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Abstract:
We argue that in an unreliable enforcement regime, transactions tend to become intermediated through institutions or concentrated among agents bound by some form of private enforcement. Provision of funding shifts from risk capital to debt, and from markets to institutions with long term relations. When minority investors' rights are poorly protected, the ability of firms to raise equity capital is impaired, leading to less finance for new risky ventures. More generally, fewer firms will be financed with outside equity, resulting in a low capitalisation relative to GNP and a predominance of internal (unlisted) equity and bank lending over traded securities. We report some supporting evidence on a small set of countries on the correlation between investor protection and development of security markets. We use existing measures of investor protection and corruption, as well as a price measure, the premium on voting stock, which is related to the control premium. In countries where the voting premium is large, corporate financing is dominated by bank lending and equity markets are much smaller. The other indicators are also consistent with our hypothesis, although the sample size is limited.

Abstract:
This Paper studies the incentives for transparency under different forms of corporate governance in a context of product market competition. This Paper endogenizes the governance and financial structure of firms and determines a strategic decision on the degree of transparency in a context of product market competition. When firms seeking outside finance resort to actively monitored debt in order to commit against opportunistic behaviour, the dominant lender can influence corporate transparency. More transparency about a firm's competitive position has both strategic advantages and disadvantages: in general, transparency results in higher variability of profits and output. Thus lenders prefer less information dissemination, as this protects firms when in a weak competitive position, while equityholders prefer more disclosure to maximize profitability when in a strong position. We show that bank-controlled firms will be opaque, while shareholder-run firms prefer more transparency. We can predict a clustering of attributes: bank dominance, established firms with valuable investment, but also significant assets in place, opaqueness, low variability of profits, somewhat lower average profits, and a reversed pattern for equity-controlled firms. Finally, bank control may fail to keep firms less transparent as global trading volumes rise.

Adverse selection, banking, capital structure, corporate governance, disclosure, imperfect competition, transparency

Abstract:
This paper studies optimal financial contracts and product market competition under a strategic transparency decision. When firms seeking outside finance resort to actively monitored debt in order to commit against opportunistic behaviour, the dominant lender can influence corporate transparency. More transparency about a firm's competitive position has both strategic advantages and disadvantages: in general, transparency results in higher variability of profits and output. Thus lenders prefer less information dissemination, as this protects firms when in a weak competitive position, while equityholders prefer more disclosure to maximize profitability when in a strong position. We show that bank-controlled firms will be opaque, while shareholder-run firms prefer more transparency. In fact, we can predict a clustering of attributes: bank dominance, established firms with valuable investment, but also significant assets in place, opaqueness, low variability of profits, somewhat lower average profits, and a reversed pattern for equity-controlled firms.

Capital Structure, Transparency, Corporate Governance, Imperfect Competition, Outside Finance

Abstract:
In this article, we review the recent academic research on the valuation of Internet companies. In particular, we focus on the valuation method(s) which were said to be suitable for new economy start ups in the boom years 1998-2000, and conclude that they were neither novel nor very accurate. Since the downturn in the sector, the valuation focus has returned to advanced fundamental valuation methods such as real options valuation.

Internet, valuation, IPOs, bubble, high tech

Abstract:
This paper investigates whether privatization in emerging economies has a significant indirect effect on local stock market development through the resolution of political risk. We argue that a sustained privatization program represents a major political test which gradually resolves uncertainty over political commitment to a market-oriented policy as well as to regulatory and private property rights. We present evidence suggesting that progress in privatization is correlated with improvements in perceived political risk. These gains tend to be gradual over the privatization period and are significantly larger in privatizing countries than in nonprivatizing countries, suggesting that the resolution of such risk is endogenous to the privatization process. Our analysis shows further that changes in political risk in general tend to have a strong effect on local stock market development and excess returns in emerging economies, suggesting that political risk is a priced factor. We conclude that the resolution of political risk resulting from successful privatization has been an important source for the rapid growth of stock markets in emerging economies.

Abstract:
We analyze politically-motivated privatization design in a bipartisan environment where politicians lack commitment power. When the median class favors redistributive policies, a strategic privatization program allocating them enough shares can induce a voting shift away from left wing parties whose policy would reduce the values of shareholdings. To induce median class voters to buy enough shares to shift political preferences, strategic rationing and underpricing is often necessary. In the extreme, this may lead to free share distribution and voucher privatization. Shifting voting preferences becomes impossible when strong ex-ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

privatization, underpricing, political economy, re-election, IPOs, political risk

Abstract:
We analyze politically-motivated privatization design in a bipartisan environment where politicians lack commitment power. When the median class favors redistributive policies, a strategic privatization program allocating them enough shares can induce a voting shift away from left wing parties whose policy would reduce the values of shareholdings. To induce median class voters to buy enough shares to shift political preferences, strategic rationing and underpricing is often necessary. In the extreme, this may lead to free share distribution and voucher privatization. Shifting voting preferences becomes impossible when strong ex-ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

privatization, underpricing, political economy, re-election, IPOs, political risk

Abstract:
Legislation affects corporate governance and the return to human and finacial capital. We allow the preference of a political majority to determine both the governance structure and the extent of labor rents. In a society where median voters have relatively more at stake in the form of human capital rather than financial wealth, they prefer a less risky environment even when this reduces profits, as labor rents are exposed to undiversifiable firm-specific risk. In general, labor and lenders prefer less corporate risk, since their claims are a concave function of firm profitability. This congruence of interests can lead the political majority to support bank over equity dominance. As shareholdings by the median voters increase, the dominance structure will move towards favoring equity markets with riskier corporate strategies and higher profits.

corporate governance system, political economy, bank control, equity control

Abstract:
We investigate the valuation of platform investment, such as a software operating system or an internet portal webpage. Platform investment is the creation of an innovative distribution and production infrastructure which increases access to customers; as a result it reduces entry costs in related products. Relative to conventional producers, firms built around platforms enjoy enhanced entry options in uncertain market segments, to be exercised at the optimal strategic timing. When the platform grants a strong strategic advantage, the innovator firm can optimally choose the timing of entry when its strategic gain exceeds the value of the wating option; in case of weaker advantage, the platform firm enters just before its competitor would. In a context of increased uncertainty, the relative value of platform to traditional strategies increases; the value of waiting to invest rises, but the value of platforms increases even more. In some cases, platform can reduce entry by making parallel monopoly sustainable.

