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Abstract:
This paper surveys the literature on payout policy. We start with a description of the Miller-Modigliani payout irrelevance proposition, and then consider the effect of relaxing the assumptions on which it is based. We consider the role of taxes, asymmetric information, incomplete contracting possibilities, and transaction costs. The accumulated evidence indicates that changes in payout policies are not motivated by firms' desire to signal their true worth to the market. Both dividends and repurchases seem to be paid to reduce potential overinvestment by management. We also review the issue of the form of payout and the increased tendency to use open market share repurchases. Evidence suggests that the rise in the popularity of repurchases increased overall payout and increased firms' financial flexibility.

Payout policy, dividends, repurchases

Abstract:
China is an important counterexample to the findings in the law, institutions, finance, and growth literature: Neither its legal nor financial system is well developed, yet it has one of the fastest growing economies. While the law-finance-growth nexus applies to the State Sector and the Listed Sector, with arguably poorer applicable legal and financial mechanisms, the Private Sector grows much faster than the others and provides most of the economy's growth. The imbalance among the three sectors suggests that alternative financing channels and governance mechanisms, such as those based on reputation and relationships, support the growth of the Private Sector.

China, law and finance, economic growth, private sector, corporate governance, reputation and relationships

Abstract:
China is an important counterexample to the findings in the law, institutions, finance, and growth literature: neither its legal nor financial system is well developed by existing standards, yet it has one of the fastest growing economies. We examine 3 sectors of the economy: the State Sector (state-owned firms), the Listed Sector (publicly listed firms), and the Private Sector (all other firms with various types of private and local government ownership). The law-finance-growth nexus established by existing literature applies to the State and Listed Sectors: with poor legal protections of minority and outside investors, external markets are weak, and the growth of these firms is slow or negative. However, with arguably poorer applicable legal and financial mechanisms, the Private Sector grows much faster than the State and Listed Sectors, and provides most of the economy's growth. This suggests that there exist effective alternative financing channels and governance mechanisms, such as those based on reputation and relationships, to support this growth.

Law and finance, economic growth, private sector, corporate governance, reputation and relationships

Abstract:
We compare China's financial system to those of the developed countries, in particular, the US system dominated by financial markets, and the German system dominated by the banking sector. We examine financial systems' properties, including risk sharing, information provision, funding new and mature industries, financial crisis, corporate governance, and the relation between the financial and legal systems and economic growth. We find that there are many fundamental differences between China's financial system and the US system, and simply adopting the US system is not optimal. Understanding the German system and reform China's banking system should be as important as developing US-style financial markets. Our findings also suggest that China differs from most countries studied in the law, finance, and growth and comparative financial systems literature: Despite its poor legal and financial systems, it has the largest, and one of the fastest growing economies in the world. We find that there are effective, informal financing channels and governance mechanisms to support the growth of various firms in the economy. Therefore, it may be best for China to develop its existing financial system, and to ensure that the informal financing channels and governance mechanisms continue to work along with the development of the legal and financial systems.

financial system, banking system, financial markets, economic growth, informal sector

Abstract:
We examine the role of China's financial system in supporting economic growth, and explore directions of future development. First, the current financial system is dominated by a large but inefficient banking sector. Reducing the amount of non-performing loans among the major banks to normal levels is the most critical task for reforming the financial system in the short run. Second, the role of the stock market in allocating resources in the economy has been limited and ineffective. Further development of China's financial markets is the most important task in the long-term. Third, the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, and institutions. This sector should co-exist with banks and markets in the future in order to continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a "twin crisis" in the currency market and banking sector.

banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis

Abstract:
In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information.

Beauty Contests, Bubbles, Noisy Rational Expectations Equilibrium, Martingales, Public Information, Asset Prices

Abstract:
In countries such as Germany, the legal system ensures that firms are stakeholder oriented. In others, like Japan, social norms achieve a similar effect. We analyze the advantages and disadvantages of stakeholder-oriented firms that are concerned with employees and suppliers compared to shareholder-oriented firms in a model of imperfect competition. Stakeholder firms are more (less) valuable than shareholder firms when marginal cost uncertainty is greater (less) than demand uncertainty. With globalization shareholder firms and stakeholder firms often compete. We identify the circumstances where stakeholder firms are more valuable than shareholder firms, and compare these mixed equilibria with the pure equilibria with stakeholder and shareholder firms only. The results have interesting implications for the political economy of foreign entry.

Firm objective, co-determination, imperfect competition

Abstract:
Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.

