Knowledge that Transforms

In this article we examine the effect of the imperfect mobility of goods on international risk sharing and, through that, on the investment in risky projects, welfare, and growth. Our main result is that the welfare gain from integration of financial markets is not greatly reduced by the presence of goods market imperfections, modeled as a cost of transferring goods from one country to the other. We also find that the gain is nonmonotonic with respect to investors' risk aversion and the aggregate volatility of output growth. The policy implication to be drawn is that financial market integration is a worthwhile goal to pursue even when full goods mobility has not been achieved. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

This article studies the security-design problem of a cash-constrained firm facing investors with diverse beliefs. Investor “rational beliefs” are modeled as varying and yet rational in the sense of Kurz (1994a). With two investors, optimal designs are similar under rational beliefs and rational expectations. With many investors, however, optimal securities under rational beliefs maximize investor differences of opinion, while under rational expectations optimal designs minimize disagreements. We demonstrate that the common practice of issuing multiple securities backed by a single asset is optimal under rational beliefs but not under rational expectations. Researching market beliefs can create substantial value for firms.

In this paper we provide a price characterization of efficient consumption bundles in multiperiod economies with market frictions. Efficient consumption bundles are those that are chosen by at least one rational agent with monotonic state-independent and risk-averse preferences and a given future endowment. Frictions include dynamic market incompleteness, proportional transaction costs, short selling costs, borrowing costs, taxes, and others. We characterize the inefficiency cost of a trading strategy -the difference between the investment it requires and the largest amount required by any rational agent to obtain the same utility level - and we propose a measure of portfolio performance based on it. We also show that the arbitrage bounds on a contingent claim to consumption cannot be tightened based on efficiency arguments without restricting preferences or endowments. We examine the efficiency of common investment strategies in economies with borrowing costs due to asymmetric information, short selling costs, or bid-ask spreads. We find that market frictions generally change and typically shrink the set of efficient investment strategies, shifting investors away from well-diversified strategies into low cost ones, and for large frictions into no trading at all. Hence we observe strategies that become inefficient with market frictions, as well as strategies that are rationalized by market frictions.

The volatility smile changed drastically around the crash of 1987, and newoption pricing models have been proposed to accommodate that change. Deterministic volatility models allowfor more flexible volatility surfaces but refrain from introducing additional risk factors. Thus, options are still redundant securities. Alternatively, stochastic models introduce additional risk factors, and options are then needed for spanning of the pricing kernel. We develop a statistical test based on this difference in spanning. Using daily S&P 500 index options data from 1986–1995, our tests suggest that both in- and out-of-the-money options are needed for spanning. The findings are inconsistent with deterministic volatility models but are consistent with stochastic models that incorporate additional priced risk factors, such as stochastic volatility, interest rates, or jumps.

Franklin Allen, Hans Gersbach, Jan-Pieter Krahnen, Anthony M. Santomero; Competition Among Banks: Introduction and Conference Overview, European Finance Re

Abstract Bank loans are more available and cheaper for new and small businesses in the U.S. in concentrated banking areas than in competitive banking areas. We explain this anomaly by analyzing banks' decisions to screen projects and their competition in loan provisions. It is shown that, by exacerbating the winner's curse, an increase in the number of banks can reduce banks' screening probability by so much that the number of banks that actively compete in loan provisions falls and the expected loan rate rises. This is the case when the screening cost is low, which induces all active bidders to be informed. The opposite outcome occurs when the screening cost is high, in which case there are sufficiently many uninformed banks in bidding to attenuate the winner's curse. We also examine the social optimum. JEL classification: G21, D44, L15

1. I am grateful for this opportunity to make some policy remarks concerning the very title of this conference, namely among banks: good or bad? This is the case not only because it is always very difficult, at least for me, to invent a title for my remarks, but also because the question is highly stimulating, and the answer - as your discussion today has illustrated - is not at all obvious. The attitudes towards the market economy are not unambiguous. As a matter of fact, no market participant really likes competition. Businessmen tend to praise the competition they practise vis-a-vis other firms, but they usually blame competition when they suffer as a result of it. The ethical attitude of a businessman, like that of a shopkeeper, is very often not to compete, and not to make life difficult for other people in the same profession. Competition ranks even lower in the financial businessmen's favours. This is so because banking activity is closely related to a sense of security, especially security concerning the future. Also, according to many people, the instability that, at least at the level of the individual firm, is inevitably brought about by a competitive system is really not congenial to banking. The Governor of the Bank of Italy in the 1950s - a person who is still held in high regard, years after his death - maintained the view that competition among banks was something to be feared as a potential source of serious disruptions. I belong to a generation which has seen a complete change of attitudes. 2. My remarks will refer to this change, touching on four points. First, I will elaborate on the journey from what I call the old to the new approach, namely from the approach prevailing when I was a student and during my early years as a central banker to that which has been developing subsequently and towards which I, to some extent, have contributed. Second, I will discuss how far this new approach can go. Third, I will bring into the picture aspects relating to the international dimension. Finally, I will address the specific aspects of the euro area dimension. Professor Padoa-Schioppa, a member of the Executive Board of the European Central Bank, presented these remarks as the keynote speech during the conference dinner.

Abstract This paper studies financial intermediation in a general equilibrium overlapping generations model. Indivisible investment projects combine with informational imperfections to create a (hidden action) moral hazard problem and introduce a role for third-party monitoring. Agency costs at the intermediary level are also considered. Under some conditions, monitors can be viewed as banks facing a non-trivial portfolio diversification problem. Equilibria are derived in which a large nationwide bank coexists with a number of community-regional banks, a structure of strong empirical relevance. Policies such as a mandatory reserve requirement are shown to have substantial effects on the levels of investment in the economy. JEL classification: E44, G21, G28

Abstract We study the effects of structural changes in banking markets on the supply of credit to small businesses. Specifically, we examine whether bank mergers and acquisitions (M&As) and entry have “external” effects on small business loans by other banks in the same local markets. The results suggest modest positive external effects from these dynamic changes in competition, except that large banks may reduce small business lending in reaction to entry. We confirm bank size and age as important determinants of this lending, and show that the measured age effect does not appear to be driven by local market M&A activity. JEL classification: G21, G28, G34, E58, L89.