Abstract:
We study the governance role of Russian Financial-Industrial Groups (FIG) and their impact on the allocation of capital. We compare member firms of groups with a control set of firms categorized by dispersed ownership or/and management and employee control.

We distinguish between hierarchical FIGs, where a bank is in firm control, and industry groups, which are looser alliances without a common control structure. We find that investment is sensitive to internal finance for the non-group firms. Industry group firms are not different from the independent firms in that respect, while there is negative correlation in bank-led group firms, suggesting extensive financial reallocation and the use of profitable firms as cash cows.

These results suggests either an internal capital market which redirects finance to firms with better investment opportunities or opportunistic value transfers by the controlling banks. We further assess the quality of the investment process in group and non group firms by measuring the correlation of investment with a proxy for Tobin's Q. The result supports the notion that hierarchical group firms allocate capital comparatively better than other firms, presumably because the controlling bank has a stronger profit motive and authority. However, the extent of redistribution is such that private appropriation of value by the controlling shareholders is a serious possibility.

Corporate groups, emerging markets, Russia, investment financing, expropriation, capital constraints

Abstract:
We study the governance role of Russian Financial-Industrial Groups (FIG) and their impact on financing of investment. We compare member firms of a group with a control set of large firms categorized by dispersed ownership or/and management and employee control. We find that investment is sensitive to internal finance for the second set of firms but not for the first; in fact, we find that cash flow is negatively correlated with investment in the FIG group firms. This is consistent with extensive reallocation of resources within the groups. One interpretation is that groups have an internal capital market which redirects finance to firms with better investment opportunities. We test this view against the alternative possibility that financial reallocation hide opportunistic value transfer across firms. Specifically, we assess the quality of the investment process in group and non group firms by regressing individual firms' investment on our measure of Tobin's Q. The result supports the notion that group firm allocate capital better than independent firms, although it does not rule out the possibility of private appropriation of value.

We then distinguish between bank-led groups, which are more hierarchical, and industry-centered groups which may be more defensive arrangements. Investment is not significantly correlated with cash flow in industry-led group firms (unlike in independent firms), while the negative correlation is entirely due to bank-led group firms, suggesting a more extensive financial reallocation and the use of profitable firms as cash-cows. Intriguingly, also the greater sensitivity of group firms' investment to Q is entirely to be attributed to firms in bank-led groups, where the controlling bank may have a stronger profit motive and authority to reallocate resources.

Abstract:
On August 17, 1998, Russia defaulted on its domestic public debt, declared a moratorium on the private banks' foreign liabilities which was equivalent to an outright default, and abandoned its exchange rate regime. The depth of the Russian meltdown shocked the international markets, and precipitated a period of serious financial instability. It is important to understand the roots of such a crisis to learn about possible lessons on both issues of bank supervision and international stability. While the visible cause of the crisis was an unsustainable fiscal deficit coupled with massive capital flight, the critical question concerns the origin of such circumstances. This paper argues that the structure of individual incentives in the Russian legal context, compounded by the exceptional support granted by international institutions to Russia, explains the cycle of nonpayment, capital flight and fiscal unbalances leading to the dramatic 1998 crisis. We offer an interpretative model of noncompliance, cash-stripping and rational collective nonpayment which led to the fiscal and banking crisis and ultimately to a complete meltdown. In our view, the banking sector was already insolvent prior to the crisis, and contributed directly and indirectly to it. The last section of the paper puts forward a radical medium-term policy proposal for a stable banking and payment system for Russia. Russia needs to create a basic foundation for savings and intermediation by asset restrictions and market segmentation, crude but effective rules used in all underdeveloped systems to restrain asset stripping and opportunism. Concretely, we propose a cautious extension of deposit insurance away from the monopolistic Sberbank and towards a narrow banking layer. The proposal also proposes measures to restore charter value in the commercial banking sector.

Banking crisis, Russia, asset stripping, legal enforcement, bank regulation, emerging market

Abstract:
The paper analyses foreign investment and asset prices in a context of uncertainty over future government policy. The model endogenizes the process of learning by foreign investors facing a potentially opportunistic government, which chooses strategically the timing of a policy reversal in order to attract more capital. We characterize the evolution of confidence, investment, and asset prices over time, as well as perceived policy risk. Quite generally, perceived risk abates as current policy is maintained, leading to a gradual appreciation of asset prices and a gradual decrease in their conditional variance. The approach thus provides a measure of the evolution over time of perceived political risk from market prices.

We next compute option prices under the process generated by the model's hazard rate of policy reversal plus an additional market risk component. We show that both the time series and the term structure of conditional volatility in general is downward sloping and its overall level falls steadily over time, although it may exhibit initially a hump shape in the case of very low initial reputation. Another testable implication is that in price series without a policy reversal, implied volatility from option prices will exceed actual volatility. Over time, and in the absence of a reversal, this wedge progressively disappears. This may be viewed as the volatility analogue of the "peso premium" for assets subject to large, infrequent price drops.

