This paper studies the dynamic investment policies of firms under asymmetric information.Managers make decisions to maximize the wealth of existing shareholders. In equilibrium, the superior firms invest “myopically”, choosing intrinsically lower-valued projects that produce “early” cash flows. The inferior firms follow the socially preferred rule of investing in intrinsically higher-valued projects that produce “late” cash flows. In addition to explaining investment myopia, the model generates numerous predictions regarding announcement effects of equity issues and attempts by firms to stockpile cash, firms' preferences for limits on mandatory disclosure rules, and the effects of managerial entrenchment motives.

The authors explain why an issuer may wish to raise external capital by selling multiple financial claims that partition its total asset cash flows, rather than a single claim. They show that, in an asymmetric information environment, the issuer's expected revenue is enhanced by such cash flow partitioning because it makes informed trade more profitable. This approach seems capable of shedding light on corporate incentives to issue debt and equity, as well as on financial intermediaries' incentives to issue multiple classes of claims against portfolios of securitized assets.

We review the contemporary theory of financial intermediation. The focus is on contributions in the past 15 years or so that have advanced our understanding of why financial intermediaries exist, the credit allocation and other services they provide in spot and forward credit markets, the contractual nature and allocational consequences of the claims they issue, and the optimal design of bank regulation. Journal of Economic Literature Classification Numbers: 310, 312, and 314.

We explain the use of legally unenforceable, discretionary financial contracts in circumstances where legally enforceable contracts are feasible. A discretionary contract allows a contracting party to choose whether or not to honor the contract. It is shown that such a contract liquefies reputational capital by permitting it to be depreciated in exchange for the preservation of financial capital and information reusability in financially impaired states. In addition, discretionary contracts foster the development of reputation. This explains discretion among highly confident letters, holding-company relationships, mutual-fund contracts, bank loan commitments, and other financial and nonfinancial contracts.

We explain why an issuer may wish to raise external capital by selling multiple financial claims that partition its total asset cash flows, rather than a single claim. We show that, in an asymmetric information environment, the issuer's expected revenue is enhanced by such cash flow partitioning because it makes informed trade more profitable. This approach seems capable of shedding light on corporate incentives to issue debt and equity, as well as on financial intermediaries' incentives to issue multiple classes of claims against portfolios of securitized assets.