Objectivity, Proximity and Adaptability in Corporate Governance

Countries appear to differ considerably in the basic orientations of their corporate governance structures. We postulate the trade-off between objectivity and proximity as fundamental to the corporate governance debate. We stress the value of objectivity that comes with distance (e.g. the market oriented U.S. system), and the value of better information that comes with proximity (e.g. the more intrusive Continental European model). Our key result is that the optimal distance between management and monitor (board or shareholders) has a bang-bang solution: either one should capitalize on the better information that comes with proximity or one should seek to benefit optimally from the objectivity that comes with distance. We argue that this result points at an important link between the optimal corporate governance arrangement and industry structure. In this context, we also discuss the ways in which investors have "contracted around" the flaws in their own corporate governance systems, pointing at the adaptability of different arrangements.http://deepblue.lib.umich.edu/bitstream/2027.42/39651/3/wp266.pd

Market Discipline in Conglomerate Banks: Is an Internal Allocation of Cost of Capital Necessary as an Incentive Device?

This paper analyzes the optimal conglomeration of bank activities. We show that incentive problems in banking sometimes dictate integration of activities, but with perfect market discipline always push us away from integration/conglomeration. Ineffective market discipline could make conglomeration optimal, even if conglomeration further undermines market discipline. We also show that an internal allocation of the cost of capital could add effective `internal' discipline and improve on the outcome of conglomeration. The analysis is subsequently applied to the Barings debacle. This paper was presented at the Financial Institutions Center's October 1996 conference on "

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.http://deepblue.lib.umich.edu/bitstream/2027.42/39841/3/wp457.pd

Objectivity, Proximity and Adaptability in Corporate Governance

Countries appear to differ considerably in the basic orientations of their corporate governance structures. We postulate the trade-off between objectivity and proximity as fundamental to the corporate governance debate. We stress the value of objectivity that comes with distance (e.g. the market oriented U.S. system), and the value of better information that comes with proximity (e.g. the more intrusive Continental European model). Our key result is that the optimal distance between management and monitor (board or shareholders) has a bang-bang solution: either one should capitalize on the better information that comes with proximity or one should seek to benefit optimally from the objectivity that comes with distance. We argue that this result points at an important link between the optimal corporate governance arrangement and industry structure. In this context, we also discuss the ways in which investors have "contracted around" the flaws in their own corporate governance systems, pointing at the adaptability of different arrangements.corporate governance, comperitive systems, corporate finance, economic reform, convergence

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.coordination, credit ratings, multiple equilibria

Restructuring in the banking industry with implications for Europe

Set against the background of a rapidly consolidating financial sector, this paper explores the main forces that are driving this process. Acknowledging that the search for scale and scope economies is one of them, the paper emphasises that the empirical evidence in support of such economies is mixed, at best; while scale and scope economies exist, in principle, they are difficult to attain in practice. The paper considers strategic positioning in an uncertain and rapidly changing environment a more important factor: by expanding scope (and scale), financial institutions acquire options to venture into new activities. An implication of this strategic-option explanation is that consolidation, scope expansion in particular, will partially unravel as and when uncertainty declines and competition forces financial institutions to discover their true competitive advantages

Competition and Entry in Banking: Implications for Stability and Capital Regulation

We assess the influence of competition and capital regulation on the stability of the banking system. We particularly ask two questions: i) how does capital regulation affect (endogenous) entry; and ii) how do (exogenous) changes in the competitive environment affect bank monitoring choices and the effectiveness of capital regulation? Our approach deviates from the extant literature in that it recognizes the fixed costs associated with banks' monitoring technologies. These costs make market share and scale important for the banks' cost structures. Our most striking result is that increasing (costly) capital requirements can lead to more entry into banking, essentially by reducing the competitive strength of lower quality banks. We also show that competition improves the monitoring incentives of better quality banks and deteriorates the incentives of lower quality banks; and that precisely for those lower quality banks competition typically compromises the effectiveness of capital requirements. We generalize the analysis along a few dimensions, including an analysis of the effects of asymmetric competition, e.g. one country that opens up its banking system for competitors but not vice versa

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

The economics of bank regulation

The object of this paper is to survey and synthesize the literature on the regulation of financial intermediaries, including the theoretical framework and also the applied literature on specific regulations such as deposit insurance, capital controls, line of business restrictions, etc

Evolution of Organizational Scale and Scope

This paper examines the determinants of organizational scale and scope, with applications to various industries, including financial services. We build a model in which new opportunities arise for firms, but the skills needed to exploit them effectively are unknown. Early investments in these new opportunities expand scope and allow firms to learn the skills needed to make more efficient production decisions later on. The value of early scope expansion is thus increasing in the strategic uncertainty about the skills needed for future success in exploiting new opportunities. The disadvantage of early scope expansion is that it requires irreversible investments before actual demand is known. This demand uncertainty means potential losses since the investment cannot be recovered when demand does not materialize. Thus, early entry into a new activity involves a tradeoff, and this tradeoff works in favor of early entry under two conditions. First, there must be sufficiently high strategic uncertainty about the skills needed for success in the new activity. Second, the firm 's existing operations must be sufficiently profitable to give it the necessary deep pockets to absorb the potential loss of the capital invested early if there is no demand. This perspective allows us to link the optimality of scope expansion to the degrees of competition in the firm's existing activities as well as the new activity, and the development of the capital market. Moreover, to the extent that a scale-expanding merger deepens the firm's pockets, scale expansion will facilitate scope expansion and thus precede it