This paper explores the role of testing in models of asymmetric information. We demonstrate conditions under which testing for underlying characteristics can overcome adverse selection problems and lead to a full-information competitive equilibrium. This paper provides a more general statement of Mirrlees result on the optimal use of infinite fines. Where testing cannot fully resolve the problems associated with asymmetric information, we outline the source of the difficulties. Our results, developed in the context of a labour market, can be directly extended to other environments. In problems with asymmetric information, testing to discover an agent's chosen action or underlying characteristics may significantly reduce the cost of moral hazard and adverse selection.

We develop a two‐tiered agency model that shows how rent‐seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent‐seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of “socialism” in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

A large share of dollar-denominated lending is done by non-U.S. banks, particularly European banks. We present a model in which such banks cut dollar lending more than euro lending in response to a shock to their credit quality. Because these banks rely on wholesale dollar funding, while raising more of their euro funding through insured retail deposits, the shock leads to a greater withdrawal of dollar funding. Banks can borrow in euros and swap into dollars to make up for the dollar shortfall, but this may lead to violations of covered interest parity when there is limited capital to take the other side of the swap trade. In this case, synthetic dollar borrowing also becomes expensive, which causes cuts in dollar lending. We test the model in the context of the Eurozone sovereign crisis, which escalated in the second half of 2011 and resulted in U.S. money market funds sharply reducing their exposure to European banks in the year that followed. During this period dollar lending by Eurozone banks fell relative to their euro lending, and firms who were more reliant on Eurozone banks before the Eurozone crisis had a more difficult time borrowing.

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By committing to terminate funding if a firm's performance is poor, investors can mitigate managerial incentive problems. These optimal financial constraints, however, encourage rivals to ensure that a firm's performance is poor; this raises the chance that the financial constraints become binding and induce exit. The authors analyze the optimal financial contract in light of this predatory threat. The optimal contract balances the benefits of deterring predation by relaxing financial constraints against the cost of exacerbating incentive problems. Copyright 1990 by American Economic Association.

During the U.S. housing credit boom, publicly traded banks increased mortgage lending activity and relaxed standards much more than privately held banks. The increase in risk had real effects for a variety of county-level aggregates including employment and consumption. Cross-sectional evidence and a quasi-experiment indicate that the increase in risk stemmed from the institutional ownership and the equity compensation of publicly traded banks, in turn leading banks to place greater weight on short-term equity performance. These results are consistent with the view that a focus on short-term earnings and stock prices amplifies boom–bust credit cycles, in turn leading to real cycles for the aggregate economy.

During business-cycle expansions, wages appear to rise relative to output prices.1 This fact is easy to square with real-business-cycle models which are based on the assumption that labor is more productive during expansions. But it is inconsistent with standard business-cycle theories based on aggregate demand fluctuations. In these models, fixed technology and diminishing returns imply that labor becomes less productive as output rises. Thus, in an expansion, wages should fall relative to output prices. Julio Rotemberg and Michael Woodford (1991, 1992) argue that imperfect competition can help to reconcile aggregatedemand theories of business cycles with observed procyclical real wages. If firms compete more aggressively during expansions, reducing the markup of price over marginal cost, the real wage can be driven up even if labor's marginal product falls. Countercyclical markups can therefore induce procyclical real wages. The difficult issue is understanding why markups would be countercyclical. Rotemberg and Garth Saloner (1986) and Rotemberg and Woodford (1991, 1992)hereafter referred to as RSW-claim that markups are countercyclical because it is harder for oligopolistic firms to sustain collusive prices during booms. When current demand is high relative to future demand, the incentive for any firm to cut its price rises because it becomes more valuable to capture current sales than to maintain collusion in the future. RSW present evidence that markups are indeed more countercyclical in more concentrated industries (where collusion can be more easily sustained). While this finding is consistent with countercyclical collusion, it is also consistent with any other theory in which imperfect competition induces firms to compete more aggressively during booms. In this paper, we analyze an alternative theory of countercyclical markups based on imperfect competition and capital-market imperfections. This theory has been suggested by Bruce Greenwald et al. (1984), Nils Gottfries (1991), and Paul Klemperer (1993). We present some preliminary evidence in an effort to distinguish this explanation from countercyclical collusion.

Within an optimal contracting framework, the authors analyze the optimal number of creditors a company borrows from. They also analyze the optimal allocation of security interests among creditors and intercreditor voting rules that govern rule renegotiation of debt contracts. The key to the authors' analysis is the idea that these aspects of the debt structure affect the outcome of debt renegotiation following a default. Debt structures that lead to inefficient renegotiation are beneficial in that they deter default but they are also costly if default is beyond a manager's control. The optimal debt structure balances these effects. Copyright 1996 by University of Chicago Press.

This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving 'nonlinear'instruments like options.

ABSTRACT This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving “nonlinear” instruments like options.