Abstract:
The authors examine the legal and business environments, financing channels, and governance mechanisms of various types of firms in India and compare them to those from other countries. Despite its English commonlaw origin, strong legal protection provided by the law, and a democratic government, corruption within India's legal system and government significantly weakens investor protection in practice. External financing of firms has been dominated by nonmarket sources of financing, while the characteristics of listed firms are similar to those from countries with weak investor protection. The evidence, including results based on a survey of small and medium-scale private firms, shows that alternative financing channels provide the most important source of funds. The authors also find that informal governance mechanisms, such as those based on reputation, trust, and relationships are more important than formal mechanisms (such as courts) in resolving disputes, overcoming corruption, and supporting growth.

Banks & Banking Reform, Corporate Law, Financial Intermediation, Governance Indicators, Small Scale Enterprise

Abstract:
With extensive cross-country datasets and India firm samples, as well as our own surveys of small and medium firms, we examine the legal and business environments, financing channels, and growth patterns of different types of firms in India. Despite the English common-law origin and a British-style judicial system, Indian firms face weak investor protection in practice and poor institutions characterized by corruption and inefficiency. Alternative finance, including financing from all non-bank, non-market sources, and generally backed by non-legal mechanisms, constitutes the most important form of external finance. Bank loans provide the second most important external financing source. Firms with access to bank or market finance are not associated with higher growth rates. Our results indicate that bank and market finance is not superior to alternative finance in fast-growing economies such as India.

India, banks, markets, alternative finance, growth

Abstract:
The purpose of this paper is to use insights from the academic literature on crises to understand the role of liquidity in the current crisis. We focus on four of the crucial features of the crisis that we argue are related to liquidity provision. The first is the fall of the prices of AAA-rated tranches of securitized products below fundamental values. The second is the effect of the crisis on the interbank markets for term funding and on collateralized money markets. The third is fear of contagion should a major institution fail. Finally, we consider the effects on the real economy.

Abstract:
Historically, much of the banking regulation that was put in place was designed to reduce systemic risk. In many countries capital regulation in the form of the Basel agreements is currently one of the most important measures to reduce systemic risk. In recent years there has been considerable growth in the transfer of credit risk across and between sectors of the financial system. In particular there is evidence that risk has been transfered from the banking sector to the insurance sector. One argument is that this is desirable and simply reflects diversification opportunities. Another is that it represents regulatory arbitrage and the concentration of risk that may result from this could increase systemic risk. This paper shows that both scenarios are possible depending on whether markets and contracts are complete or incomplete.

Abstract:
This essay was prepared for the volume on Financial Crises that we edited in THE INTERNATIONAL LIBRARY OF CRITICAL WRITINGS IN ECONOMICS - Series Editor: Mark Blaug published by Edward Elgar.

Abstract:
Using a novel hand-collected data set we investigate price and trading behavior aroundseveral well-known stock market and commodity corners which occurred between 1863 and 1980. We find strong evidence that large investors and corporate insiders possess market power that allowed them to manipulate prices. Manipulation leading to a market corner tends to increase market volatility and has an adverse price impact on other assets. We also find that the presence of large investors makes it extremely risky for would-be short sellers to trade against the mispricing. Therefore, regulators and exchanges need to be concerned about ensuring that corners do not take place since they are accompanied bysevere price distortions.

Abstract:
Using a novel hand-collected data set we investigate price and trading behavior around several well-known stock market and commodity corners which occurred between 1863 and 1980. We find strong evidence that large investors and corporate insiders possess market power that allowed them to manipulate prices. Manipulation leading to a market corner tends to increase market volatility and has an adverse price impact on other assets.

We also find that the presence of large investors makes it extremely risky for would-be short sellers to trade against the mispricing. Therefore, regulators and exchanges need to be concerned about ensuring that corners do not take place since they are accompanied by severe price distortions.

limits to arbitrage, manipulation, market corner

Abstract:
Differences in countries financial structure are prevailing despite the global converegence of the economies. In countries such as Germany or Spain the financial system is dominated by banks, whereares in the U.S. or the U.K. financial system capital markets is predominated. In our paper we investigate the relation between the structure of the real economy and country's financial system. We consider whether the development of the real economic structure determine the evolution of the financial system structure. Using both pooled FGLS regression and panel EC2SLS techniques we find that economies dominated by physical-asset-intensive firms tend to have a bank-based financial system. Conversely, countries with knowledge based industries and intangible-asset-intensive firms tend to have a market-based financial system. Our results suggests that financial structures develop and prevail in response to the financial needs of firms, hence to the characteristics of the real economy.

Financial system, Real economic structures

Abstract:
When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks' assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting.

