Bank equity stakes in borrowing firms and financial distress

The authors derive optimal financial claim for a bank when the borrowing firm's uninformed stakeholders depend on the bank to establish whether the firm is distressed and whether concessions by stakeholders are necessary. The bank's financial claim is designed to ensure that it cannot collude with a healthy firm's owners to seek unnecessary concessions or to collude with a distressed firm's owners to claim that the firm is healthy. To prove that a request for concessions has not come from a healthy firm/bank coalition, the bank must hold either a very small or a very large equity stake when the firm enters distress. To prove that a distressed firm and the bank have not colluded to claim that the firm is healthy, the bank may need to hold equity under routine financial conditions.Bank loans ; Bank investments ; Investments

DESIGN OF CORPORATE GOVERNANCE: Role of Ownership Structure, Takeovers, and Bank Debt

We examine how different economies would design an optimal corporate governance system structured from three of the main mechanisms of corporate governance (managerial ownership, monitoring by banks, and disciplining by the takeover market). We allow for interactions among the mechanisms. The first set of results characterizes the combination of governance mechanisms that can appear in any optimally designed structure: 1) when monitored debt appears in an optimal system it is accompanied by concentrated ownership, and 2) when takeovers appear in an optimal system they are accompanied by diffuse ownership. We show that out of the numerous governance structures that could arise from combinations of the governance mechanisms, only three are candidates for an optimal system. These three endogenously derived governance structures match the prevalent systems (family based, bank based and market based) in the world. The optimal system for a given economy is characterized as a function of the degrees of development of its financial institutions and markets. Our analysis yields several testable implications

Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse riskshifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers’s underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equityholder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. With risky debt outstanding, the shareholders of a firm with illiquid growth opportunities may optimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm’s future economic rents. The paper models the firm’s risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multiperiod perspective in Corporate Finance, while retaining the parsimony and elegance of finite-period settings

Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse risk shifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers’s underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equity holder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. With risky debt outstanding, the shareholders of a firm with illiquid growth opportunities may optimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm’s future economic rents. The paper models the firm’s risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multi period perspective in Corporate Finance, while retaining the parsimony and elegance of finite period settings

Temporal Resolution of Uncertainty, the Investment Policy of Levered Firms and Corporate Debt Yields

This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm’s operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed

Interactions with Frontiers of Financial Economic — A Research Agenda for Real Estate Finance

[Excerpt] Recent years have seen the emergence of substantial scholarly research in real estate finance that uses the methodology and paradigms at the frontiers of financial economics. Agency theory, search theory, and signaling have appeared in several models of real estate finance (see, for example, Damodaran, John, and Liu, 1998; Damodaran and Liu, 1993; Williams, 1993a, 1993b, 1995, 1998). Continuous time-valuation models of financial options, real options, and fixed-income securities and term structure models have also been applied in a number of papers on the pricing of mortgage-backed securities with and without sophisticated prepayment structures (for example, see Dunn and Spatt, 1985, 1986; Grenadier, 1995, 1996; John, Liu, and Radhakrishnan, 1997; Stanton and Wallace, 1998; Williams, 1993a, 1993b, 1997). Paradigms of securitization and optimal design of securities and organizational forms have also made their appearance in recent real estate research (see, for example, DeMarzo and Duffie, 1998; DeMarzo, 1998; Shiller andWeiss, 1998; Damodaran, John, and Liu, 1997). The objective of this special issue is to showcase some of this research in real estate and explore additional paradigms in financial economics that would provide the framework for interesting and innovative real estate research

Margin Rules, Informed Trading in Derivatives, and Price Dynamics

We analyze the impact of option trading and margin rules on the behavior of informed traders and on the micro structure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size

Corporate Governance and Managerial Risk Taking: Theory and Evidence

We study how the investor protection environment affects corporate managers’ incentives to take value-enhancing risks. In our model, the manager chooses higher perk consumption when investor protection is low. Since perks represent a priority claim held by the manager, lower investor protection leads the manager to implement a sub-optimally conservative investment policy, effectively aligning her risk-taking incentives with those of the debt holders. By the same token, higher investor protection is associated with riskier investment policy and faster firm growth. We test these predictions in a large Global Vantage panel. We find strong empirical confirmation that corporate risk-taking and firm growth rates are positively related to the quality of investor protection

Incentive Features in CEO Compensation: The Role of Regulation and Monitored Debt

We study CEO compensation in the banking industry by taking into account banks’ unique claim structure in the presence of two types of agency problems: the standard managerial agency problem as well as the risk-shifting problem between shareholders and debtholders. We empirically test two hypotheses derived from this framework: (1) the pay-for-performance sensitivity of bank CEO compensation decreases with the total leverage ratio; and (2) the pay-for- performance sensitivity of bank CEO compensation increases with the intensity of monitoring provided by regulators and nondepository (subordinated) debtholders. We construct an index of the intensity of outsider monitoring based on four variables: subordinated debt ratio, subordinated debt rating, non performing loan ratio and BOPEC rating assigned by regulators. We find supporting evidence for both hypotheses. Our results hold after controlling for the endogeneity among compensation, leverage and monitoring. They are robust to various regression specifications and sample criteria

Privatization with Political Constraints: Auctions versus Private Negotiations

This paper investigates the design of privatization mechanisms in emerging market economies characterized by political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparently suboptimal privatization mechanism: private negotiations. We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, then privatization auctions and private negotiations are equally successful in raising public revenues. If, however, political constraints distort the agent’s incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprise than privatization auctions. In this case the agent may play favorites among the bidders, but to the extent he cares about the price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fair price for the company, then privatization auctions will outperform private egotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In an auction, in contrast, the presence of other bidders, regardless how informed they are, induces competition and places a lower bound on the equilibrium winning bid. We also show that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of non-colluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies