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Abstract:
This paper presents a theoretical framework for understanding the investment decisions and financing decisions of financial and nonfinancial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse depositor/bondholders and relatively less risk averse stockholders. The solution to this agency problem is a corporate governance system that takes the form of an up-front contract that directs managers to make portfolio/investment decisions in the interest of their stockholders, and financing decisions in the interest of their depositor/bondholders. This enables depositor/bondholders to offset any risk shifting portfolio/investment decisions made on behalf of the shareholders, thereby mitigating the moral hazard problem among debtors and creditors. The Basle Accord on risk-based capital requirements for depository institutions is one particular regulatory application of this more general theoretical framework. The paper concludes with a comparison between the Basle Accord and the 100 percent reserve or narrow banking proposal as the means of achieving a risk-free medium of exchange and a financial system that facilitates the optimal transfer of resources from savers to investors consistent with society's aversion towards risk.

Abstract:
Research in corporate governance indicates that the relational framework within which firms make business decisions is very different across countries and these differences might be important in explaining differences in real economic phenomena such as growth rates in real output. On the other hand, research in business cycles indicates that many of the stylized facts of business cycles, themselves the result of business decisions that corporate governance presumably influences, are qualitatively similar. The objective of this paper is to see in what ways business cycles are similar and in what ways they are different across the G-7 countries, and whether any differences are related to differences in corporate governance and ownership structures. This research finds that business cycles across the G-7 countries tend to be more similar when comparing economic relationships from the product market where competition and the macroeconomic environment seem all important. On the other hand, business cycles are less similar across the G-7 countries when comparing certain financial relationships, and in certain cases these differences are related to differences in corporate governance and ownership structures.

Abstract:
This paper presents a theoretical and empirical analysis of the portfolio adjustments and financing adjustments of U.S. banks over the business cycle. The model describes a representative bank whose portfolio is financed with deposits and equity claims. At the core of the model is a moral hazard problem between relatively more risk averse depositors and relatively less risk averse equity investors. The solution to this moral hazard problem takes the form of shared management of the bank between depositors (or the deposit insuring agency) and equity investors. Towards this end portfolio decisions are made to conform to the risk aversion of equity investors, while financing decisions are made so as to offset any changes in portfolio risk caused by portfolio adjustments. Portfolio adjustments in turn are initiated by exogenous changes in the risk aversion of equity investors that are revealed to bank managers in equity share prices. The resulting portfolio adjustments and changes in portfolio risk then triggers financing adjustments that insulate depositors from any changes in portfolio risk. The model predicts that the loan component of a bank's portfolio is positively related to changes in bank stock prices, while the equity leverage ratio varies directly with the bank's loan to asset ratio. The regression evidence in this paper does not reject these two predictions. Finally the financing adjustments uncovered here were found to predate U.S. capital adequacy legislation for banks. This suggests that private arrangements may have achieved much the same qualitative results in the past as the Basle Accord now attempts to achieve with regulatory legislation.

Banks, Business Cycles, Basle Accord, Finance

Abstract:
This paper presents a theoretical framework for understanding the interaction between production-investment decisions on the one hand, and the associated financing decisions of nonfinancial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse bondholders and relatively less risk averse stockholders over the future business decisions of the firm. In this paper the solution to this agency problem is an up-front contract that directs the manager of the firm to make production-investment decisions in the interest of their stockholders, and financing decisions in the interest of their bondholders. External taste shocks initiate business cycles in this model by changing the risk aversion and required yield of shareholders. The resulting changes in share prices then sends a signal to managers to change the production-investment strategy of the firm. The changes in the production-investment strategy of firms cause business cycles. The up-front contract protecting the interests of bondholders then constrains the managers to implement a matching financial strategy (e.g., a financial leverage decision and dividend payout decision) that offsets any shock induced changes in the risk of their production-investment strategy. In this way bondholders and stockholders equitably share the risk and return resulting from the business decisions put in place by their firms over the business cycle.

Abstract:
This paper presents a theory of corporate finance from the perspective of bondholders. Towards this end an equilibrium model of a debt and equity financed firm is developed that motivates the need for an upfront bond contract that solves an agency problem between bondholders and stockholders. This bond contract guides the firm towards a no arbitrage equilibrium by directing managers to make investment decisions conforming to the risk aversion of their shareholders and then make financing decisions that preserve the investment quality of their bonds. Empirical evidence on the investment and financing of nonfinancial corporations conform to the predictions of the model.