Mark-to-market, historical cost, incomplete markets

Abstract:
With recent growth rates among large countries second only to China's, India has experienced nothing short of an economic transformation since the liberalization process began in the early 1990's. In the last few years, with a soaring stock market, significant foreign portfolio inflows including the largest private equity inflows in Asia, and a rapidly developing derivatives market, the Indian financial system has been witnessing an exciting era of transformation. The banking sector has seen major changes with deregulation of interest rates and the emergence of strong domestic private players as well as foreign banks. At the same time, there is some evidence of credit constraints for India's SME firms that rely heavily on trade credit. Corporate governance norms in India have strengthened rapidly in the past few years. Family businesses, however, still dominate the landscape and investor protection, while excellent on paper, appears to be less effective owing to an overburdened legal system and corruption. In the last few years microfinance has contributed in a big way to financial inclusion and is now attracting venture capital and for-profit companies - both domestic and foreign.

India, capital markets, microfinance, corporate finance

Abstract:
Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.

Financial innovation, Pareto inferior, banking, insurance

Abstract:
We provide a comprehensive review of China's financial system, and explore directions of future development. First, the current financial system is dominated by a large banking sector. In recent years banks have made considerable progress in reducing the amount of non-performing loans and improving their efficiency. It is important that these efforts are continued. Second, the role of the stock market in allocating resources in the economy has been limited and ineffective. Further development of China's stock market and other financial markets is the most important task in the long-term. Third, the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, and institutions. This sector should coexist with banks and markets in the future in order to continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a twin crisis in the currency market and banking sector.

banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis

Abstract:
Financial crises have been pervasive phenomena throughout history. Bordo et al. (2001) find that their frequency in recent decades has been double that of the Bretton Woods Period (1945-1971) and the Gold Standard Era (1880-1993), comparable only to the Great Depression. Nevertheless, the financial crisis that started in the summer of 2007 came as a great surprise to most people. What initially was seen as difficulties in the US subprime mortgage market, rapidly escalated and spilled over to financial markets all over the world. The crisis has changed the financial landscape worldwide and its costs are yet to be evaluated.

Abstract:
We present an overview of the financial structure of the enlarged European Union with 25 countries. We start by describing the financial system development in all member states since 1995, and then compare the structure between the old and new countries. Using financial measures we document the prevailing substantial differences in the financial structure between new and old member states after the enlargement in 2004. Finally, we compare the financial structures of an enlarged EU with those of the United States and Japan.

Abstract:
It is commonly believed that equity finance for banks is more costly than deposits. This suggests that banks should economize on the use of equity and regulatory constraints on capital should be binding. Empirical evidence suggests that in fact this is not the case. Banks in many countries hold capital well in excess of regulatory minimums and do not change their holdings in response to regulatory changes. We present a simple model of bank moral hazard that is consistent with this observation. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to guarantee monitoring because it allows higher borrower surplus.

Abstract:
This paper identifies two types of market failures. The first concerns a coordination problem associated with panics. The problem in analysing this type of market failure from a policy perspective is that there is no widely accepted method for selecting equilibria. The second market failure concerns the incompleteness of financial markets. The essential problem here is that the incentives to provide liquidity lead to an inefficient allocation of resources. The paper outlines three manifestations of market failure associated with liquidity provision: financial fragility, contagion and asset price bubbles. The framework developed allows some insight into the question of when the financial system acts a shock absorber and when it acts as an amplifier. Having identified when there is a market failure, the paper looks at whether there are policies that can correct the undesirable effects of such failures.

(This paper includes comments by Yung Chul Park.)

Bank regulation, financial crisis, financial intermediation, market failure

Abstract:
The banking sector is one of the most highly regulated sectors in the economy. However,in contrast to other regulated sectors there is no wide agreement on the market failuresthat justify regulation. We suggest that there are two important ones. The first is a coordination problem that arises because of multiple equilibria. If people believe there is going to be a panic then that can be self-fulfilling. If they believe there will be no panic then that can also be self-fulfilling. Policy analysis is difficult in this case because our knowledge of equilibrium selection mechanisms is limited. Global games represent one promising modeling technique but as yet there is limited empirical evidence in support of this approach. The second market failure is that if there are incomplete markets the provision of liquidity is inefficient. In particular there must be significant price volatility in order for the providers of liquidity to earn the opportunity cost of holding liquidity.

We argue that financial fragility, contagion, and asset price bubbles are manifestations of inefficient liquidity provision.

