Andrew Winton - Academia.edu (original) (raw)

Papers by Andrew Winton

Social Science Research Network, Oct 26, 1999

Many financial claims specify fixed maximum payments, varying seniority, and absolute priority fo... more Many financial claims specify fixed maximum payments, varying seniority, and absolute priority for more senior investors. These features are motivated in a model where a firm's manager contracts with several investors and firm output can only be verified privately at a cost. Debt-like contracts of varying seniority generally dominate symmetric contracts, and, when investors are risk neutral, it is optimal to use debtlike contracts where more senior claims have absolute priority over more junior claims. In addition to motivating severalfeatures of debt and preferred stock, the model offers an explanation for structures used in leveraged buyouts, assetbacked securitizations, and reinsurance contracts. Although firms issue many different financial claims, three features are quite common. Many of these claims have contractually fixed maximum payments, debt and preferred stock being, obvious examples. Claims often vary in their degree of seniority, which specifies who is first entitled to full payment. Moreover, the contractual order of payments typically follows This article originally formed Chapter 2 of my Ph.D.

Social Science Research Network, 2000

A financial institution that finances and monitors firms learns private information about these f... more A financial institution that finances and monitors firms learns private information about these firms. When the institution seeks funds to meet its own liquidity needs, it faces adverse selection ("liquidity") costs that increase with the risk of its claims on these firms. The institution can reduce its liquidity costs by holding debt rather than equity. Because these costs are passed through to borrowers, firms that depend on monitored finance generally prefer to give the monitoring institution debt rather than equity; an exception is a limited setting resembling venture capital. Institutions with less frequent or less severe liquidity needs have greater appetite for equity and for the debt of more risky borrowers. These predictions are consistent with general patterns of monitored finance.

Social Science Research Network, 2006

We analyze how entrepreneurial firms choose between two funding institutions: banks, who monitor ... more We analyze how entrepreneurial firms choose between two funding institutions: banks, who monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital due to the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it, and aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when (1) the aggressive continuation strategy is not too profitable, ex-ante; (2) the firm faces high uncertainty in its choice of continuation strategy; and (3) the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists' cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.

The savings/investment process in capitalist economies is organized around financial intermediati... more The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years' of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Social Science Research Network, 2006

Modern corporate finance theory suggests that bank finance results in better monitoring of borrow... more Modern corporate finance theory suggests that bank finance results in better monitoring of borrowers, but that this leads to a significant cost: the private information that banks gain from monitoring lets them "hold-up" the borrowers for higher interest rates. In this paper, we seek empirical evidence for this information holdup effect through a novel approach. Since firms are in greater danger of failure during recessions, it follows that banks that have an exploitable information advantage should be able to raise their rates in recessions by more than is justified by borrower default risk alone. We test this by comparing the pricing of bank loans for bank-dependent borrowers with the pricing of bank loans for borrowers with access to public debt markets both in good and bad times, controlling for a number of loan-and firm-specific factors. Firms with public debt market access pay lower spreads on their bank loans, and spreads tend to rise in recessions, but spreads for firms with public debt market access rise significantly less in recessions. These findings are robust to a number of loan-and firm-specific controls, and to controls for endogeneity and selection concerns. Our findings suggest that, during recessions, banks do in fact charge higher rates to customers with limited outside funding options, and that the magnitude of this effect is economically significant.

Journal of Money, Credit and Banking, Jan 27, 2017

Bank regulation has increasingly focused on capital requirements as the primary means of ensuring... more Bank regulation has increasingly focused on capital requirements as the primary means of ensuring the "safety and soundness" of the banking system. We evaluate this policy approach by providing a theory of bank capital. Bank capital is beneficial because it reduces the chance of privately and socially costly bank failure. But it is both privately and socially costly because a system-wide increase in bank capital reduces the aggregate amount of bank deposits, which are an efficient medium of exchange, forcing consumers to hold more information-sensitive bank equity, which is a poor liquidity hedge. Recessions increase the risk and thus the information-sensitivity of bank equity, increasing the liquidity-related costs of additional bank capital. As a result, welfare-maximizing bank regulators may engage in "forbearance"-that is, they may optimally renege on previously tough policies. Private incentives to increase capital are even smaller than social incentives, which may further limit regulators' ability to raise capital standards. Social and private reluctance to increase capital in a recession may in turn cause a "credit crunch." JEL: G21, G28 Some of the ideas in this paper originated in an earlier draft entitled "Bank Capital Regulation in General Equilibrium." We are grateful to Ross Levine and Thorsten Beck for providing data, and to William

Social Science Research Network, 2012

This paper analyzes the determinants of the optimal scope of incorporation in the presence of ban... more This paper analyzes the determinants of the optimal scope of incorporation in the presence of bankruptcy costs. Bankruptcy costs alone generate a non-trivial tradeo¤ between the bene…t of coinsurance and the cost of risk contamination associated with …nancing projects jointly through debt. This tradeo¤ is characterized for projects with binary returns, depending on the distributional characteristics of returns (mean, variability, skewness, heterogeneity, correlation, and number of projects), the structure of the bankruptcy cost, and the tax advantage of debt relative to equity. Our predictions are broadly consistent with existing empirical evidence on conglomerate mergers, spin-o¤s, project …nance, and securitization.

RePEc: Research Papers in Economics, Dec 11, 2003

Firms sometimes commit fraud by altering publicly reported information to be more favorable, and ... more Firms sometimes commit fraud by altering publicly reported information to be more favorable, and investors can monitor firms to obtain more accurate information. We study equilibrium fraud and monitoring decisions. Fraud is most likely to occur in relatively good times, and the link between fraud and good times becomes stronger as monitoring costs decrease. Nevertheless, improving business conditions may sometimes diminish fraud. We provide an explanation for why fraud peaks towards the end of a boom and is then revealed in the ensuing bust. We also show that fraud can increase if firms make more information available to the public. We would like to thank an anonymous referee for very helpful comments. We are also indebted to

Social Science Research Network, Oct 10, 1998

Social Science Research Network, 2001

Because many financial institutions rely heavily on debt finance and have great flexibility in th... more Because many financial institutions rely heavily on debt finance and have great flexibility in their choice of investments, they may be tempted to exploit debt holders by taking on inefficient but risky investments. By "insulating" low-risk assets from high-risk assets, a two-subsidiary ("bipartite") structure where one subsidiary holds low-risk assets and the other holds high-risk assets reduces incentives to engage in riskshifting in the safer subsidiary. Nevertheless, the risky subsidiary may engage in limited risk-shifting, and the institution may engage in "cherry-picking," putting the most profitable high-risk assets in the safer subsidiary and replacing them with inefficient high-risk assets. A bipartite structure is most likely to dominate a unitary structure when risk differs greatly across assets. Our analysis also suggests that institutions may opt for multiple subsidiaries even though this does not appear to take full advantage of gains from diversification. These results help motivate a number of institutional arrangements, including the use of separate commercial bank and finance company subsidiaries, "good bank/bad bank" structures, securitization, and "swaps" subsidiaries.

SSRN Electronic Journal, 2016

In this paper, we study the optimal credit rating system in an economy where agents need to borro... more In this paper, we study the optimal credit rating system in an economy where agents need to borrow and have incentives to renege on debt repayments. We show that credit exclusion creates "soft"collateral in the form of a borrower's reputation. Compared with individual lending, bank lending reduces search frictions, which increases the cost of credit exclusion, boosts the value of soft collateral, and facilitates borrowing and lending. A dynamic rating system allows agents' ratings to migrate over time and …ne-tunes agents' incentives. By doing so, it reduces the agency cost, makes better use of soft collateral, and improves social welfare. We show that the optimal rating system is coarse, as we observe in the real world.

Social Science Research Network, 2009

After making a loan, a bank …nds out if the loan needs contract enforcement ("monitoring"); it al... more After making a loan, a bank …nds out if the loan needs contract enforcement ("monitoring"); it also decides whether to lay o¤ credit risk in order to release costly capital. A bank can lay o¤ credit risk by either selling the loan or by buying insurance through a credit default swap (CDS). With a CDS, the originating bank retains the loan's control rights but no longer has an incentive to monitor; with loan sales, control rights pass to the buyer of the loan, who can then monitor, albeit in a less-informed manner. In a single-period setting, for high levels of base credit risk, only loan sales are used in equilibrium; risk transfer is e¢ cient, but monitoring is excessive. For low levels of credit risk, equilibrium depends on the cost of capital shortfalls. When capital costs are low, only poor quality loans are sold or hedged; risk transfer is ine¢ cient, and monitoring may also be too low. When capital costs are high, CDS and loan sales can coexist, in which case risk transfer is e¢ cient but monitoring is too low. In both cases, if gains to monitoring are su¢ ciently high, the borrowing …rm may choose to borrow more than is needed to …nance itself so as to induce monitoring. Restrictions on the bank's ability to sell the loan expand the range where CDS are used and monitoring does not occur. In a repeated setting, reputation concerns may support e¢ cient outcomes where CDS are used and the bank still monitors. Because loan defaults trigger a return to ine¢ cient outcomes in the future, total e¢ ciency cannot be sustained inde…nitely. Reputational equilibria are most likely for …rms that have high base credit quality or for …rms where monitoring has a high impact on default probabilities.

SSRN Electronic Journal, 2022

Social Science Research Network, 2005

Despite operating under substantial regulatory constraints, we find that commercial banks manage ... more Despite operating under substantial regulatory constraints, we find that commercial banks manage their investments largely consistent with the predictions of portfolio choice models with capital market imperfections. Based on 1990-2002 data for small (assets less than $1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer sectors increased with expected sector profitability, tended to decrease with the illiquidity of existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns. Small banks are most appropriate for this study, because they make illiquid loans and manage risk via on-balance sheet (non-hedged) diversification strategies.

RePEc: Research Papers in Economics, 2004

Journal of Finance, Nov 12, 2015

Social Science Research Network, 1999

We show that exposure from past business transactions-risk overhang-can reduce activity in relate... more We show that exposure from past business transactions-risk overhang-can reduce activity in related business lines, sometimes to the point where no new trade occurs. We focus primarily on the role of overhang in nonlife insurance market disruptions. Our model predicts that the relative impact, duration, and character of supply disruptions are related to the extent of overhang. These predictions are consistent with differences between the mid-1980s liability insurance crisis and the early-1990s catastrophe reinsurance crisis. The overhang model predicts attributes of these crises that prior explanations relying on adverse selection do not. We also discuss applications of the overhang model to disruptions in lending and securities markets.

A number of financial institutions have two separate subsidiaries that make loans of similar type... more A number of financial institutions have two separate subsidiaries that make loans of similar type but differing risk. Common examples include bank holding companies that have both commercial bank and finance company subsidiaries, and “good bank/bad bank ” structures where the holding company retains ownership of both banks. Although one of the subsidiaries holds riskier loans than the other, such loan risk is difficult for outside investors to observe or verify ex ante. This raises the question of why these two activities are separately funded rather than being treated as separate divisions of a single corporation. We motivate the use of such “bipartite ” structures by appealing to the role of banks and similar institutions as delegated monitors. Because such institutions rely heavily on debt finance and have great flexibility in their choice and monitoring of loans, they may be tempted to exploit debt holders by risk-shifting: i.e., making inefficient risky loans or forgoing costly...

During the recent financial crisis, the notion of “tail risk”— exposure to very unlikely yet mass... more During the recent financial crisis, the notion of “tail risk”— exposure to very unlikely yet massive losses—rapidly became the foremost concern of regulators, banks, and other market participants alike. Perotti, Ratnovski, and Vlahu (this issue) analyze how the presence of such risks affects the relationship between bank capital and bank risk taking. With policymakers looking to revamp capital regulations so as to prevent a similar crisis from occurring, there is no question that this is a very timely paper indeed. Perotti, Ratnovski, and Vlahu argue that tail risk differs from the “normal ” risks modeled in the banking literature because it can wipe out any amount of bank capital. As a result, the presence of tail risk weakens the effectiveness of capital in reducing risk-shifting incentives. Moreover, when capital is costly to raise, the combina-tion of tail risk and less-catastrophic (“non-tail”) risk can compli-cate the relationship between capital and risk shifting, making it n...

A wealth-constrained entrepreneur seeks financing from a financial institution. Because the entre... more A wealth-constrained entrepreneur seeks financing from a financial institution. Because the entrepreneur has a greater preference for continuing the firm over liquidating it, and for aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. The institution's own liquidity concerns make it prefer less exposure to the firm's risk, subject to meeting its incentive and break-even constraints. The optimal contract is either debt or convertible debt; moreover, for firms with limited financial slack, convertible debt is only used if the institution monitors more actively, and debt is used otherwise. Convertible debt and active monitoring are more likely to be optimal if: (1) the firm faces greater uncertainty in its choice of continuation strategies; (2) the aggressive continuation strategy is not too profitable on average; and (3) the firm's cash flow distribution is more skewed, with...

Social Science Research Network, Oct 26, 1999

Many financial claims specify fixed maximum payments, varying seniority, and absolute priority fo... more Many financial claims specify fixed maximum payments, varying seniority, and absolute priority for more senior investors. These features are motivated in a model where a firm's manager contracts with several investors and firm output can only be verified privately at a cost. Debt-like contracts of varying seniority generally dominate symmetric contracts, and, when investors are risk neutral, it is optimal to use debtlike contracts where more senior claims have absolute priority over more junior claims. In addition to motivating severalfeatures of debt and preferred stock, the model offers an explanation for structures used in leveraged buyouts, assetbacked securitizations, and reinsurance contracts. Although firms issue many different financial claims, three features are quite common. Many of these claims have contractually fixed maximum payments, debt and preferred stock being, obvious examples. Claims often vary in their degree of seniority, which specifies who is first entitled to full payment. Moreover, the contractual order of payments typically follows This article originally formed Chapter 2 of my Ph.D.

Social Science Research Network, 2000

A financial institution that finances and monitors firms learns private information about these f... more A financial institution that finances and monitors firms learns private information about these firms. When the institution seeks funds to meet its own liquidity needs, it faces adverse selection ("liquidity") costs that increase with the risk of its claims on these firms. The institution can reduce its liquidity costs by holding debt rather than equity. Because these costs are passed through to borrowers, firms that depend on monitored finance generally prefer to give the monitoring institution debt rather than equity; an exception is a limited setting resembling venture capital. Institutions with less frequent or less severe liquidity needs have greater appetite for equity and for the debt of more risky borrowers. These predictions are consistent with general patterns of monitored finance.

Social Science Research Network, 2006

We analyze how entrepreneurial firms choose between two funding institutions: banks, who monitor ... more We analyze how entrepreneurial firms choose between two funding institutions: banks, who monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital due to the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it, and aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when (1) the aggressive continuation strategy is not too profitable, ex-ante; (2) the firm faces high uncertainty in its choice of continuation strategy; and (3) the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists' cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.

The savings/investment process in capitalist economies is organized around financial intermediati... more The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years' of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Social Science Research Network, 2006

Modern corporate finance theory suggests that bank finance results in better monitoring of borrow... more Modern corporate finance theory suggests that bank finance results in better monitoring of borrowers, but that this leads to a significant cost: the private information that banks gain from monitoring lets them "hold-up" the borrowers for higher interest rates. In this paper, we seek empirical evidence for this information holdup effect through a novel approach. Since firms are in greater danger of failure during recessions, it follows that banks that have an exploitable information advantage should be able to raise their rates in recessions by more than is justified by borrower default risk alone. We test this by comparing the pricing of bank loans for bank-dependent borrowers with the pricing of bank loans for borrowers with access to public debt markets both in good and bad times, controlling for a number of loan-and firm-specific factors. Firms with public debt market access pay lower spreads on their bank loans, and spreads tend to rise in recessions, but spreads for firms with public debt market access rise significantly less in recessions. These findings are robust to a number of loan-and firm-specific controls, and to controls for endogeneity and selection concerns. Our findings suggest that, during recessions, banks do in fact charge higher rates to customers with limited outside funding options, and that the magnitude of this effect is economically significant.

Journal of Money, Credit and Banking, Jan 27, 2017

Bank regulation has increasingly focused on capital requirements as the primary means of ensuring... more Bank regulation has increasingly focused on capital requirements as the primary means of ensuring the "safety and soundness" of the banking system. We evaluate this policy approach by providing a theory of bank capital. Bank capital is beneficial because it reduces the chance of privately and socially costly bank failure. But it is both privately and socially costly because a system-wide increase in bank capital reduces the aggregate amount of bank deposits, which are an efficient medium of exchange, forcing consumers to hold more information-sensitive bank equity, which is a poor liquidity hedge. Recessions increase the risk and thus the information-sensitivity of bank equity, increasing the liquidity-related costs of additional bank capital. As a result, welfare-maximizing bank regulators may engage in "forbearance"-that is, they may optimally renege on previously tough policies. Private incentives to increase capital are even smaller than social incentives, which may further limit regulators' ability to raise capital standards. Social and private reluctance to increase capital in a recession may in turn cause a "credit crunch." JEL: G21, G28 Some of the ideas in this paper originated in an earlier draft entitled "Bank Capital Regulation in General Equilibrium." We are grateful to Ross Levine and Thorsten Beck for providing data, and to William