Abstract:
Innovative ideas are novel combinations of productive resources potentially addressing an economic need (Schumpeter, 1926). Even promising ideas can be unprofitable if the proposed combination fails on at least one dimension, e.g., it is technically unfeasible or does not respond to a genuine customer need. To screen good ideas the entrepreneur needs to hire experts who evaluate the idea along their dimensions of expertise. Yet sharing the idea creates the risk that an expert would steal it. In this case, the idea-thief cannot contact any other expert, lest he should in turn steal the idea. Thus idea stealing leads to incomplete screening and is unattractive if the information of the other expert is critical or highly complementary. In such cases the entrepreneur can form a partnership with the experts. Yet very valuable ideas cannot be shared because it is too tempting to steal them.

Entreprenuership, innovation, experts, information aggregation, venture capital, ideas

Abstract:
Innovative ideas are novel combinations of productive resources potentially addressing an economic need (Schumpeter, 1926). Even promising ideas can be unprofitable if the proposed combination fails on at least one dimension, e.g., it is technically unfeasible or does not respond to a genuine customer need. To screen good ideas the entrepreneur needs to hire experts who evaluate the idea along their dimensions of expertise. Yet sharing the idea creates the risk that an expert would steal it. In this case, the idea-thief cannot contact any other expert, lest he should in turn steal the idea. Thus idea stealing leads to incomplete screening and is unattractive if the information of the other expert is critical or highly complementary. In such cases the entrepreneur can form a partnership with the experts. Yet very valuable ideas cannot be shared because it is too tempting to steal them.

Entreprenuership, innovation, experts, information aggregation, venture capital, ideas

Abstract:
This paper studies product market competition under a strategic transparency decision. Dominant investors can influence information collection in the financial market, and thereby corporate transparency, by affecting market liquidity or the cost of information collection. More transparency on a firm's competitive position has both strategic advantages and disadvantages: in general, transparency results in higher variability of profits and output. Thus lenders prefer less information revelation through stock market trading, since this protects firms when in a weak competitive position, while equityholders prefer to make full use of the strategic advantage of a strong firm. We show that bank-controlled firms will tend to discourage trading to reduce price informativeness, while shareholder-run firms prefer more transparency. Our comparative statics show that bank control may fail to keep firms less transparent as global trading volumes rise.

Abstract:
Much academic literature on privatization has focused on the question of the efficiency gains associated with private property rights, the appropriate regulatory framework for privatized firms. There has been a more recent literature on the optimal design of the sale given the general uncertainty and the political risk inherent in the transaction (Perotti, 1995; Schmidt, 1998).

The empirical evidence on sales has confirmed the importance of political factors in the design of the sales. In this paper we take a radically different view from the usual normative approach about how privatization should be done and analyse an explicit political economy context to determine how politicians prefer to design sale programs.

We show that a privatization sale may be structured by a market-oriented, right wing government in order to ensure participation by the median class, in order to modify its voting preferences vis a vis the opposition, which favors more income redistribution. If appropriately designed, the share allocation at the sale align the interests of the median class with capitalists and thus make privatization politically feasible (and irreversible).

Specifically, a targeted share allocation the party will be re-elected to power because the median class becomes ex post averse to redistributive policies which would reduce the value of their shares. As it is in general illegal to target share allocations in large sales to specific groups of investors and not to others, the government has to use its control over the price of the offering. For the median class to choose to acquire enough shares to shift its political allegiance, the government needs to underprice the shares. As this leads to rationing, the government can then devises a self-selecting rationing scheme. We find that since income inequality makes the middle class more interested in redistribution, underpricing and rationing are increasing in social inequality.

This general result has already found strong empirical evidence in the literature (Jones et al, 1998) . In certain extreme situations firms shares may be sold at zero price, as in voucher privatizations; more generally zero-price share distributions may break self-fulfilling equilibria. Intuitively, there is an equilibrium in which investors do not believe other median class investors will buy shares at the sale, anticipating a victory by the opposition; such a belief can become self-fulfilling. A share distribution (directly to citizen or via investment or pension funds) rules out this possibility. In the case when only a fraction of shares needs to be sold before an election, the rest may be optimally sold later at an auction designed for richer investors.

Shifting the preferences of the middle class may be impossible when strong ex ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

Abstract:
Investor confidence is a necessary condition for the development of emerging markets. Investors recognize that since market-oriented reform policies may be reversed or hindered, they face the risk of ex post policy changes with redistributive impact on investment returns. We argue that a sustained privatization or liberalization program represents a major test of political commitment, and contributes to reduced policy risk. The evidence from our panel study suggests that progress in privatization gradually leads to increased confidence. Moreover, increased confidence has a strong effect on local market development and is a significant determinant of excess returns. We conclude that, just as financial liberalization, the resolution of policy risk resulting from successful privatization has been an important source for the broadening and deepening of emerging stock markets.

International financial markets, privatisation, financial liberalization

Abstract:
Equity carve outs, the partial listing of a corporate subsidiary, appear to be transitory arrangements, usually dissolved within a few years by either a complete sale or a buy back. Why do firms perform expensive listings just to reverse them thereafter? We interpret carve outs of a production unit as strategic options to attract information from the market over its value as an independent entity. This improves the decision to exercise the option to sell out or to regain control. A listing is costly, as it reduces coordination of production, but generates valuable information from the market over the optimal allocation of ownership. We compute the optimal timing for the final sale or buy back decisions, the value of the strategic options embedded in the carve out and the optimal shares retained. The model explains the temporary nature of carve outs, and suggests an explanation for many empirical findings. In particular, it explains why carve outs are more common in high uncertainty sectors and in more informative markets.

