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Given the long list of problems that have emerged in banks over the past several years, it is time to consider performance bonds for bankers. Performance bonds are used to ensure that appropriate actions are taken by a party when monitoring or enforcement is expensive. A simple example is a security deposit on an apartment rental. The risk of losing the deposit motivates renters to take care of the apartment, relieving the landlord of the need to monitor the premises. Although not quite as simple as a security deposit, performance bonds for bankers could provide more incentive for bankers to take better care of our financial system.
Christopher S. Armstrong, Wayne R. Guay, Hamid Mehran, and Joseph P. Weber
Financial reporting is valuable because corporate governance—which we view as the set of contracts that help align managers’ interests with those of shareholders—can be more efficient when the parties commit themselves to a more transparent information environment. This is a key theme in our recent article “The Role of Financial Reporting and Transparency in Corporate Governance,” which reviews the literature on the part played by financial reporting in resolving agency conflicts among managers, directors, and shareholders. In this post, we highlight some of the governance issues and recommendations discussed in the article.
Oil prices plunged 65 percent between July 2014 and December of the following year. During this period, the yield spread—the yield of a corporate bond minus the yield of a Treasury bond of the same maturity—of energy companies shot up, indicating increased credit risk. Surprisingly, the yield spread of non‑energy firms also rose even though many non‑energy firms might be expected to benefit from lower energy‑related costs. In this blog post, we examine this counterintuitive result. We find evidence of a liquidity spillover, whereby the bonds of more liquid non‑energy firms had to be sold to satisfy investors who withdrew from bond funds in response to falling energy prices.
Nicola Cetorelli, Fernando Duarte, and Thomas Eisenbach
Update: A technical appendix has been added to the post.
According to conventional wisdom, an open-ended investment fund that has a floating net asset value (NAV) and no leverage will never experience a run and hence never have to fire-sell assets. In that view, a decline in the value of the fund’s assets will just lead to a commensurate and automatic decline in the fund’s equity—end of story. In this post, we argue that the conventional wisdom is incomplete and then explore some of the systemic risk consequences of investment funds’ vulnerabilities to fire-sale spillovers.
Size is usually seen as the leading indication of the costs that a bank failure would impose on society. As a result, the Dodd-Frank Act of 2010 requires banks to have adequate capital and liquidity to mitigate default risk and imposes additional requirements on larger banks to enhance their safety. In this post, we show that it is highly uncommon for banks to reach sizes at which they are considered systemically important.
Valentin Haddad, Erik Loualiche, and Matthew Plosser
Buyout activity by financial investors fluctuates substantially over time. In the United States, peak years result in close to one hundred public-to-private buyout transactions and trough years in as few as ten. The typical buyout is primarily funded by debt, hence the term “leveraged buyout” (or LBO). As a result, analysis of buyout fluctuations has focused on the availability and cost of debt financing. However, in a recent staff report, we find that the overall cost of capital, rather than debt alone, is the primary driver of buyout activity. We argue that it is the common changes in both the cost of debt and the cost of equity—the aggregate risk premium—that are the source of booms and busts in buyout activity.
In the aftermath of the 2008 financial crisis, job transitions of personnel in banking supervision and regulation between the public and private sectors—often labeled the revolving door—have come under intense scrutiny and have been blamed by certain economists (Johnson and Kwak), legal scholars (John Coffee in the Financial Times), and policymakers (Dodd-Frank Act of 2010, Section 968) for distorting regulators’ actions in favor of banks. However, other commentators have downplayed these distortions and presented a more benign viewpoint of these worker flows—as a means for regulatory agencies to attract higher-ability and skilled workers. Because data on job transitions in banking regulatory agencies are scarce, these discussions are mostly informed by anecdotes. Our recent paper brings more rigor to this debate by contributing a first set of stylized facts based on data related to incidence and drivers of worker flows in U.S. banking regulation. Our data show clear evidence of higher worker inflows to the regulatory sector during bad economic conditions. When we study worker flows as a function of an enforcement proxy, we find evidence to be inconsistent with the often-cited “quid-pro-quo” hypothesis. We instead posit an alternative “regulatory schooling” hypothesis that may better explain the empirical evidence.
Commercial banks didn’t become eligible for S-Corporation status until 1997, when President Bill Clinton signed legislation (the Small Business Job Protection Act of 1996) that allowed commercial banks to select S-Corporation as their preferred tax status. In this post, we discuss the features and history of S-Corporations, as well as the effect of lifting the restriction on banks’ organizational tax choice.
This post is the tenth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks.For more on this topic, see this special issue of the Economic Policy Review.
The bankruptcy of Lehman Brothers and its 209 registered subsidiaries was one of the largest and most complex in history, with more than $1 trillion of creditor claims in the United States alone, four bodies of applicable U.S. laws, and insolvency proceedings that involved over eighty international legal jurisdictions. The experience of resolving Lehman has led to an active debate regarding the effectiveness of applying the U.S. Chapter 11 Bankruptcy Code to complex financial institutions. In this post, we draw on our Economic Policy Review article to highlight the challenges of resolving Lehman in the U.S. Bankruptcy Court.
This post is the second in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
Despite recent financial reforms, there is still widespread concern that large banking firms remain “too big to fail.” As a solution, some reformers advocate capping the size of the largest banking firms. One consideration, however, is that while early literature found limited evidence for economies of scale, recent academic research has found evidence of scale economies in banking, even for the largest banking firms, implying that such caps could impose real costs on the economy. In our contribution to the volume on large and complex banks, we extend this line of research by studying the relationship between bank holding company (BHC) size and components of noninterest expense, in order to shed light on the sources of the scale economies identified in previous literature.
Liberty Street Economics features insight and analysis from economists working at the intersection of research and policy. The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan.
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