Social Science Research Network, 2012

This paper analyzes the determinants of the optimal scope of incorporation in the presence of ban... more This paper analyzes the determinants of the optimal scope of incorporation in the presence of bankruptcy costs. Bankruptcy costs alone generate a non-trivial tradeo¤ between the bene…t of coinsurance and the cost of risk contamination associated with …nancing projects jointly through debt. This tradeo¤ is characterized for projects with binary returns, depending on the distributional characteristics of returns (mean, variability, skewness, heterogeneity, correlation, and number of projects), the structure of the bankruptcy cost, and the tax advantage of debt relative to equity. Our predictions are broadly consistent with existing empirical evidence on conglomerate mergers, spin-o¤s, project …nance, and securitization.

RePEc: Research Papers in Economics, Dec 11, 2003

Firms sometimes commit fraud by altering publicly reported information to be more favorable, and ... more Firms sometimes commit fraud by altering publicly reported information to be more favorable, and investors can monitor firms to obtain more accurate information. We study equilibrium fraud and monitoring decisions. Fraud is most likely to occur in relatively good times, and the link between fraud and good times becomes stronger as monitoring costs decrease. Nevertheless, improving business conditions may sometimes diminish fraud. We provide an explanation for why fraud peaks towards the end of a boom and is then revealed in the ensuing bust. We also show that fraud can increase if firms make more information available to the public. We would like to thank an anonymous referee for very helpful comments. We are also indebted to

Social Science Research Network, Oct 10, 1998

Social Science Research Network, 2001

Because many financial institutions rely heavily on debt finance and have great flexibility in th... more Because many financial institutions rely heavily on debt finance and have great flexibility in their choice of investments, they may be tempted to exploit debt holders by taking on inefficient but risky investments. By "insulating" low-risk assets from high-risk assets, a two-subsidiary ("bipartite") structure where one subsidiary holds low-risk assets and the other holds high-risk assets reduces incentives to engage in riskshifting in the safer subsidiary. Nevertheless, the risky subsidiary may engage in limited risk-shifting, and the institution may engage in "cherry-picking," putting the most profitable high-risk assets in the safer subsidiary and replacing them with inefficient high-risk assets. A bipartite structure is most likely to dominate a unitary structure when risk differs greatly across assets. Our analysis also suggests that institutions may opt for multiple subsidiaries even though this does not appear to take full advantage of gains from diversification. These results help motivate a number of institutional arrangements, including the use of separate commercial bank and finance company subsidiaries, "good bank/bad bank" structures, securitization, and "swaps" subsidiaries.

SSRN Electronic Journal, 2016

In this paper, we study the optimal credit rating system in an economy where agents need to borro... more In this paper, we study the optimal credit rating system in an economy where agents need to borrow and have incentives to renege on debt repayments. We show that credit exclusion creates "soft"collateral in the form of a borrower's reputation. Compared with individual lending, bank lending reduces search frictions, which increases the cost of credit exclusion, boosts the value of soft collateral, and facilitates borrowing and lending. A dynamic rating system allows agents' ratings to migrate over time and …ne-tunes agents' incentives. By doing so, it reduces the agency cost, makes better use of soft collateral, and improves social welfare. We show that the optimal rating system is coarse, as we observe in the real world.

Social Science Research Network, 2009

After making a loan, a bank …nds out if the loan needs contract enforcement ("monitoring"); it al... more After making a loan, a bank …nds out if the loan needs contract enforcement ("monitoring"); it also decides whether to lay o¤ credit risk in order to release costly capital. A bank can lay o¤ credit risk by either selling the loan or by buying insurance through a credit default swap (CDS). With a CDS, the originating bank retains the loan's control rights but no longer has an incentive to monitor; with loan sales, control rights pass to the buyer of the loan, who can then monitor, albeit in a less-informed manner. In a single-period setting, for high levels of base credit risk, only loan sales are used in equilibrium; risk transfer is e¢ cient, but monitoring is excessive. For low levels of credit risk, equilibrium depends on the cost of capital shortfalls. When capital costs are low, only poor quality loans are sold or hedged; risk transfer is ine¢ cient, and monitoring may also be too low. When capital costs are high, CDS and loan sales can coexist, in which case risk transfer is e¢ cient but monitoring is too low. In both cases, if gains to monitoring are su¢ ciently high, the borrowing …rm may choose to borrow more than is needed to …nance itself so as to induce monitoring. Restrictions on the bank's ability to sell the loan expand the range where CDS are used and monitoring does not occur. In a repeated setting, reputation concerns may support e¢ cient outcomes where CDS are used and the bank still monitors. Because loan defaults trigger a return to ine¢ cient outcomes in the future, total e¢ ciency cannot be sustained inde…nitely. Reputational equilibria are most likely for …rms that have high base credit quality or for …rms where monitoring has a high impact on default probabilities.