Equity carve out; Real option, Buy back, Sell out, Vertical integration, Horizontal integration

Abstract:
Equity carve outs, the partial listing of a corporate subsidiary, appear to be transitory arrangements, usually dissolved within a few years by either a complete sale or a buy back. Why do firms perform expensive listings just to reverse them thereafter? We interpret carve outs as strategic options to attract information from the market over the relative value of a productive unit as an independent entity and thus to improve the decision process on whether to sell out or to retain control. The separate listing is costly, as it reduces coordination of production, but generates valuable information from the market over the optimal allocation of ownership. We compute the optimal timing for the final sale or buy back decisions, the value of the strategic options embedded in the carve out and the optimal shares retained. The model explains the temporary nature of carve outs, and suggests an explanation for many empirical findings. In particular, it explains why carve outs are more common in sectors with high uncertainty and in more informative markets.

Equity carve-out, real option, spin-off, buy-back, sell-out

Abstract:
The literature on strategic growth options examines the impact of investment to gain comparative advantages. The commitment of irreversible investment may confer strategic advantages as a result of a reduction in future expansion costs (Dixit, 1980) or operating costs (Kulatilaka and Perotti, 1998); which contain competitors' production strategy and market share.
In general, strategic effects have been shown to increase the appeal of early investment. Interestingly, the value of strategic investment may often increase as uncertainty on market demand or cost increases, bacause oligopolistic profits are convex in demand. However, the impact of uncertainty is often ambiguous due to the value of the option to wait.

This paper examines the decision to invest in logistics, market profiling and distribution capabilities that allow a firm to seize market share by being able to deliver a product ahead of competitors under Cournot quantity competition. This has the strategic effect of restraining competitors' behavior, and may justify the early commitment capital even when waiting offers deferment option value due to demand uncertainty. The remarkable result is that the value of such time-to-market investment is unambiguously increasing in such uncertainty. However, when all competitors share this investment opportunity, the resulting "rush to the market" consumes resources without enhancing profitability.

Abstract:
The paper offers a theoretical model of bank lending quality in a transition economy. The model obtains that under active bank monitoring the correlation between lending and arrears should decrease over time. This empirical measure allows us to assess whether banks impose financial discipline, or act as temporary buffers for losses. We run the test on a sample of Romanian state-owned enterprises over 1991-1994. We find evidence that, contrary to the findings of Pinto and van Wijnbergen for Poland, lending criteria for Romanian banks show few signs of improvement. Most worrisome is the stability of the relation between bank credit and financial arrears, which increases in strength over the period both statistically and in terms of economic impact. Bank credit is negatively correlated with profitability; however, there is evidence that better firms reduce their credit demand as real rates rise. Banks appear to be particularly soft towards the worse performing, larger and more insolvent enterprises. There is evidence of a policy shift in 1993-1994 with banks refinancing trade arrears, perhaps following IMF pressure against further central bank bailouts. Overall, the evidence suggests a largely passive attitude of banks towards the worse borrowers and limited reallocation of credit to better users. We are currently engaged in an expansion of the sample size and time period, both necessary before a final judgement may be made on the overall state of Romanian banking.

Abstract:
External finance is critical for less established entrepreneurs, so poor investor protection can hinder competition. We model how lobbying by incumbents may reduce access to finance in countries where politicians are less accountable to voters. In a broad cross-section of countries and industries, we find that (i) the number of producers and entry rates are positively correlated with investor protection in financially dependent sectors, and (ii) countries with more accountable political institutions have better investor protection.

Financial Development, Investor protection, Competition, Lobbying, Entry, Cost of Entry

Abstract:
This paper investigates the determinants of underpricing at initial public offerings in the Hungarian Initial Public Offerings (IPO) market in 1990-1998, a period of transition from socialist to market economy and immaturity of the domestic capital market. The evidence suggests that political issues played a significant role in the process: we have found greater discount at privatization IPOs than at private issues, and a positive relation between underpricing and the proportion of shares offered for compensation coupons. These findings reinforce the hypothesis that governments in transition may pursue political objectives by selling shares at discount. Besides, the results show larger initial returns at early IPOs compared to later issues, which implies a negative relation between the discount and the maturing of the capital market. Most of the asymmetric information theories, empirically justified for well-developed stock markets, receive no support. Some results suggest that the transition related determinants of underpricing disappear as the securities market becomes more mature.

Initial Public Offerings, Underpricing, Privatization

Abstract:
Banks are highly leveraged institutions, potentially attracted to speculative lending even without deposit insurance. A counterbalancing incentive to lend prudently is the risk of loss of charter value, which depends on future rents. We show in a dynamic model that current concentration does not reduce speculative lending, and may in fact increase it. In contrast, a policy of temporary increases in market concentration after a bank failure, by promoting a takeover of failed banks by a solvent institution, is very effective. By making speculative lending decisions strategic substitutes, it grants bankers an incentive to remain solvent. Subsequent entry policy fine-tunes the trade-off between the social costs of reduced competition and the gain in stability.

Bank mergers, banking crises, charter value, market structure dynamics, prudential regulation

Abstract:
Banks are highly leveraged institutions, potentially attracted to speculative lending even without deposit insurance. A counterbalancing incentive to lend prudently is the risk of loss of charter value, which depends on future rents. We show in a dynamic model that current concentration does not reduce speculative lending, and may in fact increase it. In contrast, a policy of temporary increases in market concentration after a bank failure, by promoting a takeover of failed banks by a solvent institution, is very effective. By making speculative lending decisions strategic substitutes, it grants bankers an incentive to remain solvent. Subsequent entry policy fine-tunes the trade-off between the social costs of reduced competition and the gain in stability.

