Firms as clubs in Walrasian markets with private information
Using private information and club theories, this paper develops a theory of firms in general equilibrium. Firms are defined to be assignments of technologies and agents to clubs. In equilibrium, firms form endogenously and multiple types may co-exist. We formulate the general equilibrium problem as both a Pareto program and as a competitive equilibrium. Welfare and existence theorems are provided. In the competitive equilibrium, club memberships are priced and purchased, so the market determines which organizations exist as well as who is a member. Pareto optima and competitive equilibria of ...
Incentives, communication, and payment instruments
Alternative payment instruments are studied in an economy with private information, delayed communication, and limited commitment. Attention is restricted to checks and bank drafts, which differ in resource cost and communication characteristics. Checks are less costly but settlement delays create a limited commitment constraint. We find that drafts dominate at low wealths and checks at higher wealths. Applications to 19th century and modern payment systems are discussed.
Bank capital regulation with and without state-contingent penalties
A moral hazard model with exogenous bank franchise value is used to analyze bank capital regulation. Banks choose their capital structure as well as the riskiness and mean of their portfolio. The portfolio mean is determined by the level of costly screening. Screening and portfolio risk are private information, so there are two dimensions to the moral hazard problem. Deposit insurance gives banks an incentive to hold less capital, and to choose a higher-risk, lower-mean portfolio. To mitigate these incentives, capital requirements with and without ex post fines are studied. We find an ...
Should bank supervisors disclose information about their banks?
Bank supervisors spend a great deal of resources collecting information on banks, information that would be useful to investors and other market participants. Given that duplicating these efforts is expensive, why not require bank supervisors to disclose this information? In this article, the author argues that this type of disclosure makes it more expensive for supervisors to collect the information in the first place. Furthermore, existing regulatory rules forbid banks from releasing the results of their supervisory exam. The author shows that there are good reasons for these rules because ...
Using Economic Experiments to Improve Contingent Convertible Capital Bonds
This Commentary describes experiments conducted to study alternative designs for a new type of financial security, CoCo bonds, that is being used in some European countries to manage the risk of financial crises. CoCo bonds are bank-issued debt that converts to equity when a trigger is breached. The conversion into equity serves to recapitalize a bank during financial distress, precisely when it is hardest to raise capital. The types of trigger used for all CoCos issued thus far are defined in terms of book capital. The experiments we conducted explore the effects of using triggers that are ...
Banker Compensation, Relative Performance, and Bank Risk
A multi-agent, moral-hazard model of a bank operating under deposit insurance and limited liability is used to analyze the connection between compensation of bank employees (below CEO) and bank risk. Limited liability with deposit insurance is a force that distorts effort down. However, the need to increase compensation to risk-averse employees in order to compensate them for extra bank risk is a force that reduces this effect. Optimal contracts use relative performance and are implementable as a wage with bonuses tied to individual and firm performance. The connection between pay for ...
Did Banking Reforms of the Early 1990s Fail? Lessons from Comparing Two Banking Crises
New Richmond Fed research on community and midsize banks evaluates the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and Basel I by comparing failures in the 1986-92 period to those in 2007-13. Banks greatly increased commercial real estate lending between the two banking crises, but higher capital mitigated this risk. Failure rates in the recent crisis were mainly driven by the severity of the economic shocks. However, higher capital did not help contain FDIC losses, which were much larger in the recent crisis. One possible explanation is limitations in the accounting ...
The Financial Crisis, the Collapse of Bank Entry, and Changes in the Size Distribution of Banks
We document the effects of the recent financial crisis on the size distribution of U.S. commercial banks. There was a 14 percent drop in the number of banks from 2007 to 2013. Proportionally, the largest declines were to the smallest banks, those with less than $100 million in assets. This drop in the number of small banks is not due to bank failures. Despite the severity of the crisis, the rate at which a bank exits the industry, either due to failure or acquisition, is similar to that before the crisis. We show that there has been very little entry into banking since the crisis and that ...
State-contingent bank regulation with unobserved actions and unobserved characteristics
This paper studies bank regulation in the presence of deposit insurance, where banks have private information on their own ability and their investment strategy. Banks choose the mean and variance of their portfolio return. Regulators wish to control banks' risk choice, even though all agents are risk neutral and there are no deadweight costs of bank failure, because high risk adversely affects banks' ex ante incentives along other dimensions. Regulatory tools studied are capital requirements and return-contingent fines. Regulators can seek to separate bank types by offering a menu of ...
Market-based regulation and the informational content of prices
Various laws and policy proposals call for regulators to make use of the information reflected in market prices. We focus on a leading example of such a proposal, namely that bank supervision should make use of the market prices of traded bank securities. We study the theoretical underpinnings of this proposal in light of a key problem: if the regulator uses market prices, prices adjust to reflect this use and potentially become less revealing. We show that the feasibility of this proposal depends critically on the information gap between the market and the regulator. Thus, there is a strong ...