SSRN Electronic Journal, 2022

Social Science Research Network, 2005

Despite operating under substantial regulatory constraints, we find that commercial banks manage ... more Despite operating under substantial regulatory constraints, we find that commercial banks manage their investments largely consistent with the predictions of portfolio choice models with capital market imperfections. Based on 1990-2002 data for small (assets less than $1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer sectors increased with expected sector profitability, tended to decrease with the illiquidity of existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns. Small banks are most appropriate for this study, because they make illiquid loans and manage risk via on-balance sheet (non-hedged) diversification strategies.

RePEc: Research Papers in Economics, 2004

Journal of Finance, Nov 12, 2015

Social Science Research Network, 1999

We show that exposure from past business transactions-risk overhang-can reduce activity in relate... more We show that exposure from past business transactions-risk overhang-can reduce activity in related business lines, sometimes to the point where no new trade occurs. We focus primarily on the role of overhang in nonlife insurance market disruptions. Our model predicts that the relative impact, duration, and character of supply disruptions are related to the extent of overhang. These predictions are consistent with differences between the mid-1980s liability insurance crisis and the early-1990s catastrophe reinsurance crisis. The overhang model predicts attributes of these crises that prior explanations relying on adverse selection do not. We also discuss applications of the overhang model to disruptions in lending and securities markets.

A number of financial institutions have two separate subsidiaries that make loans of similar type... more A number of financial institutions have two separate subsidiaries that make loans of similar type but differing risk. Common examples include bank holding companies that have both commercial bank and finance company subsidiaries, and “good bank/bad bank ” structures where the holding company retains ownership of both banks. Although one of the subsidiaries holds riskier loans than the other, such loan risk is difficult for outside investors to observe or verify ex ante. This raises the question of why these two activities are separately funded rather than being treated as separate divisions of a single corporation. We motivate the use of such “bipartite ” structures by appealing to the role of banks and similar institutions as delegated monitors. Because such institutions rely heavily on debt finance and have great flexibility in their choice and monitoring of loans, they may be tempted to exploit debt holders by risk-shifting: i.e., making inefficient risky loans or forgoing costly...

During the recent financial crisis, the notion of “tail risk”— exposure to very unlikely yet mass... more During the recent financial crisis, the notion of “tail risk”— exposure to very unlikely yet massive losses—rapidly became the foremost concern of regulators, banks, and other market participants alike. Perotti, Ratnovski, and Vlahu (this issue) analyze how the presence of such risks affects the relationship between bank capital and bank risk taking. With policymakers looking to revamp capital regulations so as to prevent a similar crisis from occurring, there is no question that this is a very timely paper indeed. Perotti, Ratnovski, and Vlahu argue that tail risk differs from the “normal ” risks modeled in the banking literature because it can wipe out any amount of bank capital. As a result, the presence of tail risk weakens the effectiveness of capital in reducing risk-shifting incentives. Moreover, when capital is costly to raise, the combina-tion of tail risk and less-catastrophic (“non-tail”) risk can compli-cate the relationship between capital and risk shifting, making it n...

A wealth-constrained entrepreneur seeks financing from a financial institution. Because the entre... more A wealth-constrained entrepreneur seeks financing from a financial institution. Because the entrepreneur has a greater preference for continuing the firm over liquidating it, and for aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. The institution's own liquidity concerns make it prefer less exposure to the firm's risk, subject to meeting its incentive and break-even constraints. The optimal contract is either debt or convertible debt; moreover, for firms with limited financial slack, convertible debt is only used if the institution monitors more actively, and debt is used otherwise. Convertible debt and active monitoring are more likely to be optimal if: (1) the firm faces greater uncertainty in its choice of continuation strategies; (2) the aggressive continuation strategy is not too profitable on average; and (3) the firm's cash flow distribution is more skewed, with...