Knowledge that Transforms

This paper analyzes the accuracy of the risk-based capital formula for property-liability insurers that was adopted in 1993 by the National Association of Insurance Commissioners (NAIC). A logit analysis is conducted on a large sample of solvent and insolvent insurers spanning the period 1989–1993. Predictive accuracy is very low when the ratio of NAIC risk-based capital to actual capital is the sole indendent variable in the logit analysis, but accuracy improves significantly when the components of the formula and variables for firm size and organizational form are used as regressors. Improvements in the formula are needed to facilitate prompt corrective action and reduce insolvency costs.

This introductory article examines the role of capital in financial institutions — why it is important, how market-generated capital ‘requiremenents’ differ from regulatory requirments and the form that regulatory requirements should take. Along the way, we examine historical trends in bank capital, problems in measuring capital, and some possible unintended consequences of capital requirements. Within this framework, we evaluate how the contributions to this special issue advance the literature and suggest topics for future research.

Ji-Chai Lin, Michael S. Rozeff, Price Adjustment Delays and Arbitrage Costs: Evidence from the Behavior of Convertible Preferred Prices, The Journal of Financial and Quantitative Analysis, Vol. 30, No. 1 (Mar., 1995), pp. 61-80

Jinwoo Park, A Market Microstructure Explanation for Predictable Variations in Stock Returns following Large Price Changes, The Journal of Financial and Quantitative Analysis, Vol. 30, No. 2 (Jun., 1995), pp. 241-256

Unlike previous studies, this paper finds a consistent and highly significant relationship between beta and cross-sectional portfolio returns. The key distinction between our tests and previous tests is the recognition that the positive relationship between returns and beta predicted by the Sharpe-Lintner-Black model is based on expected rather than realized returns. In periods where excess market returns are negative, an inverse relationship between beta and portfolio returns should exist. When we adjust for the expectations concerning negative market excess returns, we find a consistent and significant relationship between beta and returns for the entire sample, for subsample periods, and for data divided by months in a year. Separately, we find support for a positive payment for beta risk.

This paper contrasts technical default, debt service default and bankruptcy, and establishes that the valuation effects of their announcements are significant and increasingly severe. We show the events are interrelated. Specifically, we show that technical default is a timely warning of further distress insofar as adverse stock price effects of debt service default are mitigated if preceded by technical default. We find this arises in part because technical default increases the likelihood of further distress. The extent of the mitigation suggests reduced costs of future distress, likely because technical default triggers the early exercise of contractual rights that allow lenders to increase control over the firm. We also evaluate explanations of why debt service default and bankruptcy occur without firms first reporting technical default. Our analysis is based on the small sample of firms for which we can ascertain the terms of debt covenant constraints. Given this limitation, we find that it is not because debt agreements are written with too much covenant slack, nor do we observe material cases of nonreporting of covenant defaults. We conclude that covenants do not always provide warnings of future difficulties. Résumé. Les auteurs établissent la différence entre le manquement technique, le manquement au service de la dette et la faillite et font la preuve que les conséquences de ces indicateurs sur l'évaluation des entreprises sont appréciables et de plus en plus sérieuses. Ils démontrent que ces événements sont reliés entre eux et, plus précisément, que le manquement technique est un avertissement hâtif d'autres difficultés, dans la mesure où les conséquences néfastes du manquement au service de la dette sur le cours des actions sont atténuées si ledit manquement est précédé par un manquement technique. Les auteurs en viennent à la conclusion que cette situation se produit en partie parce que le manquement technique augmente la probabilité d'autres difficultés. L'ampleur de cette atténuation permet de supposer une réduction des coûts associés aux autres difficultés, sans doute parce que le manquement technique déclenche l'exercice anticipé des droits contractuels qui permettent aux bailleurs de fonds de resserrer le contrôle qu'ils exercent sur l'entreprise. Les auteurs évaluent également les facteurs qui expliquent pourquoi une entreprise peut manquer au service de la dette et faire faillite sans faire d'abord état d'un manquement technique. Leur analyse se fonde sur un petit échantillon d'entreprises à l'égard desquelles il est possible de s'assurer des conditions relatives aux contraintes imposées par les clauses restrictives des contrats de prêt. Compte tenu de cette limitation, les auteurs concluent que ce genre de situation n'est pas attribuable au fait que les contrats de prêt comportent des clauses trop permissives et n'observent pas non plus de cas probants de non‐divulgation d'information relative au manquement aux clauses restrictives. Ils en déduisent que les clauses restrictives ne préviennent pas toujours les difficultés futures.

In the competitive model, externalities lead to inefficiencies, and inefficiencies increase with the size of externalities. However, as argued by Coase, these problems may be mitigated in a decentralized system through voluntary coordination. We show how coordination is limited by the combination of two factors: respect for individual autonomy and the existence of private information. Together they imply that efficient outcomes can only be achieved through coordination when external effects are relatively large. Moreover, there are instances in which coordination cannot yield any improvement at all, despite common knowledge that social gains from agreement exist. This occurs when external effects are relatively small, and this may help to explain why coordination is so seldom observed in practice. When improvements are possible, we describe how simple subsidies can be used to implement second-best solutions and explain why standard solutions, such as Pigovian taxes, cannot be used. Possible extensions to issues arising in the structure of research joint ventures, assumptions in the endogenous growth literature, and the location of environmental hazards are also described.

A general-equilibrium model is developed to highlight the link between neo-Keynesian mod-els of unemployment and recent results on the constrained sub-optimality of competitive economies with incomplete asset markets. Although the model deviates from the Arrow-Debreu paradigm only by the absence of some contingent claims, the competitive equilibrium exhibits under-employ-ment and balanced-budget fiscal policies have Keynesian effects which are Pareto improving. I.

This paper considers a representative agent model of asset prices based on a recursive utility specification. A constant elasticity of intertemporal substitution is assumed but the risk-preference component of utility is restricted only by qualitative, non-parametric regularity conditions. A principal contribution is to determine the exhaustive implications of this semiparametric recursive utility model for the one-step ahead joint probability distribution for consumption growth and asset returns. It is also shown, in contrast to the claims of previous studies, that the generalization from expected utility to recursive utility contributes substantially to the resolution of the equity premium puzzle.