Abstract:
In this paper we examine and compare the formal systems of law and finance in China and India and the alternative institutional arrangements and governing mechanisms in the two countries, and the relation between the development of these systems and their economic growth. China differs from most of the countries studied in the law, institutions, finance, and growth literature: Its legal and financial systems as well as institutions are all underdeveloped, but its economy has been growing at a very fast rate. More importantly, the growth in the Private Sector, where applicable legal and financial mechanisms are arguably poorer than those in the State and Listed sectors, is much faster than that of the other sectors. The system of alternative mechanisms and institutions plays an important role in supporting the growth in the Private Sector, and they are good substitutes for standard corporate governance mechanisms and financing channels. Despite its English commonl aw origin and British-style judicial system and democratic government, there is enough documented evidence to suggest that the effective level of investor protection and the quality of legal institutions in India are quite weak as well. Once again, this has evidently not prohibited growth. We find that to a large extent Indian firms conduct business outside the formal legal system and do not rely on formal financing channels from markets and banks for most of their financing needs. Instead, firms across the board, and in particular, small and medium firms, use non-legal methods based on reputation, trust and relationships to settle disputes and enforce contracts, and rely on alternative financing channels such as trade credits to finance their growth. The scope, methodologies, and results of our paper paint a more complete picture of the law-finance-growth nexus and how businesses and investors respond to the limitations of legal system and formal financial system than existing studies.

India, law and finance, institutions, growth, banks, markets, SME sector

Abstract:
The extraordinary economic performance of China and India in recent decades raises questions about the conventional wisdom of using the legal system as the basis of commerce. Despite many well-known advantages, the legal system can be captured by interest groups and become a barrier to change. We argue that one way to solve this problem is not to use the law as the basis for commerce but instead to use alternative mechanisms outside the legal system. Our prior work on China and India suggests that these alternative mechanisms can be quite effective. In the context of a fast-growing economy such as China or India, there is an additional advantage that this type of system can adapt and change much more quickly than when the law is used. In particular, competition can ensure the most efficient mechanism prevails and this process does not require persuading the legislature and the electorate to revise the law when circumstances change.

Dispute resolution, institutions, law, legislature, competition

Abstract:
We define a financial system to be fragile if small shocks have disproportionately large effects. In a model of financial intermediation, we show that small shocks to the demand for liquidity cause either high asset-price volatility or bank defaults or both. Furthermore, as the liquidity shocks become vanishingly small, the asset-price volatility is bounded away from zero. In the limit economy, with no shocks, there are many equilibria; however, the only equilibria that are robust to the introduction of small liquidity shocks are those with non-trivial sunspot activity.

financial crisis, financial fragility, liquidity, sunspots

Abstract:
The extraordinary performance of China and India's economies raises questions about the traditional measures of the size and depth of financial systems. While banks and markets have played a limited role in providing funds for corporate sectors and supporting economic growth in these two countries, non-state, non-listed firms, relying mostly on internal and alternative financing channels, have been growing faster than the state and listed sectors and contributing much of the growth. The alternative financing channels, excluded in the traditional measures of financial systems, operate outside legal institutions and are backed by alternative mechanisms such as reputation, relationships, and trust. We define the capacity of a financial system to be the total funding available for all corporate sectors in an economy. Our findings from China and India demonstrate that alternative finance can significantly expand the financial system capacity and promote growth at the firm level and economy wide.

China, India, financial system capacity, banks, markets, alternative finance

Abstract:
In recent years, there has been a large literature on how stock exchange specialists set prices when there are investors who know more about the stock than they do. An important assumption in this literature is that there are "liquidity traders" who are equally likely to buy or sell for exogenous reasons. It is plausible that some buyers have cash needs and are forced to sell their stock. However, buyers will usually be able to choose the time at which they trade. It will be optimal for them to minimize the probability of trading with informed investors by choosing an appropriate time to trade and clustering at that time. This asymmetry means that when liquidity buyers are not clustering, purchases are more likely to be by an informed trader than sales so the price movement resulting from a purchase is larger than for a sale. As a result, profitable manipulation by uninformed investors may occur. A model where the specialist takes account of the possibility of manipulation in equilibrium is presented.

Abstract:
A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system a system with complete markets for aggregate risk and limited market participation is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.

Abstract:
Competition policy in the banking sector is complicated by the necessity of maintaining financial stability. Greater competition may be good for (static) efficiency, but bad for financial stability. From the point of view of welfare economics, the relevant question is: What are the efficient levels of competition and financial stability? We use a variety of models to address this question and find that different models provide different answers. The relationship between competition and stability is complex: sometimes competition increases stability. In addition, in a second-best world, concentration may be socially preferable to perfect competition and perfect stability may be socially undesirable.

Abstract:
Competition policy in the banking sector is complicated by the necessity of maintaining financial stability. Greater competition may be good for (static) efficiency, but bad for financial stability. From the point of view of welfare economics, the relevant question is: What are the efficient levels of competition and financial stability? We use a variety of models to address this question and find that different models provide different answers. The relationship between competition and stability is complex: sometimes competition increases stability. In addition, in a second-best world, concentration may be socially preferable to perfect competition and perfect stability may be socially undesirable.