Banking crisis, banking competition, charter value, prudential regulation

Abstract:
We develop a model of endogenous lobby formation in which wealth inequality and political accountability undermine entry and financial development. Incumbents seek a low level of effective investor protection to prevent potential entrants from raising capital. They succeed because they can promise larger political contributions than the entrants due to the higher rents earned with less competition. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Consistent with these predictions, in a cross-section of 38 countries we find that greater accountability is associated with higher entry in sectors that are more dependent on external capital and have greater growth opportunities. Also, higher accountability and lower income inequality are associated with more effective legal enforcement, even after controlling for legal origin and per-capita income.

Politics, entry, financial development, entrepreneurship, investor protection, income inequality, growth

Abstract:
We develop a model of endogenous lobby formation in which wealth inequality and political accountability undermine entry and financial development. Incumbents seek a low level of effective investor protection to prevent potential entrants from raising capital. They succeed because they can promise larger political contributions than the entrants due to the higher rents earned with less competition. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Consistent with these predictions, in a cross-section of 38 countries we find that greater accountability is associated with higher entry in sectors that are more dependent on external capital and have greater growth opportunities. Also, higher accountability and lower income inequality are associated with more effective legal enforcement, even after controlling for legal origin and per-capita income.

Politics, Entry, Financial Development, Entrepreneurship, Investor protection, Income Inequality, Growth

Abstract:
This paper reviews the state of thinking on the governance role of public ownership and control. We argue that the transfer of operational control over productive assets to the private sector represents the most desirable governance, due to the inherent difficulty for citizens to constrain political abuse relative to the ability of governments to regulate private activity. However in weak institutional environments the process needs to be structured so as to avoid capture of the regulatory process. The speed of transfer should be timed on the progress in developing a strong regulatory governance system, to which certain residual rights of intervention must be vested. After all, what are "institutions" if not governance mechanisms with some degree of autonomy from both political and private interests? The gradual creation of institutions partially autonomous from political power must become central to the development of an optimal mode of regulatory governance. We advance some suggestions about creating accountability in regulatory governance, in particular creating an internal control system based on a rotating board representative of users, producers and civil society, to be elected by a process involving frequent reporting and disclosure.

Regulatory Governance, Privatization

Abstract:
Perotti reviews the state of thinking on the governance role of state ownership. He argues that a gradual transfer of operational control and financial claims over state assets remains the most desirable goal, but it needs to be paced to avoid regulatory capture, and the capture of the privatization process itself. In addition, the speed of transfer should be timed on the progress in developing a strong regulatory governance system, to which certain residual rights of intervention must be vested. In many countries institutional weakness limits regulatory capacity and reliability, yet the author's conclusion is that in such environments, maintaining state control undermines the very emergence of institutional capacity, and so the balance should tip toward progressively less direct state control.

After all, what are "institutions" if not governance mechanisms with some degree of autonomy from both political and private interests? The gradual creation of institutions partially autonomous from political power must become central to the development of an optimal mode of regulatory governance.

The author offers some suggestions about creating maximum accountability in regulatory governance, in particular creating an internal control system based on a rotating board representative of users, producers, and civic organizations, to be elected by a process involving frequent reporting and disclosure.

This paper - a product of the Global Corporate Governance Forum, Investment Climate Unit - is part of a larger effort in the department to improve the understanding of corporate governance reform in developing countries.

Abstract:
We investigate the valuation of platform investment, such as a software operating system or an internet portal webpage. Platform investment is the creation of an innovative distribution and production infrastructure which increases access to customers; as a result it reduces entry costs in related products. Relative to conventional producers, firms built around platforms enjoy strategic pre-empitve advantages, creating a set of entry options in uncertain market segments, to be exercised once demand ensures profitability. In a context of increased uncertainty, the relative value of platform to traditional strategies increases; moreover, the value of waiting to invest rises, but the value of platforms increases even more.

Abstract:
On August 17, 1998, Russia defaulted on its domestic public debt, declared a moratorium on the private banks' foreign liabilities and abandoned its pegged exchange rate regime. This created a considerable international financial instability and marked a major turning point in the history of post-Soviet reforms. We analyze this collapse as the result of the longstanding failure to establish some of the key microeconomic and institutional foundations on which a market economy should rest. In Russia, especially since the 1995 stabilization, the difficulty of enforcing legal and contractual discipline implied that the settlement of commercial and financial liabilities largely remained an issue of bargaining and show of force. Though the legacy from the past regime weighed heavily, this was mostly the reflection of the collusive nature of systemic non-payment: when the vast majority of agents does not abide by the rules, the challenge to enforcement becomes overwhelming and the expropriation of the weaker agents is the rule. Aggregate monetary policy cannot be an effective control mechanism in these circumstances. This environment created extremely adverse microeconomic incentives: the opportunistic appropriation of cash-flow resources was much more important than medium-term profit-oriented strategies: demonetization, barter trade and capital flight developed on a large scale, product markets remained dominated by established unreformed firms. As a consequence, the physical capital base was run down and all financial obligations became as many financial pyramids.

Abstract:
This paper argues that historical political preferences on the role of capital markets shaped national choices on pension reliance on private funding. Under democratic voting, a majority will support investor protection and a privately funded pension system when the middle class has significant financial participation, while high wealth concentration favors a state-funded retirement system and weak investor rights. We present evidence that pension funding is well explained by wealth distribution shocks in the first half of the 20th Century. The effect is very significant: a large shock reduces the stock of private retirement assets by 58% of GDP. The results stand after controlling for complementary explanations, such as legal origin, past and current demographics, religion, electoral voting rules, national experiences with financial market performance, or other major financial shocks that were not specifically redistributive.

