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Abstract:
While stock options are commonly used in managerial compensation to provide desirable incentives, their adverse effects have not
been widely appreciated. We show that a call-type contract
creates incentives to distort the choice of investment risk.
Relative to the risk level that maximizes firm value, a call
option contract can induce too much or too little corporate
risk-taking, depending on managerial risk aversion and the
underlying investment technology. We show that including additional compensation features of option repricing and/or severance packages has desirable countervailing effects on managerial choice of corporate risk policies. We argue that lookback call options are analogous to the observed practice of option repricing, and put options are analogous to severance packages. Such complex option-like features in managerial contracts can induce risk policies that increase shareholder wealth.

Managerial compensation, option repricing and severance packages, managerial incentives

Abstract:
We model the vulnerability of an economy to a financial crisis as arising from the interaction of the degree of economic specialization and the intermediated financing of the investment opportunities. The probability of a financial crisis is shown to increase in the degree of economic specialization. Bank debt financing (the most common source of intermediated financing in emerging economies) has the beneficial effect of lowering the degree of economic specialization by increasing access to financing of investment opportunities that would not have been financed due to wealth constraints of entrepreneurs (financial access effect). However, bank debt financing induces risk-shifting incentives (leverage effect). The net effect on the probability of a financial crisis depends on which of these two effects dominates. We show that commonly employed mechanisms in managing financial crises, particularly bailouts, induce an additional agency cost on the part of banks. Since the bailout is focused only on the financial crisis state, it distorts bank incentives to concentrate its loans in specific sectors (bank debt concentration effect). We propose a solution mechanism that consists of two tax structures: (1) a corporate tax that changes the ex ante incentives of the residual claimants in the right direction by concavifying the pay-off structure of the after-tax cash flows, and (2) a tax on bank cash flows that eliminates the bank debt concentration effect. Our proposed solution mechanism is targeted towards prevention rather than an ex post resolution of a financial crisis. The foundation for our main results linking financial crisis with the degree of economic specialization is supported by the available data (presented in the form of a couple of empirical tests) - a full-fledged empirical analysis of the predictions of this theory paper is left for future research. Implementation issues and empirical/policy implications are also discussed.

Access, Bailouts, Banks, Conflicts of interest, Financial crisis, Incentives, Leverage, Taxes

Abstract:
This paper provides empirical evidence on the impact of deposit insurance on financial development and stability, broadly defined to include the level of banking activity and the stability of the banking sector. We use a unique dataset capturing a variety of deposit insurance features across countries, such as coverage, premium structure, etc. and synthesize available information by means of principal component indices. This paper is the first in this field of the literature to specifically address sample selection concerns by estimating a generalized Tobit model both via maximum likelihood and the Heckman 2-step method. The empirical construct is guided by recent theories of banking regulation that employ an agency framework. The basic moral hazard problem is the incentive for depository institutions to engage in excessively high-risk activities, relative to socially optimal outcomes, in order to increase the option value of their deposit insurance guarantee. The overall empirical evidence is consistent with the likelihood that generous government-funded deposit insurance might have a negative impact on financial development and growth in the long run, except in countries where the rule of law is well established and bank supervisors are granted sufficient discretion and independence from legal reprisals. Insurance premium requirements on member banks, even when risk-adjusted, are instead found to have little effect in restraining banks' risk-taking behavior.

Deposit Insurance, Moral Hazard and Bank Supervision, financial development, bank regulation

Abstract:
Do deposit insurance programs contribute to financial development? Yes, but only if the regulatory environment is sound.

Cull, Senbet, and Sorge examine the effect of different design features of deposit insurance on long-run financial development, defined to include the level of financial activity, the stability of the banking sector, and the quality of resource allocation. Their empirical analysis is guided by recent theories of banking regulation that employ an agency framework.

The authors examine the effect of deposit insurance on the size and volatility of the financial sector in a sample of 58 countries. They find that generous deposit insurance leads to financial instability in lax regulatory environments. But in sound regulatory environments, deposit insurance does have the desired impact on financial development and growth.

