We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.

This paper characterizes the optimal securities for venture capital finance in an environment with multiple investment stages and double-sided moral hazard in the relationship between entrepreneurs and venture capitalists. We show that if the conditions relevant for continuation into later stages are verifiable, the optimal security gives the venture capitalist a constant share in the success return of the project over a predetermined set of continuation states. Otherwise, the parties sign an initial start-up contract that is later renegotiated. In this case, in order to minimize the incentive distortions associated with the burden of early financing stages, the optimal start-up security gives a zero payoff in low profitability states and thereafter an increasing share in the success return of the project.

We claim that the stock market encourages business creation, innovation, and growth by allowing the recycling of “informed capital”. Due to incentive and information problems, start-ups face larger costs of going public than mature firms. Sustaining a tight relationship with a monitor (bank, venture capitalist) allows them to finance their operations without going public until profitability prospects are clearer or incentive problems are less severe. However, the earlier young firms go public, the quicker monitors' informed capital is redirected towards new start-ups. Hence, when informed capital is in limited supply, factors that lower the costs for start-ups to go public encourage business creation. Technological spill-overs associated with business creation and thick market externalities in the young firms segment of the stock market provide prima facie cases for encouraging young firms to go public.