Inflationary shocks, pension, political economy, redistribution, retirement finance

Abstract:
The paper seeks to explain the historical origins of state oriented pension structure. It proposes a political explanation related to the Great Reversal argument in Rajan and Zingales (2003) and Perotti and von Thadden (2006). Large inflationary shocks in the first half of the XX century devastated middle class savings in some countries, where they shaped political support against capital markets and for social insurance, ahead of the establishment of universal pension systems after the Great Depression. We present evidence that reliance on state pensions is well explained by these wealth distribution shocks. The economic effect is huge: a large shock reduces the stock of private retirement assets by 58% of GDP. We verify that these price shocks were the outcome of exogenous war damages and were not related to institutional characteristics. The results stand after controlling for complementary explanations, such as original financial development, legal origin, past and current demographics, religion, electoral voting rules, national experiences with financial market performance, or other major financial shocks that were not specifically redistributive. However, it is hard to disentangle whether the change in political preferences is driven by a shift in economic interest or in ideological beliefs.

Pension system, political economy, wealth distribution, investor protection, retirement finance

Abstract:
We study whether Russian Financial-Industrial Groups help the Russian industrial sector to obtain investment finance. We examine the set of firms which are members of official Financial Industrial Groups and/or are owned by one of the large Russian banks, and compare them with a set of other large firms categorized by dispersed ownership or/and management and employee control. We find that investment is sensitive to internal liquidity for the second set of firms but not for the first. This is consistent with extensive reallocation of resources within the groups. One possibility is that group firms have easier access to finance than independent firms, suggesting that financial groups may alleviate agency problem and result in better corporate control over the investment process. Interestingly, large independent firms with a significant stock market valuation and trading appear also less liquidity constraints, suggesting that the Russian equity market may start to provide a positive function. The possibility for opportunistic value transfer across firms is harder to assess. In future research we plan to distinguish between bank-led groups, which appear more hierarchical, and industry-centered groups which may be more defensive.

Abstract:
We provide a framework to interpret the recent literature on financial development and inequality. In many developing countries, access to funding and financial services by firms and households is still very skewed. Recent evidence suggests that poor access does not only reflect economic constraints but also barriers erected by insiders. Inequality affects the distribution of political influence, so financial regulation often is easily captured by established interests in unequal countries. Captured reforms deepen rather than broaden access, as small elites obtain most of the benefits while risks are socialized. Financial liberalization motivated to increase access may in practice increase fragility and inequality, and lead to political backlash against reforms. Thus financial reforms may succeed only if matched by a buildup in oversight institutions.

financial development, entry, inequality, politics, access to financial services

Abstract:
Using a new dataset of currency option prices, we study the evolution of investor confidence in 1992-98 over the chance of individual currencies to converge to the euro. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility (volatility wedge). We show formally that confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge that declines over time, only for those currencies involved in convergence. The wedge and other convergence risk measures are correlated with both observable fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks, as the confidence-building model suggests. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.

Convergence risk, confidence building, currency options, regime-switching models

Abstract:
Using a unique dataset of currency option prices, we study the evolution of investor confidence in 1992-1998 over the chance of individual currencies to converge to the Euro. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility (volatility wedge). We show formally that confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge only for those currencies involved in convergence, which declines over time. The wedge is correlated with both exogenous fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks, as the confidence building model suggests. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.

Euro, exchange rate, credibility, option pricing, regime switching, implied volatility, convergence

Abstract:
This paper studies the financing of enterprise investment in listed Hungarian firms during the first years of transition. These firms were selected for listing on the exchange and presumably had better access to external capital. In particular, we look for evidence of financial constraints that limit real investment and attempt to identify the effect of different ownership and governance structures. The empirical results indicate significant financial constraints even among the better-known firms in the period from 1992 to 1998. Consistent with studies from other countries, we find evidence that foreign-owned firms do not suffer from limited external finance. Previous leverage can strain investment, suggesting that hard budget constraints are binding. State ownership does not alleviate capital constraints and larger firms do not appear to be less constrained than the smaller firms, which contrasts with the evidence in Western countries.

Abstract:
This Paper studies the financing of enterprise investment in listed Hungarian firms during the first years of transition. These firms were selected for listing on the exchange and presumably had better access to external capital. In particular, we look for evidence of financial constraints that limit real investment and attempt to identify the effect of different ownership and governance structures. The empirical results indicate significant financial constraints even among the better-known firms in the period from 1992 to 1998. Consistent with studies from other countries, we find evidence that foreign-owned firms do not suffer from limited external finance. Previous leverage can strain investment, suggesting that hard budget constraints are binding. State ownership does not alleviate capital constraints and larger firms do not appear to be less constrained than the smaller firms, which contrasts with the evidence in Western countries.

Financial constraints, transition, foreign investment, governance

Abstract:
This paper studies the financing of enterprise investment in listed Hungarian firms during the first years of transition. These firms were selected for listing on the exchange and presumably had better access to external capital. In particular, we look for evidence of financial constraints that limit real investment and attempt to identify the effect of different ownership and governance structures. The empirical results indicate significant financial constraints even among the better-known firms in the period from 1992 to 1998. Consistent with studies from other countries, we find evidence that foreign-owned firms do not suffer from limited external finance. Previous leverage can strain investment, suggesting that hard budget constraints are binding. State ownership does not alleviate capital constraints and larger firms do not appear to be less constrained than the smaller firms, which contrasts with the evidence in Western countries.