Abstract:
This paper investigates the effect of European Monetary Union on the integration of the financial services industry within European using data on the announcements of M&A's within the industry. We find some evidence that EMU has helped financial integration within the euro area. In addition, financial institutions in EMU countries became more active in initiating integration between EMU and nonEMU partners, which also contributed to overall regional integration within European. The more active role of EMU institutions suggests that institutions residing in the eurozone became stronger players in the corporate control market. However, EMU does not facilitate the entry of non-European institutions into European.

Abstract:
There has been a long-running debate about whether stock market prices are determined by fundamentals. To date no consensus has been reached. An important issue in this debate concerns the circumstances in which deviations from fundamentals are consistent with rational behavior. A continuous-time example where there are a finite number of rational traders with finite wealth is presented. It is shown that a finitely-lived security can trade above its fundamental.

Abstract:
Most of the literature on corporate governance emphasizes that firms should be run in the interests of shareholders. This is an appropriate objective function when markets are perfect and complete. In many emerging economies this is not the case: markets are imperfect and incomplete. The first theme of the paper is that alternative firm objective functions, such as pursuing the interests of all stakeholders, may help overcome market failures. The second theme is that it is not necessarily optimal to use the law to ensure good corporate governance. Other mechanisms such as competition, trust, and reputation may be preferable.

Abstract:
In a financial market where traders are risk averse and short lived and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not, in general, equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher-order beliefs in a fully rational asset pricing model.

Abstract:
In these extracts from the world's bestselling graduate textbook, the authors offer a number of suggestions for practitioners, including:

- When valuing a company or an investment project, managers should start whenever possible with the asset's market price as the best initial estimate and then make adjustments that reflect their own private information. One obvious example of this process is when companies are evaluating possible acquisitions.

- When valuing a company or an asset, dont worry about risks that you can hedge separately. For example, foreign exchange risk can be hedged using forwards or futures, and there is no need to form an opinion on the future path of exchange rates.

- A positive NPV for a project is credible only if the company has some special advantage that competitors cannot match. That requires an understanding of the sources of the competitive advantage and how long they are likely to last.

- Although market inefficiencies may offer economic rents from convergence trades, as a general rule nonfinancial corporations gain nothing, on average, by speculating in financial markets.

- Since corporate managers know more about their company than outside investors, investors are likely to infer from corporate decisions to issue equity that the firm is overvalued (otherwise, why not issue debt instead?). And issuing overpriced stock to invest in projects that offer below-normal rates of return is a sure way to destroy value.

- To make the most of their growth opportunities and create value for outside investors, most public companies require a co-investment of insiders' human capital with outsiders' financial capital. Such co-investment in turn implies a larger return to managers' and employees' human capital than that suggested by either the conventional prescription of shareholder value maximization (or even the financial economist's model of firm value maximization).

Abstract:
These contributions are seen as falling into three main categories: In a 40-plus year career notable for path-breaking work on capital structure and innovations in capital budgeting and valuation, MIT finance professor Stewart Myers has had a remarkable influence on both the theory and practice of corporate finance. In this article, two of his former students, a colleague, and a co-author offer a brief survey of Professor Myers's accomplishments, along with an assessment of their relevance for the current financial environment.

Abstract:
Real options are valuable sources of flexibility that are either inherent in, or can be built into, corporate assets. The value of such options are generally not captured by the standard discounted cash flow (DCF) approach, but can be estimated using a variant of financial option pricing techniques.

This article provides an overview of the basics of real option valuation by examining four important kinds of real options:

1. The option to make follow-on investments. Companies often cite strategic value when taking on negative-NPV projects. A close look at the payoffs from such projects reveals call options on follow-on projects in addition to the immediate cash flows from the projects. Todays investments can generate tomorrow's opportunities.

2. The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But often it's better to defer a positive-NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flowswhich are lost or postponed by waitingare small.

3. The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use.

4. The option to vary the firm's output or its production methods. Companies often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another.

The authors also make the point that, in most applications, real-option valuation methods are a complement to, not a substitute for, the DCF method. Indeed DCF, which is best suited to and usually sufficient for safe investments and "cash cow" assets, is typically the starting point for real-option analyses. In such cases, DCF is used to generate the values of the "underlying assets" - that is, the projects when viewed without their options or sources of flexibility.

