A bilateral moral-hazard problem provides a rationale for "up-or-out" employment contracts. The employer sets a wage higher than opportunity cost to induce the worker to invest in firm-specific capital. If the individual does not make the grade, it is in the firm's interest ex post to fire him. Had the initial arrangement not included provisions for firing individuals, the firm would underreport the value of the employee, wrecking the incentive scheme. The basic model permits both firm and worker to be risk neutral. Therefore, it admits a straightforward multiperiod extension, which we also investigate.

This paper surveys the growing literature on payments. We begin by presenting a simple model that illustrates the essential function of payments and how this may be implemented through various arrangements. We show how the basic models of payments have been used to address a variety of microeconomic and macroeconomic policy issues. We then discuss the links between payments economics and other fields, including monetary theory, corporate finance, and industrial organization. We conclude with an overview of the empirical literature and directions for future research.

Increased awareness of the importance of non-bank financial infrastructures has brought increased concern about the potential for bailouts and the resultant moral hazard problem. This paper examines the question with regard to derivatives central counterparties. We consider the layers of protection that derivatives central clearing parties (CCPs) have established in the absence of an expectation of regulatory rescue. We then provide a model of the tension between the desire for ex post rescue of a systemically important financial infrastructure and the desire to maintain ex ante discipline on the infrastructure. The model illustrates the factors that should lead to relaxation or tightening of the financial regulator's discretion for rescue. We consider examples of failures of derivatives CCPs in order to highlight the importance of these considerations.

Financial regulators considering the desirability of a new rule or regulation sometimes use pilot studies for evidence-based decision making. Although pilot studies can generate new knowledge, they also can be expensive and subject to serious selection biases, spillover problems, and the infeasibility of a blind design. Alternatively, regulators can often evaluate a proposed regulation’s impact by analyzing archival data or applying theory based on well-accepted economic principles. We discuss why pilot studies can be useful, but also why regulators and industry participants sometimes favor pilot studies with little scientific value. We illustrate these issues by discussing various SEC pilot studies.

In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The "put option" value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.

[In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The "put option" value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.]

This paper presents a strategic theory of contract renegotiation. In this theory, suboptimal contracts are put in place initially to protect one party against undesirable actions by another party and are renegotiated once the danger is past. We develop a model to establish the cases in which simple contracts cannot achieve desirable outcomes, so that only a complicated contract or renegotiation will serve. Unlike most previous accounts of contract renegotiation, this theory does not rely on exogenous uncertainty to motive renegotiation.