Covenants, Production - Investment Decisions, Financing Decisions, Security Markets, Business Cycles

Abstract:
This paper formulates and empirically tests a model that describes the balance sheet adjustments of debt and equity financed U.S. nonfinancial enterprises over the twentieth century. In this model asset adjustments change the expected income and operating risk of firms while financing adjustments change the financial risk. To protect debt and equity investors from a conflict of interest problem, an up-front contract develops an assignment rule for managing the firm's balance sheet. That assignment rule has managers making asset adjustment decisions that conform to changes in the risk aversion of their equity investors as revealed to them by changes in equity share prices. These asset adjustments by themselves and then through the production function cause business cycles. Financing adjustments are then made to insulate bondholders from changes in operating risk initiated by the investment decisions of firms. In this way the contract induced assignment rule resolves the conflict of interest problem between bondholders and stockholders and in the process coalesces their welfare over the business cycle. The model makes several important predictions about the balance sheet adjustments of firms. One prediction is that firms adjust their assets in response to changes in lagged stock prices as they proxy for changes in stockholder risk aversion. A second prediction of the model is that long-term financial leverage is countercyclical; i.e., an increase in risky capital investment that causes a cyclical expansion is financed with equity, while reductions in investment that cause a recession is supported with debt. These and other predictions of the model are not rejected by the intertemporal balance sheet data for U.S. nonfinancial enterprises over the twentieth century.

Business Cycles, Real Investments, Securities Markets, Corporate Finance

Abstract:
What factors cause banks to lend to the private sector in a bank-based financial system like the ones in place in Europe? In this paper we compare a traditional demand oriented model to a non-traditional capital budgeting model of bank lending based on movements in the equity cost of capital for banks in France, Germany, and the Euro area. Using non-nested hypothesis tests and omitted variables tests we find that we can reject the traditional demand oriented model of bank lending and fail to reject the capital budgeting model of bank lending for Monetary Financial Institutions in France and the Euro area. For Germany the evidence is mixed in that both models are rejected for Monetary Financial Institutions, but only the traditional demand oriented model is rejected for the commercial bank sector. Even though Europe may be a bank-based financial system, it appears the stock market plays a key role in the lending decisions of banks.

Bank Loans, Stock Market, Non-Nested Hypothesis Tests

Abstract:
This paper presents a model of the portfolio and financing adjustments of U.S. banks over the business cycle. At the core of the model is a moral hazard problem between depositors/bank regulators and stockholders. The solution to this problem takes the form of shared management of the bank. Stockholders manage the bank's portfolio and the regulator manages the financing of the portfolio. The model predicts that portfolio adjustments are made to conform to the risk aversion of shareholders and financing adjustments are made to offset changes in portfolio risk. Regression evidence for 1955-2000 fails to reject these predictions.

Banks, Business Cycles, Basle Accord, Finance

Abstract:
This paper presents a model of the portfolio and financing adjustments of U.S. banks over the business cycle. At the core of the model is a moral hazard problem between depositors/bank regulators and stockholders. The solution to this problem takes the form of shared management of the bank. Stockholders manage the bank's portfolio and the regulator manages the financing of the portfolio. The model predicts that portfolio adjustments are made to conform to the risk aversion of shareholders and financing adjustments are made to offset changes in portfolio risk. Regression evidence for 1955-2000 fails to reject these predictions.

Banks, Business Cycles, Basle Accord, Finance

Abstract:
Fifty years ago Milton Friedman published a book entitled A Program for Monetary Stability. In it he outlined a number of suggestions for the conduct of monetary and fiscal policies that he thought would contribute to monetary stability and pari passu to price stability and a greater degree of output/employment stability. In this paper I review some of his policy prescriptions in light of the financial and economic crisis of 2007-2009. From the perspective of financial development the world today is very different from the world that Friedman knew in the late 1950's. In what way would his policy recommendations have to be modified to account for these changes in financial development? We argue that his proposal for 100 percent reserves or narrow banking merits serious consideration in current policy discussions designed to stabilize the banking system. To stabilize asset markets we propose two very un-Friedman-like policies. The first is to reinstate selective credit controls in the areas of the stock market and the real estate market. The second policy designed to dampen excessive variability in the stock market is for the Central Bank to carry out some open market operations in one or more equity index funds.

Financial Stability, Narrow Banking, Open Market operations, Selective Credit Controls