Abstract:
Researchers have presented evidence that, at certain times in particular industries, initial public offerings (IPOs) of firms' stocks are underpriced. Several models have been developed that offer explanations of these "hot issue" markets; e.g. Baron's model (1982), in which investment bankers have superior information about the firm's prospects, or Rock's model (1986), in which investors are best informed. In the present model, the new firm itself possesses the best information about its own prospects. Good firms use a low IPO price thus signaling to investors that they expect to recoup this loss in their later performance, while bad firms cannot afford such signaling, since they do not expect to perform well. Unlike other studies, this analysis assumes that investors do not have a full prior knowledge of the firm's quality, but rather update their Bayesian priors on the basis of the firm's performance. In the model, firms fall into two types: good firms and bad firms. A firm's type can change through time, depending on its performance. The only basis investors have for their belief about the firm's prospects is the price of its IPO. Over time, they observe either good or bad performance, and thus update their Bayesian prior. The price of a firm will be bid up to the value placed on it by investors, given their revised knowledge of the quality of the firm. The analysis distinguishes between a separating equilibrium, where good firms signal their type to investors with a low IPO, and a pooling equilibrium, where no underpricing occurs, and hence investors cannot tell good and bad firms apart. Pooling is more profitable for good firms if they are likely to remain good, and signaling is more profitable if they are likely to get worse. Empirical evidence confirms that underpricing can signal favorable prospects for the firm, and that it is temporary, industry-specific, and associated with improvements in the profitability of entry. (AT)

Signaling, Initial public offerings (IPO), Underpricing, Investors, Firm performance, Equilibrium

Abstract:
We develop a model where financial institutions form strategic connections through overlapping portfolio exposures weighing the benefits of risk diversification against the costs of due-diligence. We study the effects of different network structures for systemic risk and welfare depending on whether financial institutions issue long or short term debt. Clustered networks where banks hold very similar portfolios are compared with unclustered networks where they hold less correlated portfolios. The network structure plays a role only in the case of short term financing, when investors condition their debt rollover decision on a signal revealing potential future bank defaults. We show that, depending on the size of costs banks incur when they default, the arrival of a negative signal can lead to early liquidation in a clustered network but not in an unclustered one so the latter can be superior. But if such a signal leads to early liquidation in both networks then the clustered network can be superior.

Abstract:
The term corporate governance is used in two distinct ways. In Anglo-Saxon countries like the US and UK good corporate governance involves firms pursuing the interests of shareholders. In other countries like Japan, Germany and France it involves pursuing the interests of all stakeholders including employees and customers as well as shareholders. Anglo-Saxon capitalism has been widely analyzed but stakeholder capitalism has not. This paper argues that stakeholder capitalism can often be superior when markets are not perfect and complete.

Abstract:
Capital adequacy regulation is often justified, directly or indirectly, by an appeal to the need to prevent financial crises. By contrast, we argue that, in the absence of a welfare-relevant pecuniary externality, banks will choose the socially optimal capital structure themselves, without government coercion.

Abstract:
We consider data from 16 Asian countries, 16 European countries and the US to investigate the relationship between venture capital and corporate governance. There are five main findings. First, the variable measuring law and order is negatively related to the importance of venture capital finance. Second, the allocation of investment across different stages and different industries depends more on macroeconomic factors than on corporate governance variables. Third, in Low-GDP countries the allocation of venture capital is greater for low technology industries than for high technology industries. Fourth, venture capital boomed and became significant in many countries during the stock market boom or 'bubble' of the late 1990's. Finally, a comparison of Asian and European venture capital shows that in Asia there was more investment in early stage projects while in Europe there was more investment in late stage projects. Also, in Europe there was more investment in medical and biotechnology industries.

Abstract:
The effect of stock market interlinkages on asset price bubbles are considered. Bubbles can occur when there is an agency problem between banks and the people they lend money to because the banks cannot observe how the funds are invested. This causes a risk shifting problem and asset prices are bid up above their fundamental. The greater is uncertainty about asset returns or about the amount of aggregate credit the greater is the bubble. Stock market interlinkages can moderate or exacerbate asset price bubbles.

Abstract:
E-finance is defined as "The provision of financial services and markets using electronic communication and computation". In this paper we outline research issues related to e-finance that we believe set the stage for further work in this field. Three areas are focused on. These are the use of electronic payments systems, the operations of financial services firms and the operation of financial markets. A number of research issues are raised. For example, is the widespread use of paper-based checks efficient? Will the financial services industry be fundamentally changed by the advent of the Internet? Why have there been such large differences in changes to market microstructure across different financial markets?

E-finance, internet, research

Abstract:
E-finance is defined as "The provision of financial services and markets using electronic communication and computation". In this paper we outline research issues related to e-finance that we believe set the stage for further work in this field. Three areas are focused on. These are the use of electronic payments sys tems, the operations of financial services firms and the operation of financial markets. A number of research issues are raised. For example, is the widespread use of paper-based checks efficient? Will the financial services industry be fundamentally changed by the advent of the internet? Why have there been such large differences in changes to market microstructure across different financial markets?

Abstract:
A complex financial system comprises both financial markets and financial institutions. Financial institutions can take the form of intermediaries or banks. Bank-based financial systems unlike intermediary-based systems, are subject to crises, but crises do not imply market failure. We show that a sophisticated financial system - a system with complete markets for aggregate risk and limited market participation - is incentive-efficient, if the institutions take the form of intermediaries, or else constrained-efficient, if they take the form of banks. We also consider an economy in which the markets for aggregate risks are incomplete. In this context, there is a role for prudential regulation: regulating liquidity can improve welfare.

