Why Do Firms Smooth Earnings?

We explain why a firm may smooth reported earnings. Greater earnings volatility leads to a bigger informational advantage for informed investors over uninformed investors. If sufficiently many current shareholders are uninformed and may need to trade in the future for liquidity reasons, an increase in the volatility of reported earnings will magnify these shareholders' trading losses. They will, therefore, want the manager to smooth reported earnings as much as possible. Empirical implications are drawn out that link earnings smoothing to managerial compensation contracts, uncertainty about the volatility of earnings, and ownership structure.

Banking stability, reputational rents, and the stock market: should bank regulators care about stock prices?

In this paper I begin with a model that generates quantity credit rationing by banks in the spot credit market when the stock market is not doing well, i.e., asset prices are low. Then I provide a theoretical rationale for a bank loan commitment as partial insurance against such future rationing. Incorporating uncertainty about both the creditworthiness of borrowers and the abilities of banks to screen borrowers, I show that the reputational concerns of banks can lead to an equilibrium in which loan commitments serve their role in increasing the supply of credit relative to the spot credit market, but produce the inefficiency of excessive credit supply when the stock market is doing well. Despite this, welfare is higher with loan commitments than with spot credit. ; I use this result to then examine whether the level of the stock market--and more generally asset prices--should matter to bank regulators. My analysis suggests that it should, but not for the usual reason that a bull stock market could trigger inflation. Rather, it is because reputation-concerned banks lend too much during bull markets, leading to a worsening of credit quality and a higher liability for the federal deposit insurer. More stringent stock market information disclosure rules tend to attenuate this distortion and thus deserve consideration by bank regulators. A regulatory policy implication of the analysis is that regulation should be "state-contingent"--regulatory auditing of bank asset portfolios should be more stringent during bull stock markets, or asset pricing bubbles.Risk management ; Stock market

Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting

Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient “pet” projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund correlated assets. A minimum equity capital requirement can rule out asset substitution but also compromises market discipline by making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors upon failure, and be available to shareholders only contingent on good performance.Bank capital ; Moral hazard ; Systemic risk

Competitive Equilibrium in the Credit Market under Asymmetric Information

We study a competitive credit market equilibrium in which all agents are risk neutral and lenders a priori unaware of borrowers' default probabilities. Admissible credit contracts are characterized by the credit granting probability, the loan quantity, the loan interest rate and the collateral required. The principal result is that in equilibrium lower risk borrowers pay higher interest rates than higher risk borrowers; moreover, the lower risk borrowers get more credit in equilibrium than they would with full information. No credit is rationed and collateral requirements are higher for the lower risk borrowers.

Incentives to innovate and financial crises

a b s t r a c t In this paper I develop a model of a competitive financial system with unrestricted but costly entry and an endogenously determined number of competing financial institutions (''banks'' for short). Banks can make standard loans on which plentiful historical data are available and unanimous agreement exists on default probabilities. Or banks can innovate and make new loans on which limited historical data are available, leading to possible disagreement over default probabilities. In equilibrium, banks make zero profits on standard loans and positive profits on innovative loans, which engenders innovation incentives for banks. But innovation brings with it the risk that investors could disagree with the bank that the loan is worthy of continued funding and hence could withdraw funding at an interim stage, precipitating a financial crisis. The degree of innovation in the financial system is determined by this trade-off. Welfare implications of financial innovation and mechanisms to reduce the probability of crises are discussed

Disagreement and Flexibility: A Theory of Optimal Security Issuance and Capital Structure

In this paper we introduce flexibility as an economic concept and apply it to the firm’ssecurity issuance decision and capital structure choice. Flexibility is the ability to makedecisions that one thinks are best even when others disagree. The firm’s management valuesflexibility because it allows management to make decisions it believes are best forshareholders without being blocked by dissenters. The amount of flexibility management has atany point in time depends on how the firm is financed. Debt offers little flexibility relativeto equity. However, the flexibility offered by equity depends on the extent to whichshareholders are inclined to agree with management’s strategic choices. Equity offers thegreatest flexibility when the propensity for shareholder agreement is the highest. It turnsout that the firm’s stock price is also increasing in shareholders’ propensity to agree withmanagement. Thus, the flexibility benefit of equity is high only when the sh!are price is high. The firm’s optimal security-issuance choice trades off the flexibilitybenefit of equity against the now-familiar debt tax shield, and the firm’s capital structure isthe consequence of a sequence of past security-issuance choices. The strongest implication ofthis theory of capital structure evolution is that optimal capital structure is essentiallydynamic, and depends on the firm’s stock price, implying that firms issue equity when stockprices are high and debt when stock prices are low. The theory explains many stylized factsthat fly in the face of existing capital structure theories and also generates new testablepredictions. Moreover, the theory can rationalize the use of debt in the absence of taxes,agency costs or signaling considerations

Information, Investment Horizon, and Price Reactions

This paper studies the dynamic investment policies of firms under asymmetric information. Managers make decisions to maximize the wealth of existing shareholders. In equilibrium, the superior firms invest 'myopically', choosing intrinsically lower-valued projects that produce 'early' cash flows. The inferior firms follow the socially preferred rule of investing in intrinsically higher-valued projects that product 'late' cash flows. In addition to explaining investment myopia, the model generates numerous predictions regarding announcement effects of equity issues and attempts by firms to stockpile cash, firms' preferences for limits on mandatory disclosure rules, and the effects of managerial entrenchment motives.

The economics of bank regulation

The object of this paper is to survey and synthesize the literature on the regulation of financial intermediaries, including the theoretical framework and also the applied literature on specific regulations such as deposit insurance, capital controls, line of business restrictions, etc

The Valuation of Assets under Moral Hazard

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of manages can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.