Thus countries introducing a deposit insurance scheme need to ensure that it is accompanied by a sound regulatory framework. Otherwise, the scheme will likely lead to instability and deter financial development. In weak regulatory environments, policymakers should at least limit deposit insurance coverage.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to design financial safety nets for developing countries. The study was funded by the Bank's Research Support Budget under the research project "Deposit Insurance" (RPO 682-90). Robert Cull may be contacted at rcull@worldbank.org.

Abstract:
This paper investigates the relationship between capital structure and stock liquidity surrounding pure leverage recapitalizations. A substitution of debt for equity in the firm's capital structure concentrates private information in the remaining equity, increasing the informational asymmetry of the firm's equity, leading to increases in the firm's equity liquidity costs. Changes in the firm's leverage are associated with both changes in the probability of informed trading in the firm's stock and with changes in the firm's underlying equity liquidity even after controlling for changes in the commonly used liquidity, equity volatility, or capital structure choice control variables. In aggregate, leverage increasing firms experience an increase of 1% in the bid-ask spread and leverage decreasing firms experience a decrease of 2% in the bid-ask spread. We argue that leverage's effect on equity liquidity costs represents an economically relevant cost to debt usage, and this cost potentially reduces firm value relative to a zero transaction costs environment.

Liquidity Costs, Capital Structure

Abstract:
This paper provides empirical evidence on the impact of deposit insurance on the growth of bank intermediation in the long run. We use a unique dataset capturing a variety of deposit insurance features across countries, such as coverage, premium structure, etc. and synthesize available information by means of principal component indices. This paper specifically addresses sample selection and endogeneity concerns by estimating a generalized Tobit model both via maximum likelihood and the Heckman 2-step method. The empirical construct is guided by recent theories of banking regulation that employ an agency framework. The basic moral hazard problem is the incentive for depository institutions to engage in excessively high-risk activities, relative to socially optimal outcomes, in order to increase the option value of their deposit insurance guarantee. The overall empirical evidence is consistent with the likelihood that generous government-funded deposit insurance might have a negative impact on the long-run growth and stability of bank intermediation, except in countries where the rule of law is well established and bank supervisors are granted sufficient discretion and independence from legal reprisals. Insurance premium requirements on member banks, even when risk-adjusted, are instead found to have little effect in restraining banks' risk-taking behavior.

Deposit Insurance, Moral Hazard, Bank Regulation and Supervision, Financial development

Abstract:
In a setting where corporate investment imposes positive externalties, the social impact of corporations depends on the sharing rule between the owners of the corporation and non-financial claimants. We examine the role of law and organizational form in altering the sharing rule. Since the legal regime affects the extent to which corporate owners are held responsible for the negative externalties they impose, unlimited liability may discourage investment in strong legal regimes. Limited liability, however, might be accompanied by excessive investment. We highlight the role of the government in altering the sharing rule due its claim through corporate taxation and investigate the relation between law and corporate taxation. We find that corporate tax rates are are a decreasing function of legal strength. Finally, we document supporting evidence using cross-country data.

Corporate Taxation, Corporate Liability, Organizational Design, Law

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation, particularly the role of prompt corrective action, capital requirements and mandatory restrictions on asset choice as primary tools to control risk-shifting incentives of depository institutions. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features top-management compensation as well as the level of bank capitalization. With this pricing scheme (for FDIC insurance) we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank s management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation, particularly the role of prompt corrective action, capital requirements and mandatory restrictions on asset choice as primary tools to control risk-shifting incentives of depository institutions. We show that capital regulation has limited effectiveness, given the observed high leverage ratios of banks. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features of top-management compensation as well as the level of bank capitalization. With this pricing scheme (for FDIC insurance) we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank s management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
This paper examines the incentive structure underlying the current features of bank regulation. We show that capital regulation has limited effectiveness, given the observed high leverage ratios of banks. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features of top-management compensation. With this pricing scheme (for FDIC insurance), we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank's management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.