Abstract:
The U.S. traditionally had a radically different view of competition in the financial sector compared to other countries. Distrust of power in the hands of large financial institutions very early led to restrictions on the ability of banks to expand geographically or to diversify into other activities. Throughout the nineteenth century the U.S. banking system was highly fragmented and unlike every other industrializing country the U.S. failed to develop nationwide banks with extensive branch networks. Prior to the Civil War, states were free to regulate their own banking systems and there was no national system. Many states adopted a "free banking" system that allowed free entry. The advent of the Civil War in 1861 significantly changed the role of the Federal Government in the financial system. The National Bank Acts of 1863 and 1864 set up a national banking system. These granted limited powers to banks. In particular, the 1864 Act was interpreted as confining each to a single location. This ensured there were a large number of banks. It is often argued that this promotes competition.

In other countries, including both those with market-oriented systems and those with bank-oriented systems, the banking sectors became highly concentrated many years ago. For example, in the U.K. banks developed nationwide networks during the latter part of the nineteenth century, so that by the beginning of the twentieth century there were essentially only five major banks. Other industrialized countries also experienced consolidation and the development of nationwide networks around this time. In many cases governments actively encouraged this change.

Abstract:
In standard asset pricing theory, investors are assumed to invest directly in financial markets. The role of financial institutions is ignored. The focus in corporate finance is on agency problems. How do you ensure that managers act in shareholders' interests? There is an inconsistency in assuming that when you give your money to a financial institution there is no agency problem but when you give it to a firm there is. It is argued both areas need to take proper account of the role of financial institutions and markets. Appropriate concepts for analyzing particular situations should be used.

Abstract:
Financial contagion is modeled as an equilibrium phenomenon. Because liquidity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile. A small liquidity preference shock in one region can spread by contagion throughout the economy. The possibility of contagion depends strongly on the completeness of the structure of interregional claims. Complete claims structures are shown to be more robust than incomplete structures.

Abstract:
We present a finite period general equilibrium model of an exchange economy with asymmetric information. We say that a rational expectations equilibrium exhibits an expected bubble if the price of an asset in one period is higher than any agent's marginal valuation of holding the asset to maturity. We say the equilibrium exhibits a strong bubble if the price is higher than the dividend with probability one. We show that a necessary condition for an expected bubble to exist is that each agent must be short sale constrained at some period in the future with positive probability. We show that necessary conditions for a strong bubble to occur are that (1) each agent must have private information in the period and state in which the bubble occurs and (2) agents' trades are not common knowledge. We also present examples of rational expectations equilibria that exhibit strict bubbles when the necessary conditions are satisfied.

Abstract:
This paper contains a survey of the literature on dividend policy. We start with a description of the Miller-Modigliani dividend irrelevance proposition and then consider the effect of relaxing the assumptions it is based on. In particular, we consider the role of taxes, asymmetric information, incomplete contracting possibilities and transaction costs.

Abstract:
The firm can be regarded as consisting of several groups of investors and managers whose interests are regulated by the contracts between them. This survey covers the literature that looks at the nature of optimal financial contracts in the face of various asymmetries of information, control and type. Five areas are considered: (i) costly state verification and agency; (ii) adverse selection; (iii) the allocation of control rights among investors and the design of ownership structure; (iv) the allocation of risk and (v) acquisition of information.

Abstract:
The objective is to compare the effectiveness of financial markets and financial intermediaries in financing new industries and technologies in the presence of diversity of opinion. In markets, investors become informed about the details of the new industry or technology and make their own investment decisions. In intermediaries, the investment decision is delegated to a manager. She is the only one who needs to become informed, which saves on information costs, but investors may anticipate disagreement with her and be unwilling to provide funds. Financial markets tend to be superior when there is significant diversity of opinion and information is inexpensive.

Abstract:
There is a wide variation in the structures of financial systems in different countries. We compare two idealized polar extremes. In one, which we refer to as the "German model," banks and other intermediaries predominate. In the other, which we refer to as the "U.S. model," financial markets play the major role. On the household side, we consider issues such as inter-generational and cross- sectional risk sharing, noise suppression and the provision of services. On the firm side, we consider the allocation of investment, the market for corporate control, the market for internal funds, incentives, monitoring and long term relationships and diversity of opinion.

