Banking crises are frequent events. Gerard Caprio and Daniela Klingebiel (1997) catalog over 80 banking crises during the last 25 years. Interestingly, some banking crises are associated with no output losses whatsoever, while others involve massive recessions. Finally, it is known that the probability of a banking crisis rises as the rate of inflation rises (see Asli Demirguc-Kunt and Enrica Detragiache, 1997; John Boyd et al., 2001a, b). While received wisdom exists about the conduct of monetary policy while a crisis is underway, there is no formal treatment of how the conduct of monetary policy during “normal times” affects the potential for banking crises to occur. To fill that gap, I consider economies where spatial separation and limited communication create a transactions role for money, and random shocks to agents’ liquidity preferences create a role for banks. In addition, banks confront randomness in withdrawal demand. When withdrawal demand is sufficiently high, banks exhaust their cash reserves. There are good reasons to associate this with a banking panic. The output lost during a banking panic depends on how great withdrawal demand is. Some banking crises generate no output losses, while others generate large reductions in resource availability. In addition, the conduct of monetary policy during “normal times” affects the probability of a banking crisis. The higher the nominal interest rate (the inflation rate), the higher is the probability of a panic. Driving the nominal interest rate to zero (following the Friedman rule) eliminates bank panics. This constitutes a new rationale for the Friedman rule. Nonetheless, conventional methods of implementing the Friedman rule never produce an optimal resource allocation. In particular, low nominal interest rates induce banks to hold large cash reserves, thereby forgoing socially more productive investments. In effect, the Friedman rule induces banks to become narrow banks voluntarily. The banking system is very safe, but it undertakes a suboptimal level of investment. Less conventional methods for implementing the Friedman rule, such as allowing unrestricted access to the discount window at a zero nominal interest rate, lead either to the nonexistence of equilibrium, or to massive indeterminacies. None of the equilibria will be consistent with full optimality.

We use a simulation model for a pharmaceutical R&D program to examine the tradeoff between objectivity and relevance of accounting information under various methods of R&D reporting. A simple capitalization rule, similar to the successful‐efforts method of capitalizing oil and gas exploration costs, provides a stronger relation between accounting information and economic values than immediate expensing of R&D outlays or capitalizing the full cost of outlays. The superior relevance of this “successful‐efforts” method persists even when earnings management is widespread.

Audit committees evaluate financial reporting quality as part of their corporate oversight responsibilities. Given this responsibility, the national stock exchanges now require all audit committee members to be financially literate and at least one member to have financial expertise. In light of recent debates over this requirement, we provide evidence on how experts and literates differ in their evaluations of financial reporting quality. Results suggest that experts' evaluations of financial reporting quality are more strongly associated with their assessments of characteristics underlying reporting quality (e.g., relevance) espoused in Statement of Financial Accounting Concepts No. 2's framework than literates' evaluations. Additionally, literates are more likely than experts to identify concerns about reporting treatments for business activities that are prominent in the business press or are distinguished by their nonrecurring nature, while experts are more likely to raise concerns about reporting treatments for less prominent, recurring activities. This same pattern occurs in the ratings of the quality of the reporting treatments for specific financial statement items with respect to elements underlying reporting quality (e.g., neutrality); literates (experts) assess the quality elements for the reporting treatments of prominent and nonrecurring items (less prominent and recurring items) comparatively lower than experts (literates). These results suggest that including financial experts on audit committees is likely to change the structure and focus of audit committee discussions about financial reporting quality, and may affect the committee's overall assessment of the quality of a company's financial reports.

We use Dealscan , a database of private corporate lending agreements, to provide large–sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous studies, principally larger and more representative samples and the availability of extensive actual covenant detail. These advantages allow us to construct powerful tests in which we find clear support for the debt covenant hypothesis. We also use these data to provide broad evidence on the economic role of debt covenants. We find that private lenders set debt covenants tightly and use them as “trip wires” for borrowers, that technical violations occur relatively often, and that violations are not necessarily associated with financial distress. Finally, since we measure covenant slack directly, we report evidence that the extensively–used leverage variable is a relatively noisy proxy for closeness to covenants.

This paper provides a review of developments in the area of risk management at both the firm level and the macro-economy. We review rationales regarding why firms choose to manage risk, as well as new developments in measuring and managing risk in a dynamic setting. We also consider current risk sharing arrangements in light of the theory regarding optimal risk sharing. The paper concludes with some suggestions for additional research that emphasizes the importance of incorporating market incompleteness in an equilibrium setting. We also discuss the role of incompleteness at the macro-level and speculate on how derivatives markets may influence macro-economic stabilization policy.

This article studies information blockages and the asymmetric release of information in a security market with fixed setup costs of trading. In this setting, “sidelined” investors may delay trading until price movements validate their private signals. Trading thereby internally generates the arrival of further news to the market. This leads to (1) negative skewness following price run-ups and positive skewness following price rundowns (even though the model is ex ante symmetric), (2) a lack of correspondence between large price changes and the arrival of external information, and (3) increases in volatility following large price changes.

The options-based approach to studying irreversible investment under uncertainty emphasizes that the opportunity cost of investment includes the value of the option to wait that is extinguished when an investment is undertaken. Thus, the investment decision is affected by the determinants of the value of this option. We extend and generalize a standard model of irreversible investment by introducing a second fully reversible technology, and also incorporate partial reversibility by allowing capital to be abandoned at a cost. As in the existing literature, we find that the threshold value of the “underlying asset” (in our case, demand) at which investment takes place is increasing in the uncertainty of demand. We also find that the value of the option and thus the threshold value of the option value multiple at which investment takes place may be either increasing or decreasing in the uncertainty of demand. In addition, we find that for the case in which capital is used to replace the reversible technology, the threshold value of the option value multiple is insensitive to the degree of reversibility of capital.

The informational role of prices contributes positively to their variability. In a noisy rational expectations equilibrium, traders rationally respond to price changes by revising their estimates of other traders' private signals and hence their own expectations of future dividends. The resultant shifts in traders' demands amplify any supply shock-induced price changes. We develop an infinite horizon noisy rational expectations model and calibrate, simulate, and test it using U.S. stock market data. The price variability in a heterogeneous information economy is shown to be 20% to 46% higher than in an otherwise equivalent economy in which all signals are publicly announced.

The relation of competition and cost accounting has been the subject of conflicting prescriptions, theories, and empirical evidence. Practitioner literature and textbooks argue that higher competition generally requires more accurate product costing. Theoretical economic analysis, in contrast, predicts that the optimal level of product‐costing accuracy is sometimes higher at lower levels of competition. Results of survey research are inconsistent, suggesting a need for further identification of conditions under which higher competition leads to more accurate product costing. This study shows experimentally that individuals' choices of the level of product‐costing accuracy depend not only on the current level of competition but also on the previous level of competition — that is, on an interaction between market structure (monopoly, duopoly, and four‐firm competition) and market history (increasing versus decreasing competition). In the experiment, subjects decide on the quantity of data to collect at a pre‐set price per datum to support more accurate product‐cost estimates. Subjects collect the most cost data (i.e., choose the most accurate product costing) in monopoly, collect the least in duopoly, and an intermediate amount in the four‐firm market, consistent with the pattern of optimal cost‐data collection in Hansen's 1998 model. The process of convergence to the optimum differs significantly across market types and market histories, however. Subjects who begin in four‐firm competition adapt more successfully to change than those who begin in monopoly. The lowest levels of decision performance occur when ex‐monopolists face their first competitor: they overreact to this first encounter with competition and overspend on cost data.