Transition, Corporate Governance, Hungary, Financial Constraints, Foreign Investors

Abstract:
In a democracy, a political majority can influence both the corporate governance structure and the return to human and financial capital. We argue that when financial wealth is sufficiently concentrated, there is political support for high labor rents and a strong governance role for banks or large investors. The model is consistent with the "great reversal" phenomenon in the first half of the twentieth century. We offer evidence that in several financially developed countries a financially weakened middle class became concerned about labor income risk associated with free markets and supported a more corporatist financial system. We offer suggestive evidence using post WW1 inflationary shocks as the source of identifying exogenous variation.

corporate governance, political economy, bank control, family firms, great reversals, labor rents

Abstract:
We present a model of endogenous lobby formation in which wealth inequality and political accountability undermine both entry and financial development. The elite will seek a lower level of effective minority protection than the middle class to prevent potential entrants from raising financing. The elite wins because its lobby can promise larger political contributions due to the higher rents earned by restricting entry. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Evidence across 48 countries indicates that greater accountability and lower income inequality are associated with stronger legal enforcement, even after controlling for legal origin and per-capita income. Moreover, greater political accountability increases entry in external capital-dependent industries; its inclusion makes financial development insignificant. These results suggest that lobbying protects established interests by creating entry barriers and undermining legal enforcement.

Abstract:
While financial liberalization has in general favourable effects, reforms in countries with poor regulation is often followed by financial crises. We explain this variation as the outcome of lobbying interests capturing the reform process. Even after liberalization, market investors must rely on enforcement of investor protection, which may be structured so as to block funding for new entrants, or limit their access to refinance after a shock. This forces inefficient default and exit by more leveraged entrepreneurs, protecting more established producers. As a result, lobbying may deliberately worsen financial fragility. After large external shocks, borrowers from the political elite in very corrupt countries may successfully lobby for weak enforcement, and retain control of collateral. We provide evidence that industry exit rates and profit margins after banking crises are higher in the most corrupt countries.

Financial crises, political economy, entry, exit, refinancing, strategic default, inequality

Abstract:
We investigate the timing and the valuation of strategic investment aimed at enhancing entry opportunities in related market segments. As demand is uncertain, entry options should be exercised at the optimal time, trading off the market share gain against the option to wait until more information is revealed, while anticipating competitors' entry behaviour. When the strategic investment grants a strong competitive advantage, the innovator can optimally choose the timing of entry; in case of weaker advantage, the investing firm enters just before its competitor would. In a context of increased uncertainty, the value of waiting to invest rises, but the value of a strategic investment increases even more. In some cases, strategic investment can act as a threat to discourage cross-entry, making parallel monopoly sustainable.

Real options, entry, strategic investment, technological innovation, growth opportunities

Abstract:
Legislation affects corporate governance and the return to human and financial capital. We allow the preference of a political majority to determine both the governance structure and the extent of labour rents. In a society where median voters have relatively more at stake in the form of human capital rather than financial wealth, they prefer a less risky environment even when this reduces profits, as labour rents are exposed to undiversifiable firm-specific risk. In general, labour and lenders prefer less corporate risk, since their claims are a concave function of firm profitability. This congruence of interests can lead the political majority to support bank over equity dominance. As share-holdings by the median voters increase, the dominance structure will move towards favoring equity markets with riskier corporate strategies and higher profits.

Corporate governance, bank centered system, social insurance, political economy, median voter, corporate investment

Abstract:
We describe new ideas as incomplete concepts for which the innovator needs feedback from agents with complementary skills. Once shared, ideas may be stolen. We compare how different contractual environments support invention and implementation. Markets, as open exchange systems, are good for circulation and thus elaboration, but may fail to reward idea generation. Firms, as controlled idea exchange systems, can reward idea generation but can do so only by restricting their circulation. This identifies a basic trade-off between protecting the rights of invention and the best implementation of ideas. An environment that allows ideas to cross firm boundaries enhances the rate of innovation and creates a symbiotic relationship between markets and firms.

Ideas, firms, innovation

Abstract:
Investor confidence in reliable property rights and stable, market-oriented policies are a necessary condition for financial integration and the development of emerging stock markets. Announced market-oriented policies may be reversed, however, and are initially not fully credible. We argue that sustained privatization and liberalization programmes represent a major test of political commitment to safer private property rights. We investigate whether successful privatization has a significant effect on emerging stock market development through the resolution of policy risk, i.e. the risk of ex post policy changes with redistributive impact on investment returns. The evidence from our panel study suggests that progress in privatization gradually leads to increased confidence. Moreover, increased confidence has a strong effect on local market development and is a significant determinant of excess returns. We conclude that financial liberalization and the resolution of policy risk resulting from successful privatization has been an important source for the broadening and deepening of emerging stock markets.

Financial integration, liberalization, stock market development, political risk, privatization, emerging market

Abstract:
This article proposes a theory of corporate transparency and its determinants. We show that under imperfect product market competition, the corporate transparency decision affects the value of equity and debt claims differently. We then embed this insight in a model of endogenous investor influence in which banks may emerge as dominant investors. In line with evidence from continental Europe and Japan, we find that dominant creditors seek to decrease transparency below the level preferred by equity holders. The theory predicts a clustering of firm characteristics that emerge when capital markets are not sufficiently investor friendly to allow arm's-length monitoring: bank dominance, opaqueness, uncertainty about assets in place, low variability of profits, and reduced average profits.

Abstract:
Equity carve outs, the partial listing of a corporate subsidiary, appear to be transitory arrangements, usually dissolved within a few years by either a complete sale or a buy back. Why do firms perform expensive listings just to reverse them thereafter? We interpret carve outs of a production unit as strategic options to attract information from the market over its value as an independent entity. This improves the decision to exercise the option to sell out or to regain control. A listing is costly, as it reduces coordination of production, but generates valuable information from the market over the optimal allocation of ownership. We compute the optimal timing for the final sale or buy back decisions, the value of the strategic options embedded in the carve out and the optimal shares retained. The model explains the temporary nature of carve outs, and suggests an explanation for many empirical findings. In particular, it explains why carve outs are more common in high uncertainty sectors and in more informative markets.