Abstract:
We show that concentrating bank regulation on bank capital
ratios may be ineffective in controlling risk-taking. We
propose, instead, a more direct mechanism of influencing
bank risk-taking incentives, in which the FDIC insurance
premium scheme incorporates incentive features of
top-management compensation. With this scheme, we show
that bank owners choose an optimal management compensation
structure that induces first-best value-maximizing investment
choices by a bank's management. We explicitly characterize
the parameters of the optimal management compensation
structure and the fairly priced FDIC insurance premium, in
the presence of a single or multiple sources of agency
problems.

Bank regulation, Capital regulation, FDIC insurance, Management compensation, Agency problems

Abstract:
This paper surveys the empirical and theoretical literature on the mechanisms of corporate governance. We focus on the internat mechanisms of corporate governance (e.g., arising from conflicts of interests between managers and equityholders, equityholders and creditors, and capital contributors and other stakeholders to the corporate firm. We also examine the substitution effect between internal mechanisms of corporate governance and external mechanisms, particularly markets for corporate control. Directors for future research are provided.

Abstract:
This paper examines the effect of global diversification on firm value using a dataset of U.S. firms from 1994-2002. We document that global diversification enhances firm value. Specifically, we find Tobin's q and excess value, our proxies for firm value, increase with foreign sales, measured as a fraction of a firm's total sales even after we control for well-known determinants of firm value.

In contrast, we find no such evidence for industrial diversification. Furthermore, we find that the valuation benefit from global diversification is higher if a firm diversifies into countries with stronger creditor rights or higher GDP per capita. Our results are also robust to controlling for a firm's endogenous choice to diversify across countries or across industries. Overall, our results suggest that global diversification is inherently quite different from industrial diversification.

Abstract:
No abstract is available for this paper.

Abstract:
This paper provides an analysis of the design and pricing of closed-end country funds (CECFs) under segmented capital markets, where an investment company acquires a set of eligible securities from the home country to form a CECF and issues shares to the residents of the host country. The key findings are: First, a country fund will trade at its net asset value (zero premium), effectively as an open-end, if the fund acquires as much of eligible securities as the differential 'substitution' demand for them between the host and home country investors. Under the open-ending design rule, the implied premium will also be zero for all eligible securities. Second, the fund will command a higher premium, the more (less) close a substitute the fund is for the market portfolio of the home (host) country, and the more (less) risk-averse the home (host) country investors are collectively. Third, the optimal design rule for a profit- maximizing intermediary, which creates and markets the fund, calls for investing heavily in those eligible securities that covary most with the market portfolio of the home country and least with that of the host country. In our framework, the (monopolistic) intermediary can actually maximize its profit by acquiring just half as much of eligible securities as are necessary to effectively open-end the fund, due to the quadratic nature of the fund premium function.

Abstract:
Corporate limited liability can create agency conflicts between the public and private sectors. The resulting distortion may induce overinvestment in risky technologies relative to the social optimum. This paper examines the role of a well-designed corporate tax structure in aligning private investment choices with socially optimal levels. An appropriate constant tax rate imposed on the positive cash flows provides sufficient investment disincentives to offset the overinvestment incentives of limited liability. However, the optimal tax rate is specific to the technology of individual firms. It is shown that a tax structure designed with an economy-side single tax rate when combined with other features such as an initial zero tax bracket, investment-based deductions, tax credits and tax deductibility of debt can replicate the same incentives as that of an economy with multiple technology-specific tax rates. Institutional features observed in many advanced economies are consistent with such a design of taxation.

Abstract:
This paper provides an optimal design of managerial compensation in the presence of an exogenous capital structure with its associated debt agency costs. The model entails the analysis of a three-party conflict between debtholders, equity holders, and management. Equityholders, as principals owning a production technology, design a compensation contract for managers. Management is engaged solely in the choice of project risk with risky return outcomes along a production frontier. It is shown that, in the absence of debt, risk averse managers would tend to risk-shift downwards, realizing suboptimal firm value. In the presence of a senior debt claim equity holders find it advantageous to choose higher risk projects and it is possible that for sufficiently high debt levels, the agency costs of debt and managerial risk aversion counterbalance each other, with the final outcome coinciding with first best risk choices. The empirical relationship between capital structure and compensation is also studied, as are the implications of debt and risk aversion for the pay- performance relations.