Abstract:
A genetic algorithm is used to learn technical trading rules for Standard and Poor's composite stock index using data from 1963-69. In the out-of-sample test period 1970-1989 the rules are able to identify periods to be in the indexwhen returns are positive and volatility is low and out when the reverse is true. Compared to a simple buy-and-hold strategy, they lead to positive excess returns after transaction costs in the period of 1970-89. Using data for other periods since 1929, the rules can identify high returns and low volatility but do not lead to excess returns after transaction costs. The results are compared to benchmark models of a random walk, an autoregressive model, and a GARCH-AR model. Bootstrapping simulations indicate that none of these models of stock returns can explain the findings.

Abstract:
This paper offers a novel explanation for why some firms prefer to pay dividends rather than repurchase shares. It is well-known that institutional investors are relatively less taxed than individual investors, and that this induces "dividend clientele" effects. We argue that these clientele effects are the very reason for the presence of dividends, because institutions have a relative advantage in monitoring firms or in detecting firm quality. Firms paying dividends attract relatively more institutions and perform better. The theory is consistent with some documented regularities, such as a reluctance of firms to cut dividends, and offers novel empirical implications, such as a prediction that is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments.

Abstract:
This paper develops a financial pricing model to determine prices by line of business in a multiple line insurer subject to default risk. The model implies that it is not appropriate to allocate equity capital by line; rather, the price in a given line depends upon the overall default risk of the firm. Thus, prices should not vary by line within a given insurer after controlling for line-specific liability growth rates. This result is modified somewhat for groups of insurers under common ownership. Corporation law gives the owners of the group the option to allow individual subsidiaries to fail, and claimants against the subsidiary cannot reach the assets of other group members unless they succeed in "piercing the corporate veil." Thus, insurers that concentrate their business in one or a few corporate entities are predicted to command higher prices than otherwise similar insurers where business is widely dispersed among group members. Empirical tests based on publicly traded property-liability insurers support the hypotheses: prices vary across firms depending upon overall-firm default risk and the concentration of business among subsidiaries; but within a given firm, prices do not vary by line after adjusting for line-specific liability growth rates.

Abstract:
Bubbles where asset prices rise and then collapse are often followed by financial crises where default is widespread. A simple theory of bubbles based on an agency problem is developed. Investors use money borrowed from banks to invest. Risky assets are relatively attractive because investors can default in low payoff states so there is asset substitution and prices are bid up. The overall level of asset prices depends on the amount of credit. Risk can originate in both the real and financial sectors. Financial fragility occurs when credit expansion might be insufficient to ensure asset prices are high enough to prevent default.

Abstract:
Empirical evidence suggests that banking panics are a natural outgrowth of the business cycle. In other words panics are not simply the result of "sunspots" or self-fulfilling prophecies. Panics occur when depositors perceive that the returns on the bank's assets are going to be unusually low. In this paper we develop a simple model of this type of panic. In this setting bank runs can be incentive-efficient: they allow more efficient risk sharing between depositors who withdraw early and those who withdraw late and they allow banks to hold more efficient portfolios. Central bank intervention to eliminate panics can lower the welfare of depositors. However there is a role for the central bank to prevent costly liquidation of real assets by injecting money into the banking system during a panic.

Abstract:
The purpose of this paper is to consider the strengths and weaknesses of the Japanese financial system and to propose possible changes for the future. The apparent reversal in opinions on the effectiveness of the Japanese and US financial systems in recent years suggests a long term view should be taken. All financial systems have problems in the short term and it is important not to put too much weight on these. Section 2 briefly considers the historical development and the current differences between the Japanese and US financial systems. Section 3 considers the functions of a financial system and how the Japanese and US systems have performed these functions. Suggestions for reforms for Japan are outlined in Section 4 and Section 5 contains concluding remarks.

Abstract:
Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.

Abstract:
In an overlapping generations economy with (incomplete) financial markets but no intermediaries, there is underinvestment in safe assets. In an economy with intermediaries and no financial markets, accumulating reserves of safe assets allows returns to be smoothed, nondiversifiable risk to be eliminated, and an ex ante Pareto improvement compared to the allocation in the market equilibrium to be achieved. In a mixed financial system, however, competition from financial markets constrains intermediaries so that they perform no better than markets alone.

Abstract:
The returns of assets that are traded on financial markets are more volatile than the returns offered by intermediaries such as banks and insurance companies. This suggests that individual investors are exposed to more risk in countries which rely heavily on financial markets. In the absence of a complete set of Arrow-Debreu securities, there may be a role for institutions that can smooth asset returns over time. In this paper, we consider one such mechanism. We present an example of an economy in which the incompleteness of financial markets leads to underinvestment in reserves whereas the optimum, for a broad class of welfare functions, requires the holding of large reserves in order to smooth asset returns over time. We then argue that a long-lived intermediary may be able to implement the optimum. However, the position of the intermediary is fragile; competition from financial markets can cause the intertemporal smoothing mechanism to unravel, in which case the intermediary will do no better than the market.The views expressed here are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.