In my paper, Opacity in Financial Markets, forthcoming in the Review of Financial Studies, I study the implications of opacity in financial markets for investor behavior, asset prices, and welfare. In the model, transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds) trade transparent assets (e.g., plain-vanilla products) and opaque assets (e.g., structured products). Investors observe neither opaque funds’ portfolios nor opaque assets’ payoffs. Consistent with empirical observations, the model predicts an “opacity price premium”: opaque assets trade at a premium over transparent ones despite identical payoffs. This premium arises because fund managers bid up opaque assets’ prices, as opacity potentially allows them to collect higher fees by manipulating investor assessments of their funds’ future prospects. The premium accompanies endogenous market segmentation: transparent funds trade only transparent assets, and opaque funds trade only opaque assets. A novel insight is that opacity is self-feeding in financial markets: given the opacity price premium, financial engineers exploit it by supplying opaque assets (that is, they render transparent assets opaque deliberately), which in turn are a source of agency problems in portfolio delegation, resulting in the opacity price premium.
Posts Tagged ‘Moral hazard’
In a landmark vote, the United Nations General Assembly overwhelmingly decided on September 9 to begin work on a multilateral legal framework—effectively a treaty or convention—for sovereign debt restructuring, in order to improve the global financial system. The resolution was introduced by Bolivia on behalf of the “Group of 77” developing nations and China. In part, it was sparked by recent litigation in which the U.S. Supreme Court held that, to comply with a pari passu clause (imposing an equal-and-ratable repayment obligation), Argentina could not pay holders of exchanged bonds without also paying holdouts who retained the original bonds. That decision was all the more dramatic because the holdouts included hedge funds—sometimes characterized as “vulture funds”—that purchased the original bonds at a deep discount, yet sued for full payment.
On September 29, 2014, the Financial Stability Board (the “FSB”) published a consultative document concerning cross-border recognition of resolution actions and the removal of impediments to the resolution of globally active, systemically important financial institutions (the “Consultative Document”). The Consultative Document encourages jurisdictions to include in their statutory frameworks seven elements that would enable prompt effect to be given to foreign resolution actions. In addition, due to a recognized gap between the various national legal resolution regimes that are currently in place and those recommended by the FSB, the Consultative Document sets forth two “contractual solutions”—that is, resolution-related arrangements to be implemented as a matter of contract among the private parties involved—to address two underlying substantive issues that the FSB considers critical for orderly cross-border resolution, namely:
In prior articles (see, e.g., Regulating Shadows: Financial Regulation and Responsibility Failure, 70 Wash. & Lee L. Rev. 1781 (2013)), I have argued that shadow banking is so radically transforming finance that regulatory scholars need to rethink certain of their basic assumptions. In a forthcoming new article, The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability, I argue that the governance structure of shadow banking should be redesigned to make certain investors financially responsible, by reason of their ownership interests, for their firm’s liabilities beyond the capital they have invested. This argument challenges the longstanding assumption of the optimality of limited liability.
In our paper, Managerial Risk Taking Incentives and Corporate Pension Policy, forthcoming in the Journal of Financial Economics, we examine whether the compensation incentives of top management affect the extent of risk shifting versus risk management behavior in pension plans.
The employee beneficiaries of a firm’s defined benefit pension plan hold claims on the firm similar to those held by the firm’s debtholders. Beneficiaries are entitled to receive a fixed stream of cash flows starting at retirement. The firm sponsoring the plan is required to set aside assets in a trust to fund these obligations, but if the sponsor goes bankrupt with insufficient assets to fund pension obligations, beneficiaries are bound to accept whatever reduced payouts can be made with the assets secured for the plan.
Most of the empirical work on executive compensation investigates the role of contemporaneous performance measures in setting cash compensation, ignoring the relevance of past performance measures and the structure of cash compensation. In our paper, The Relation between CEO Compensation and Past Performance, forthcoming in The Accounting Review, we focus on the relation between cash compensation components (salary and bonus) and past performance measures as signals of a CEO’s ability.
We first develop a simple two-period principal-agent model with moral hazard and adverse selection. Our model suggests that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection problems by separating agents into contracts with different levels of risk. Agents are screened and receive different bonus arrangements according to their types. The higher an agent’s type, the more sensitive his bonus is to contemporaneous performance. A higher ability agent receives a larger portion of his compensation in the form of bonus and less as salary. For a given agent, salary increases with his past performance and higher current salary predicts higher future performance. Current bonus, however, is negatively correlated with both past and future performance.