Equity carve out, Real option, Buy back, Sell out, Vertical integration, Horizontal integration

Abstract:
In the Anglo-American capital market tradition, shareholders hold only equity and creditors only debt. Suppliers and corporate customers may extend credit to each other, but they typically do not have shareholding relationships. In particular, these relationships are rarely reciprocal. On the European continent, and in Asia, trading relationships are often cemented with financial ties. Enterprises are part of complex customer and supplier networkswhere financing patterns and trade are interlinked; financial institutions holds both corporate debt and equity. This article analyses one of the most conspicuous and well-known example of such networks: the Japanese financial keiretsu. We rationalize the crossholdings of debt and equity within the Japanese keiretsu as acontingent governance mechanism through which internal discipline is sustained over time. The reciprocal allocation of control rights supports cooperation and mutual monitoring among managers through a coalition-enforced threat of removal from control. This suggests that the main bank is not a dominant agent while firms are performing well. In financial distress the threat of control loss is less effective. While the coalition still relies on mutual monitoring by trade creditors, the governance mode shifts to hierarchical enforcement under the leadership of the main bank, which absorbs losses suffered from junior trade creditors within the coalition and broadens its residual control role. We can thus interpret the apparent consensual behavior by Japanese firms as cooperative behavior by self- interested parties supported by severe implicit threats, which in equilibrium need not be employed.

Abstract:
The paper develops a theoretical framework to analyse foreign investment and asset prices in a context of uncertainty over future government policy, and tests it on a time series of option prices written on Hang Seng stocks. The model endogenizes the process of learning by foreign investors facing a potentially opportunistic government. We characterize the resulting evolution of confidence over time, and generate testable implications for the evolution over time of option prices written on invested assets. The model predicts that uncertainty over treatment of foreign capital will lead initially to a hump-shaped path for implied volatility. However, over time perceived political risk abates as learning over long term government policy progresses. An implication is that measured implied volatility exceeds actual volatility because of a political uncertainty component. In the absence of a policy reversal, this wedge progressively disappears. We test this view using Hong Kong medium term option prices. We are able to identify a long term downward trend in implied volatility which is not explained by ex post historical volatility or other common empirical regularities. The evidence is consistent with a progressive reduction in the perceived political risk of investing in Hong Kong.

Abstract:
The paper explores a model of the intertemporal process of financial stabilization in a transition economy. We derive an empirical measure to assess whether the banking sector acts as a source of financial discipline, or as a short-term buffer for enterprise losses. Specifically, in the presence of active bank monitoring the correlation between bank lending and arrears should be decreasing over time, while it would increase if banks rolled over bad loans in the expectation of a bailout. We run the test on balance sheet data from a sample of Romanian state-owned enterprises over 1991-1994. We find evidence that financial discipline has not improved in this time period, and that soft bank financing seems to have substituted for centralized clearing of trade arrears as a source of soft budget constraint for the worse Romanian firms.

Abstract:
We study investment timing under uncertainty and imperfect competition. The real options literature studies investment timing when (a) the firm has a monopoly over an investment opportunity, and (b) the product market is perfectly competitive. As a result, firms tend to postpone investment as uncertainty increases. We show instead that in a market with strategic competition, early investment endogenously confers a greater capability to take advantage of future growth opportunities. This strategic advantage leads to the capture of a greater share of the market, either by dissuading entry or by inducing competitors to 'make room' for the stronger competitor. As a result of this growth option effect, payoffs are usually more convex than under the waiting-to-invest option. When this strategic effect is strong, increased uncertainty encourages immediate investment. The result is confirmed when we allow for simultaneous entry, and is robust to different forms of strategic interaction. Our results may be surprising in the light of current practice, which tends to view volatility as a strong disincentive for new investment. However, under strong strategic competition, higher uncertainty clearly presents greater opportunities than risks.

Abstract:
Financial liberalization under weak regulatory institutions is often followed by financial crises. We argue that poor regulation may be the deliberate outcome of lobbying interests capturing the reform process. Lobbying on investor protection may be directed at limiting entry, in which case reforms will focus on deepening rather than broadening access to capital. Interestingly, lobbying may deliberately create financial fragility. When blocking entry is too costly, limiting access to refinance after a shock forces inefficient exit, and protects more established producers.

We model access to finance in a setting where investor protection is a legislative or enforcement choice taken by politicians subject to lobbying. Richer entrepreneurs will lobby for lower investor protection to limit access to finance and thus entry by poorer entrepreneurs. Poor investor rights induce ex post incentives to default for firms requiring more external finance, and may cause investors to refuse financing to valuable projects. Richer and thus less leveraged entrepreneurs can still credibly promise to repay their loans and will be able to raise the finance needed to enter. In our dynamic setting, investor protection affects not only entry, but also exit, which arises when entrepreneurs are not able to obtain refinancing after an external shock.

We obtain three distinct policy outcomes, corresponding to different financial regimes. They lead to different entry and exit rates, and different degrees of financial fragility. In countries with high democratic accountability, bribing politicians to block entry of poor entrepreneurs is too expensive for the rich. Thus investor protection will be set so as to ensure access for all to finance and refinance after a shock. At intermediate levels of accountability, lobbying to block ex ante access is still too costly, but investor protection may be set deliberately low so as to limit access to refinancing after a shock. This reduces competition for rich producers as the poorer, more leveraged producers are forced to exit. This form of involuntary default is a case of deliberately induced fragility. Finally, when democratic accountability is very weak, the rich find it attractive to lobby for very low investor protection so as to block any access by poor entrepreneurs. We term this case a narrow financial equilibrium.

We present supporting empirical evidence for a broad sample of countries, showing how profits in more financially dependent industries fall less in more corrupt countries after a crisis, and confirm that this is associated with higher exit rates.

financial dependence, exit, entry, growth, minority protection, political economy, lobbying