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With Amil Dasgupta
Effective monitoring by equity blockholders is important for good corporate governance. A prominent theoretical literature argues that the threat of block sale ("exit") can be an effective governance mechanism. Many blockholders are money managers. We show that when money managers compete for investor capital, the threat of exit loses credibility, weakening its governance role. Money managers with more skin in the game will govern more successfully using exit. Allowing funds to engage in activist measures ("voice") does not alter our qualitative results. Our results link widely prevalent incentives in the ever-expanding money management industry to the nature of corporate governance.
Since the worst employment slumps follow periods of high household debt and almost all household debt is provided by banks, we theoretically investigate whether bank regulation can play a role in stimulating employment. Using a competitive search model, we find that levered households suffer from a debt overhang problem that distorts their preferences, making them demand high wages. In general equilibrium, firms internalize these preferences and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment. Unemployed households default on their debt. In equilibrium, the level of household debt is inefficiently high due to a household-debt externality—banks fail to internalize the effect that household leverage has on household default probabilities via the vacancy-posting effect. As a result, household debt levels are inefficiently high. Our results suggest that a combination of loan-to-value caps for households and capital requirements for banks can elevate employment and improve efficiency, providing an alternative to monetary policy for labor market intervention.
How does competition among financiers affect the nature of borrowers’ investments in the economy and how does this, in turn, affect which financial intermediaries arise as lenders in equilibrium? This paper develops a general equilibrium model to address these questions. There are four main results. First, efficient project choices arise in equilibrium for only intermediate levels of competition. Entrepreneurs invest excessively in (riskier) specialized projects at low levels of credit market competition, and invest excessively in (safer) standardized projects at high levels of credit market competition. Second, the emergence of relationship lending eliminates the investment inefficiency for low levels of competition, but not the inefficiency for high levels of competition. Third, this residual investment inefficiency encourages the emergence of highly levered specialized intermediaries that resemble private equity firms and that eliminate the investment inefficiency at high levels of competition. Fourth, these private equity firms arise only in competitive credit markets and fund only specialized projects with high expected returns. The model thus explains the co-existence of bank lending and private equity funding in general equilibrium.
This paper contrasts profit-maximizing individual investors with career-concerned portfolio managers in terms of their effect on firms' funding, economic welfare, and shareholder wealth. The finance literature has shown the negative effects of portfolio managers' career concerns. In contrast, I show a positive side: I find that delegated portfolio managers allocate capital more efficiently than do individual investors, which promotes investment, fosters firm growth, and enriches shareholders. Funding markets require information, but individual speculators are sometimes disinclined to acquire it; in contrast, the career concerns of portfolio managers lead them endogenously to embed information into prices and to trade more often. Finally, I show that career-concerned speculators mitigate the effect of the winner's curse and thereby reduce the discount in a seasoned equity offering.
With Jason R Donaldson
How wide should credit ratings categories be? This paper presents a model that suggests that widening ratings categories makes everyone better off and, thus, that banning ratings announcements altogether would be optimal. Specifically, we propose a model of delegated investment with a public signal (credit rating) that suggests (i) that contracts do not have to refer to the public signal in order to overcome incentive problems; (ii) that contracts include references to the public signal not to address incentive problems, but rather to help agents compete; and, finally, in contrast to the contracting literature, (iii) that decreasing the precision of the public signal leads to Pareto improvements.
With Jason R Donaldson
Firms issue securities to fund projects in an opaque market in which investors cannot infer the value of assets. As a result, good firms, unable to differentiate themselves, bypass profitable investment opportunities: informational inefficiency leads to allocational inefficiency. A rating agency enters the market, providing certification for a fee; it not only fails to inform investors and encourage investment, but also captures a tidy share of firms’ rents. With two agencies competing in fees and disclosure rules, though, problems disappear—information is complete and investment efficient. When the agencies interact repeatedly they are prone to collusion. When investment opportunities are plentiful they rate honestly, but charge fees so high that some positive NPV projects go unfunded. On the other hand, when there are few investment opportunities in the economy they overrate and good firms don’t invest. Regulatory prescriptions of bundling ratings with CDS issues and flooring fees solve the problem.