policy recommendations to strengthen domestic financial systems. The analysis and policy prescriptions aim at three areas: 1) the appropriate design of regulatory and supervisory institutions; 2) the role of foreign banks; and 3) how international financial practices affect Latin America.

Excessive (substantially above peer) litigation against a bank is indicative of operational risk because it often suggests failure to maintain a strong system of internal control. We examine the relation between bank performance and weak internal control using legal expense as a proxy. We find that legal expense is a strong determinant of loan losses and stock returns. Bank regulators should require reporting of legal expense on call reports to help identify institutions with weaknesses in internal control. Current reporting creates unnecessary information asymmetries because investors are not well informed about operational risk, leading to mispricing of bank securities.

Despite the extensive literature on prediction of banking crises by Early Warning Systems (EWSs), their practical use by policy makers is limited, even in the international financial institutions. This is a paradox since the changing nature of banking risks as more economies liberalise and develop their financial systems, as well as ongoing innovation, makes the use of EWS for informing policies aimed at preventing crises more necessary than ever. In this context, we assess the logit and signal extraction EWS for banking crises on a comprehensive common dataset. We suggest that logit is the most appropriate approach for global EWS and signal extraction for country-specific EWS. Furthermore, it is important to consider the policy maker's objectives when designing predictive models and setting related thresholds since there is a sharp trade-off between correctly calling crises and false alarms.