Formulation of optimal regulation of asset-backed securities (ABS) markets has been hindered by the inability to identify specific market failures as well as the absence of well-defined social welfare objectives. In our paper, Skin in the Game and Moral Hazard, which was recently presented at Harvard University, we develop a tractable framework for analyzing social welfare in both regulated and unregulated ABS markets, accounting for moral hazard at the origination stage, private information at the distribution stage, and asymmetric information across ABS investors. We show originators operating in unregulated markets fail to internalize the costs they impose on investors if they utilize a common ABS structure (e.g. zero retentions) rather than credibly signaling positive information to the market via higher retentions. Further, originator effort incentives are reduced since those developing high value assets must either signal via high retentions or otherwise face underpricing of their securities. Mandated retentions have the potential to raise welfare by increasing originator effort incentives in an efficient way, accounting for investor-level spillovers.
The first important policy implication to emerge from the model is that regulators must choose between a “one-size scheme” under which all originators are forced to hold the same retention size (e.g. 5%) or a “menu scheme” under which originators must choose amongst multiple retention sizes (e.g. 4% or 8%). Both schemes can restore effort incentives. However, the menu scheme carries the added social benefit of allowing originators to signal positive information to investors via the choice of a larger retention. Signaling promotes efficient sharing of risks by mitigating the adverse selection problem confronting uninformed ABS investors. The weakness of the menu scheme is that it generally results in higher average retentions, resulting in lower originator fundraising.
The governance structure of a firm can influence any number of its policies and actions, sometimes to the benefit and sometimes to the detriment of shareholders. Among the many studies of these relationships, numerous ones investigate the link between firm governance and corporate investment; however, the findings are inconclusive. Some studies report results suggesting poor governance associates with excessive investment (over-investment or empire-building), while others suggest the opposite (poorly governed managers may prefer the “quiet life”).
In our paper, The Influence of Governance on Investment: Evidence from a Hazard Model, forthcoming in the Journal of Financial Economics, we revisit the question of how governance affects corporate investment behavior in an attempt to reconcile these conflicting findings. Unlike prior studies we use a hazard framework, wherein we study how governance influences the time between large investment expenditures. This empirical approach helps alleviate some of the concerns with the methods of prior studies and also provides an unexplored perspective. In this framework, we find that governance does influence the time between major investments (investment spikes). Poor governance associates with shorter periods between spikes than that for firms with stronger governance. We further show that this relation is due to poorly governed firms over-investing, rather than stronger governance firms under-investing.
In the paper, Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid, which was recently made publicly available on SSRN, we investigate the effect of TARP on bank risk taking. One of the key features of the past decade has been an increased role of government regulation, which culminated in the bailout of over 700 firms under the Emergency Economic Stabilization Act (EESA) of 2008. At the forefront of an ongoing regulatory debate is the potential effect of the bailout on the risk-taking behavior of financial institutions, since imprudent risk-taking is often blamed for leading to the crisis in the first place. On the one hand, recent regulatory reforms, including the EESA, the Dodd-Frank Act of 2010, and Basel III, were tasked with promoting financial stability and preventing excessive risk-taking by financial institutions. On the other hand, the bailout sent a signal of implicit protection of certain financial institutions, which could encourage risk-taking as a response to a perceived safety net for institutions that encounter financial distress.
We study three channels of bank operations – retail lending, corporate lending, and financial investments. We use hand-collected data on bank applications for government capital to control for the selection of fund recipients and investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we also control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans.
Did mortgage securitization cause the mortgage crisis? One popular story goes like this: Banks that originated mortgage loans and then sold them to securitizers didn’t care whether the loans would be repaid. After all, since they sold the loans, they weren’t on the hook for the defaults. Without any “skin in the game” those banks felt free to make worse and worse loans until… kaboom! The story is an appealing one, and since the beginning of the crisis it has gained popularity among academics, journalists, and policymakers. It has even influenced financial reform. The only problem? The story might be wrong.
In this post we report on the latest round in an ongoing academic debate over this issue. We recently released two papers, available here and here, in which we argue that the evidence against securitization that many have found most damning has in fact been misinterpreted. Rather than being a settled issue, we believe securitization’s role in the crisis remains an open and pressing question.