Corporate Control, Portfolio Choice, and the Decline of Banking

The authors focus on the persistence of bank unprofitability during the 1980s. A large literature in banking, following Merton (1977), concentrates on the incentives of shareholders to maximize the value of the (fixed rate) deposit insurance subsidy provided by the government by taking on risk inefficiently, so called moral hazard' risk. This paper takes issue with this moral hazard explanation for the performance of the banking industry. The moral hazard view assumes that shareholders make the lending decisions and can take on risk to maximize the value of insurance if they desire. The authors assume bank managers, who may own a fraction of the bank, make the lending decisions. If managers have different objectives than outside shareholders and disciplining in managers is costly, then managerial decisions may be at odds with the decisions outside shareholders would like them to take. When investment opportunities are declining, managers behave differently than in healthy' industries. This is particularly true in banking, where asymmetric information and deposit insurance allow banks resources to invest even if there are few good lending opportunities. The risk-avoiding behavior of managers stressed in the corporate finance literature presumes that conservative behavior is sufficient for job and perquisite preservation. When bad managers predominate, conservative behavior may not allow most managers to keep their jobs and perquisites. These managers may find it optimal to take excessively risky actions. The paper sets out a game between a bank manager and shareholders and solves for a sequential Nash equilibrium. A bank manager chooses either risky or safe loans based on the quality of the loan opportunities available to the manager (the manager s type). The choice of loan portfolios is observed by shareholders, but the manager s type is not. If the manager is fired, shareholders decide whether to invest in new bank assets (hire a new manager) or move their capital out of banking (liquidate capital). In any period that they are employed, managers receive a private benefit. Using data on the equity ownership structure of large bank holding companies, the authors test the predictions of the corporate control model of banking against an alternative model based on moral hazard problems between banks and regulators. With respect to the choice of loans made, the authors findings are consistent with corporate control problems playing an important role, but are inconsistent with moral hazard playing a dominant role in banking. None of the results are what a moral hazard model would predict. However, the analysis is done for adequately-capitalized banks. Thus, if the value of bank equity is low enough, the interests of inside and outside owners are aligned, so there are no corporate control problems of the sort modeled by the authors. It may be accurate to say that, for large U.S. banks, corporate control problems have been the cause of the conditions of which moral hazard may be an accurate characterization. The presence of agency costs suggests that the underlying trends that reduced profitability in the 1980s may persist, despite high bank earnings in the early 1990s. That banking is regulated does not appear to be a sufficient countervailing force. To the extent that chartered banks must transform themselves into nonbanks as they seek nonlending and deposit-taking activities which are profitable, the authors suggest that banking' is in decline. Their conclusions concern the difficulties that outside equityholders face during the transition period.

Bank Credit Cycles

Private information about prospective borrowers produced by a bank can affect rival lenders due to a "winner%u2019s curse" effect. Strategic interaction between banks with respect to the intensity of costly information production results in endogenous credit cycles, periodic "credit crunches." Empirical tests are constructed based on parameterizing public information about relative bank performance that is at the root of banks%u2019 beliefs about rival banks%u2019 behavior. Consistent with the theory, we find that the relative performance of rival banks has predictive power for subsequent lending in the credit card market, where we can identify the main competitors. At the macroeconomic level, we show that the relative bank performance of commercial and industrial loans is an autonomous source of macroeconomic fluctuations. We also find that the relative bank performance is a priced risk factor for both banks and nonfinancial firms. The factor-coefficients for non-financial firms are decreasing with size.

Air Transport and EC Competition Law

This Essay is about air transport and EC competition Law. The air transport industry has, in many countries, developed as a mixture of public utility and commercial venture. With the deregulation of the airline market, the EC Commission has also, to an increasing extent, become involved in the competition aspects of the airline industry. Part I deals with the transportation industry. Part II discusses liberalization within the EC. Finally, Part III deals with competition rules

Class Struggle Inside the Firm: A Study of German Codetermination

Who should control the firm? What should be the firm's objective function? If contracts are incomplete, then the group of input providers that most needs their interests protected should be allocated control rights to the firm. Existing theories argue that the suppliers of capital are most in need of protection. We empirically assess this answer by examining the German system of codetermination,' a governance system under which employees are allocated some control rights over corporate assets by law. Codetermination laws require that employees be represented on the (supervisory) board of directors. If codetermination sufficiently empowers employees, and if stockholders' rights cannot be contractually protected, then employees may redistribute the firm's surplus towards themselves. In addition, if employee interests are not contractually protected, then employees' may prefer a different objective function for the firm. For example, employees may hamper capitalist flexibility by resisting restructuring of the firm if that would jeopardize their human capital. We examine this with particular reference to the unification of East Germany and West Germany, a shock that may have caused employees in the former West to resist restructuring; the more so in codetermined firms. We also examine whether shareholders respond to codetermination with more concentrated block holdings, perhaps increasing their bargaining power with employees, or with higher leverage, committing more cash to leave the firm. Finally, we examine the relationship between codetermination and the performance sensitivity of compensation for board members.

Liquidity, Efficiency and Bank Bailouts

Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ( liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

Blockholder Identity, Equity Ownership Structures and Hostile Takeovers

We determine firms' equity ownership structures and provide a theory of hostile takeovers by distinguishing the roles of two types of blockholders: rich investors and institutional investors. We also distinguish the roles of two types of stock markets: the block market and the market with small investors. Rich investors have their own money at stake while institutional investors are run by proffessional managers and hence face agency conflicts. Because rich investors face no agency problems they are better at monitoring managers. If their wealth is insufficient to control all corporations, then "agency-cost free" capital is scarce. We investigate the allocation of this scarce resource. A hostile takeover is the consequence of a state-contingent allocation of agency-cost free capital. We show that only rich investors engage in hostile takeovers. Institutional investors instead are either permanent blockholding monitors or facilitate takeovers by selling blocks to rich investors. Even though all firms are ex ante identical, some may rely on the takeover mechanism while others rely on permanent institutional monitoring. We characterize the ownership structure of firms showing, in particular, that (ex ante) identical firms can have different ownership structures. Some can have initially dispersed ownership while others have an institutional blockholder.

Haircuts

“When confidence is lost, liquidity dries up.” The authors investigate the meaning of “confidence” and “liquidity” in the context of the recent financial crisis, which they maintain is a manifestation of an age-old problem with private money creation: banking panics. The authors explain this problem and provide some evidence with respect to the recent crisis.Bank liquidity ; Financial crises