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Abstract:
The paper shows that mispriced deposit insurance and capital regulation were of second order importance in determining the capital structure of large U.S. and European banks during 1991 to 2004. Instead, standard cross-sectional determinants of non-financial firms’ leverage carry over to banks, except for banks whose capital ratio is close to the regulatory minimum. Consistent with a reduced role of deposit insurance, we document a shift in banks’ liability structure away from deposits towards non-deposit liabilities. We find that unobserved time-invariant bank fixed effects are ultimately the most important determinant of banks’ capital structures and that banks’ leverage converges to bank specific, time invariant targets.

bank capital, capital regulation, capital structure, leverage

Abstract:
This paper documents that standard cross-sectional determinants of firm leverage also apply to the capital structure of large banks in the United States and Europe. We find a remarkable consistency in sign, significance and economic magnitude. Like non-financial firms, banks appear to have stable capital structures at levels that are specific to each individual bank. The results suggest that capital requirements may only be of second-order importance for banks' capital structures and confirm the robustness of current corporate finance findings in a holdout sample of banks.

capital structure, corporate finance, leverage, bank capital, banking regulation

Abstract:
This paper argues that firms may not issue debt in order to avoid the adverse selection cost of debt. Theory suggests that since debt is a concave claim, it may be mispriced when outside investors are uninformed about firms' risk. The empirical literature has however paid little attention the caveat that the "lemons" problem of external financing first identified by Myers (1984) only leads to debt issuance, i.e. a pecking order, if debt is risk free or, if it is risky, that it is not mispriced. This paper therefore examines whether and for what firms the adverse selection cost of debt is more than a theoretical possibility? And how does this cost relate to other costs of debt such as bankruptcy? Absent any direct measure of something that is unknown to investors and thus cannot be in the econometrician's information set, we present an extensive collage of strong and robust evidence in a large unbalanced panel of publicly traded US firms from 1971 to 2001 that firms avoid issuing debt when the outside market is likely to know little about their risk.

capital structure, risk, asymmetric information

Abstract:
We study the functioning and possible breakdown of the interbank market due to asymmetric information about counterparty risk. We allow for privately observed shocks to the distribution of asset risk across banks after the initial portfolio of liquid and illiquid investments is chosen. Our model generates several interbank market regimes: 1) low interest rate spread and full participation; 2) elevated spread and adverse selection; and 3) liquidity hoarding leading to a market breakdown. The regimes are in line with observed developments in the interbank market before and during the 2007-09 financial crisis. We use the model to examine various policy responses.

Financial crisis, Interbank market; Liquidity, Asymmetric information

Abstract:
A multi-divisional firm can engage in "winner-picking" to redistribute scarce funds efficiently across divisions. But there is a conflict between rewarding winners (investing) and producing resources with which to reward winners (incentives). Managers in winning divisions are tempted to free-ride on resources produced by managers in loosing divisions whose incentives to produce resources, anticipating their loss, are also weakened. Corporate headquarters' investment and incentive policies are therefore inextricably linked and have to be treated as jointly endogenous. The analysis links corporate strategy, compensation and the value of diversification to the characteristics of multi-divisional firms.

Abstract:
This paper examines the agency cost of winner-picking in multi-divisional firms and uses explicit incentive contracts to analyze the interaction between corporate headquarters' investment and incentive policies. Winner-picking, i.e. the efficient reallocation of scarce resources in an internal capital market, adds an extra layer of noise to the moral-hazard problem of incentivizing division managers to produce the resources that can then be redistributed. In particular, division managers with strong future investment opportunities anticipate that headquarters bails them out should they fail to produce enough resources themselves. This reduces incentives to create the resources in the first place with possible consequences for the optimal investment policy.

