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.

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

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

Response to reflected-force feedback to fingers in teleoperations

Reflected-force feedback is an important aspect of teleoperations. The objective is to determine the ability of the human operator to respond to that force. Telerobotics operation is simulated by computer control of a motor-driven device with capabilities for programmable force feedback and force measurement. A computer-controlled motor drive is developed that provides forces against the fingers as well as (angular) position control. A load cell moves in a circular arc as it is pushed by a finger and measures reaction forces on the finger. The force exerted by the finger on the load cell and the angular position are digitized and recorded as a function of time by the computer. Flexure forces of the index, long and ring fingers of the human hand in opposition to the motor driven load cell are investigated. Results of the following experiments are presented: (1) Exertion of maximum finger force as a function of angle; (2) Exertion of target finger force against a computer controlled force; and (3) Test of the ability to move to a target force against a force that is a function of position. Averaged over ten individuals, the maximum force that could be exerted by the index or long finger is about 50 Newtons, while that of the ring finger is about 40 Newtons. From the tests of the ability of a subject to exert a target force, it was concluded that reflected-force feedback can be achieved with the direct kinesthetic perception of force without the use of tactile or visual clues

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.

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