When monitoring is not contractible—so investors monitor only when, at that time, they expect to benefit from doing so—efficient contracts sometimes induce managers to makefalsereports to investors. Because of monitoring discretion, management misrepresentation can produce Pareto improvements by reducing monitoring costs. When costs of renegotiation are small, optimal contracts necessarily induce misrepresentation. Discretionary monitoring also generates an equilibrium role for multiple-security capital structures. When an optimal contract has two investors, securityholder conflict arises endogenously as a means of reducing monitoring costs. It is efficient to write the contract so that one investor's decision to monitor hurts the other investor.Journal of Economic LiteratureClassification Number: G32.

As discussed in Merton (1993, Sections 5 and 6) and here in the section to follow, the effective delivery of many financial services depends critically on the credit-worthiness of the provider financial institution. Such service activities are said to be 'credit-sensitive'. The intermediary's credit standing can cause significant extemality-like effects on the various business activities of the intermediary, even when there are no interconnections among them. For example, the announcement by a U.S. investment bank that it is even thinking of entering into a new merchant-banking activity of extending bridge financing and other interim risk-taking positioning for restructuring firms can materially and negatively affect its over-the-counter derivatives-products business for corporate customers because those customers may perceive the risk of the merchant-banking involvement as jeopardizing the bank's ability to fulfill its obligations on its long-dated contractual agreements. Thus the potential merchant-banking business affects the derivative-products business although there is no overlap of personnel, customer base, location, or employee skill sets between them. The shared credit standing of the institution's individual businesses can therefore cause a significant failure ofthe principle of 'value-additivity', which complicates decentralization of the capital budgeting and financial decisions. The issue of monitoring credit quality are made more complex because those intermediaries such as banks and insurance companies that are principals to customer contractual agreements tend to be 'opaque' institutions, as defined in Ross (1989) and Merton

Abstract. I examine how an internal auditor, called the firm, designs a control system for a strategic employee who conditions his thefts on the amount and types of controls. Society sets minimum testing amounts and fines for detected theft, whereas the firm determines the employee's wages and the amount of monitoring above the minimum. The results fall into three separate cases. When society's minimum testing standards and fines are sufficiently high, the employee never steals in any period. In this case, the firm performs the minimum amount of testing and pays the lowest feasible wage. In the remaining two cases, the testing standard and fines are too low to prevent theft by themselves. In these two cases the firm's control system determines whether there will be theft in the first period. I show that if the firm chooses to prevent all first‐period theft, then it uses only one type of control. She offers a wage premium and monitors the minimum amount. The wage premium substitutes for a tine large enough to prevent all theft. If the firm designs controls that do not prevent all theft, then the firm also uses only one control. In contrast to the no‐theft case, the firm pays the lowest feasible wage and monitors above the minimum. This choice reflects the increasing returns to scale of monitoring in preventing theft.

This paper presents an asymmetric information model of share repurchases when shareholders have heterogeneous reservation values. Consistent with empirical evidence, managers in the model repurchase shares at a premium above the post-repurchase share value — transferring wealth from shareholders who do not tender to those who do — in order to signal that the firm is undervalued. Such dilutive repurchases would not occur under the classical assumption of perfectly elastic share supply; they depend critically on shareholder heterogeneity. It is also shown that repurchases are more efficient signals than other strategies like dividends and ‘burning money’. The model's implications are consistent with much empirical evidence regarding announcement returns, repurchase size, repurchase premiums and expiration-day price drops.

This paper develops a model of repeated innovation with knowledge spillovers. The model's novel feature is that firms compete on two dimensions: (1) product quality, where one firm's innovation ultimately spills over to other firms; and (2) distribution costs, where there are no spillovers across firms and where learning-by-doing on the part of incumbent firms gives them a competitive advantage over would-be entrants. Such firm-specific learning-by-doing has two important consequences: (1) it can in some circumstances dramatically reduce the long-run average level of innovation; (2) it leads to endogeneous bunching, or waves, in innovative activity.

I hypothesize that risk taking is greater in stock thrifts than in mutual thrifts because the residual and fixed claims are separable. I find that stock thrifts exhibit greater profit variability during the 1982–1988 period and that conversions from mutual to stock ownership are associated with increased investment in risky assets and increased profit variability. These findings illustrate the relation between the structure of residual claims, incentives, and firm performance as well as the unintended consequences resulting from changes in thrift regulations.

I analyze the investment and funding strategies of two thrifts, one stock owned and one mutually owned, from 1983 to 1988. Despite their similarities prior to 1983, the stock thrift implemented a riskier financial strategy and did so only after converting to stock ownership. Although this strategy ultimately led to its failure, the stock thrift still made significant payouts to its controlling shareholders. This case study illustrates in stark terms the relation between organizational form and risk shifting in the thrift industry.

Abstract. Accounting research contains two distinct approaches to the interaction between accounting management and the independent auditor. Game theory suggests that the auditor's testing strategy will affect the manager's reporting strategy and that the two strategies form an equilibrium. The game‐theoretic approach views the auditor as active, in that the auditor acknowledges the effect that his or her testing strategy has on the manager's reporting. In contrast, in the decision‐theoretic approach, the auditor tests reports, but ignores the effect that such testing might have on the manager's reporting behavior. Essentially, the decision‐theoretic approach views the auditor as passive, taking the reporting strategy as given when designing tests. We use United Kingdom data to estimate both models and test their validity using nested hypothesis tests. Our results demonstrate that the active, game‐theoretic model better describes the auditor‐manager interaction. This is the first empirical validation of the game‐theoretic model using archival accounting data.

Abstract In this paper we present and estimate a model of short-term interest rate volatility that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of bond options. Our findings indicate that the inclusion of a volatility effect reduces the estimate of the level effect, and has option implications that differ significantly from the Chan, Karolyi, Longstaff and Sanders (1992) model.

This article compares various measures of on-the-job training, from a new source that matches establishments and workers, allowing the authors to compare the responses of employers and employees to identical training questions. Establishments report 25 percent more hours of training than do workers, although workers and establishments report similar incidence rates of training. Both establishment and worker measures agree that there is much more informal training than formal training. Further, informal training is measured about as accurately as formal training. Finally, the authors show that measurement error reduces substantially the observed effect of training, in particular the effect of training on productivity growth. Copyright 1997 by University of Chicago Press.