Internal Capital Markets, Conglomerate Discount, Transfers, Moral-hazard

Abstract:
The extended period of limited growth experienced until recently in many European countries raises the issue as to which policies could be most effective in improving their economic performance. This paper argues that further financial sector reforms may be a valuable complement to ongoing efforts to reform labour and product markets. There is a long-standing view in the economic literature that well-functioning financial systems allow economies to exploit the benefits of innovation in terms of productivity and growth. Moreover, measured productivity differentials between Europe and the United States seem to originate particularly in the financial sector and from sectors that are particularly dependent on external financing. Building on and summarising the existing literature, this paper first introduces a number of concepts that are important for financial sector analyses and policies. Second, it presents a selection of indicators describing the efficiency and development of the European financial system from the perspective of a variety of dimensions. Third, an attempt is made to estimate the extent to which greater financial efficiency might improve the allocation of productive capital in Europe. While in the recent past the research and policy debate in Europe has focused on fostering financial integration, the present paper puts the main emphasis on financial development or modernisation in the context of the finance and growth literature. The results suggest that there are a number of ways in which the financial market framework conditions in Europe can be improved to increase the contribution of the financial system to innovation, productivity and growth. The most robust conclusions can be drawn for certain aspects of corporate governance, the efficiency of legal systems in resolving conflicts in financial transactions and some structural features of European bank sectors. For example, econometric estimations indicate that improving these conditions is likely to increase the size of capital markets - a summary measure of overall financial development - and thereby enhance the speed with which the financial system helps to reallocate capital from declining sectors to sectors with good growth potentials.

Abstract:
This paper develops a theory of firms' debt-equity choice based on the role of risk in the adverse selection problem of external financing. When risk matters, debt cannot be optimal since it is a concave claim whose value to uninformed investors depends critically on risk. This means that Myers and Majluf (1984)'s pecking order is a special case that only applies when risk does not matter (or is perfectly known). Firms should issue less debt and more equity when risk matters since it reduces the concavity of the outside claim. Unlike existing asymmetric information theories of capital structure, this analysis can explain why small young non-dividend paying firms issue more equity-like securities.

Abstract:
This paper shows that there is a natural trade-off when designing market-based executive compensation. The benefit of market-based pay is that the stock price aggregates speculators' dispersed information and therefore takes a picture of managerial performance before the long-term value of a firm materializes. The cost is that informed speculators' willingness to trade depends on trading that is unrelated to any information about the firm. Ideally, the CEO should be shielded from shocks that are not informative about his actions. But since information trading is impossible without non-information trading (due to the "no-trade" theorem), shocks to prices caused by the latter are an unavoidable cost of market-based pay. This trade-off generates a number of insights about the impact of market conditions, e.g. liquidity and trading horizons, on optimal market based pay. A more liquid market leads to more market based pay while short-term trading makes it more costly to provide such incentives leading to lower CEO effort and worse firm performance on average. The model is consistent with recent evidence showing that market-based CEO incentives vary with market conditions, e.g. bid-ask spreads, the probability of informed trading (PIN) or the dispersion of analysts' forecasts.

Executive compensation, moral hazard, liquidity, trading, stock price informativeness

Abstract:
The paper presents a simple model arguing that the pecking order theory is an extreme when there is only asymmetric information about value. We show how asymmetric information about both, value and risk, transforms the adverse selection logic underlying the pecking order into a general theory of capital structure that accounts for both debt and equity issues. The model predicts that firms issue more equity and less debt if there is more asymmetric information about risk relative to value. We find robust empirical support for the prediction and document a strong link between risk and capital structure in a large unbalanced panel of publicly traded US firms from 1971 to 2001.

Abstract:
The paper presents a simple model arguing that the pecking order theory is an extreme when there is only asymmetric information about value. We show how asymmetric information about both, value and risk, transforms the adverse selection logic underlying the pecking order into a general theory of capital structure that accounts for both debt and equity issues. The model predicts that firms issue more equity and less debt if there is more asymmetric information about risk relative to value. We find robust empirical support for the prediction and document a strong link between risk and capital structure in a large unbalanced panel of publicly traded US firms from 1971 to 2001.

Abstract:
When insiders (management) of a firm have more information than outsiders (investors) then insiders desire to sell overpriced securities creates an Adverse Selection problem. To mitigate the problem, the Pecking-Order hypothesis proposes that debt finance should dominates equity finance. But according to the debt rationing literature, debt finance is also prone to the Adverse Selection problem. The paper addresses the puzzle by allowing firms to issue both debt and equity together and by having a general notion of what it is that insiders know more about. We show that safe firms use more equity than risk firms to credibly signal their type to investors. The paper provides a generalization of the existing financial signalling literature and reconciles previously contradictory findings.

Abstract:
We study the functioning of secured and unsecured interbank markets in the presence of credit risk. The model generates empirical predictions that are in line with developments during the 2007-2009 financial crises. Interest rates decouple across secured and unsecured markets following an adverse shock to credit risk. The scarcity of underlying collateral may amplify the volatility of interest rates in secured markets. We use the model to discuss various policy responses to the crisis.

Financial crisis, Interbank market, Liquidity, Credit risk, Collateral