the cost of market versus regulatory discipline in banking1 abstract we present evidence that insured deposit financing shields banks from the full costs of market discipline moody s downgrades indicators of increasing risk are associated with negative abnormal equity returns that are increasing in the bank s reliance on insured deposits moreover banks raise their use of insured deposits following increases in risk these findings cast doubt on the ability of capital market participants to effectively discipline bank behavior within the current regulatory environment more generally our findings highlight the potential for regulation to undermine market discipline in regulated industries

day of the week effects and asset returns the number of empirical studies using daily stock returns is rapidly increasing researchers generally assume that the distribution of stock returns is identical for all days of the week a convenient statistical assumption but not a necessary condition of market equilibrium nevertheless there are reasons to suspect that the distribution of returns may vary according to the day of the week the most obvious is the impact of weekends on monday s return since monday s return is calculated over three instead of one calender day the mean and variance may well be higher on monday compared with any other daily return perhaps three times as large previous research has examined the daily distribution of stock returns for a monday effect while fama 1965 does not compare daily mean returns he does report that monday s variance is about 20o greater than other daily returns with a traditional distributional assumption regarding the returns on a financial asset specifies that the expected returns are identical for all days of the week contrary to this plausible assumption this paper discovers that the expected returns on common stocks and treasury bills are not constant across days of the week the most notable evidence is for monday s returns where the mean is unusually low or even negative several explanations of the results are investigated but none proves satisfactory aside from documenting significant day of the week effects the implications of the results for tests of market efficiency are examined while market adjusted returns continue to exhibit day of the week effects these effects are no longer concentrated on monday during the last year we have had many conversations with our colleagues throughout the professions we are particularly thankful to the participants at sessions of the western and american finance associations where preliminary versions of this paper were presented special thanks are due to gene fama gailen hite jon ingersoll robert jarrow merton miller clifford smith and rex thompson the expert research assistance of frank rabinovitch and youngsup yun is gratefully acknowledged 1 the list of papers using daily stock returns is too long to name recent examples include charest 1978 dodd 1980 banz 1981 and reinganum 1981

the emergence of market monitoring in japanese banks evidence from the subordinated debt market abstract this paper uses a unique data set on the spreads of subordinated debts issued by japanese banks to investigate the presence of market monitoring the results show that subordinated debt investors punished weak banks by requiring higher interest rates moreover i find that the spreads and the sensitivity of spreads to moody s bank ratings both increased dramatically after the japanese government allowed a large city bank hokkaido takushoku bank to fail and passed the financial reform act and the rapid revitalization act in the late 1990s these results suggest that the decline of conjectural guarantee led to the emergence of market monitoring in addition i find the relationship between spreads and accounting measures of bank risk to be quite fragile

limited liability and incentive contracting with ex ante action choices abstract this article examines a principal agent model of financial contracting in which a risk neutral entrepreneur agent makes an unobservable ex ante effort choice while employing the investment funds of a risk neutral investor principal the key innovation is that the investment contract is subject to statutory liability limits given these liability limits two settings are considered one in which the investor payoff function is also constrained to be monotonically nondecreasing in firm profit and another in which no such monotonic contract constraint is imposed in the former case a standard debt contract is shown to emerge and a first best effort choice is not achieved in the latter setting the optimum is characterized by a live or die payoff function and a first best effort level may or may not be realized

a liquidity based model of security design we consider the problem of the design and sale of a security backed by specified assets given access to higher return investments the issuer has an incentive to raise capital by securitizing part of these assets at the time the security is issued the issuer s or underwriter s private information regarding the payoff of the security may cause illiquidity in the form of a downward sloping demand curve for the security the severity of this illiquidity depends upon the sensitivity of the value of the issued security to the issuer s private information thus the security design problem involves a tradeoff between the retention cost of holding cash flows not included in the security design and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer s private information we characterize the optimal security design in several cases we also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer s retention costs for assets

pricing risk adjusted deposit insurance an option based model this paper presents a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships betweeen equity and a call option and insurance and a put option the data utilizes the market value of equity to solve for the asset value and its volatility market perceptions of fdic bailout policies are explicitly modeled so as to eliminate the bias in inverted values of assets and their volatility sensitivity analyses are performed to show that rank orderings based on premiums are robust to changes in specification thus facilitating allocation of aggregate premium across banks while economists have long argued in favor of risk adjusted deposit insurance as both more equitable and more efficient than the current system of flatrate premiums various recent developments have further contributed to an increasing dissatisfaction with the current system first both the banking industry and the government seem to be tending to the view that deregulation of the banking industry would be necessary in order to meet more sophisticated future demands on the industry as well as desirable as a policy means of stimulating greater competition among banks moreover a sudden rise in the incidence of bank failures 1 and the vulnerability of the u s banks to the socalled international debt crisis have served to bring to the fore concern about the health of the banking industry in the absence of deposit insurance riskier banks will be able to attract deposits only at higher rates and these higher costs of funding serve as built in market regulated incentives to limit excessive risk taking by banks as introduction of deposit insurance makes deposits equally risk free across banks these incentives disappear and regulation and close supervision of the banking industry must necessarily replace them as deterrents to excessive risk taking thus when insurance is offered at a flat premium regulation is designed to ensure that the risk posed to the insurer both asset and financial risk is appropriately uniform

regulating banks through market discipline a survey of the issues abstract the interest in the application of market discipline to regulate the financial industry has boomed recently due to the proposed new capital accord this paper reviews the potential role market discipline can play in financial regulation we start with a discussion of the rationale for financial regulation and with a brief history of the current regulatory mechanisms next a definition of market discipline as a regulatory mechanism is advanced we evaluate the disciplining power various market participants have finally we argue that more external risk management disclosure is a condition sine qua non in order to enable market discipline as a regulatory mechanism in this respect the basle committee has taken the right approach

the principal agent relationship with an informed principal ii common values in many circumstances a principal may have relevant private information when she proposes a contract to an agent we analyze such a principal agent relationship as a noncooperative game the principal proposes a contract which is accepted or rejected by the agent who for most of our analysis has no private information the contract is executed if accepted otherwise the reservation allocation takes effect this allocation may be determined by a pre existing contract which the principal by her proposal is attempting to renegotiate or it may simply be the no trade point in this paper we assume that the principal s information directly affects the agent s payoff before solving the game we discuss pareto efficiency with asymmetric information we define an incentive compatible allocation to be weakly interim efficient wie if there exists no alternative incentive compatible allocation that both parties prefer for all possible beliefs that the agent might have about the principal s private information type we show that any wie allocation is interim efficient ie for some beliefs the rothschild stiglitz wilson rsw allocation relative to the reservation allocation l is the allocation that maximizes the payoff of each type of principal within the class of incentive compatible allocations that guarantee the agent at least the utility he gets from a irrespective of his beliefs about the principal s type the equilibrium set of the contract proposal game consists of the allocations that weakly pareto dominate the rsw allocation thus there is a unique equilibrium outcome if and only if the latter is ie and the equilibrium outcome is the rsw allocation itself after characterizing the equilibrium allocations we study those that are renegotiation proof when either the principal or the agent leads the renegotiation we then compare our contract proposal game which is a signaling model with its screening counterpart we conclude by extending our results to the case in which the agent as well as the principal has private information under the assumption of quasi linear preferences

stock market returns and inflation evidence from other countries this paper investigates the relation between common stock returns and inflation in twenty six countries for the postwar period our results do not support the fisher hypothesis which states that real rates of return on common stocks and expected inflation rates are independent and that nominal stock returns vary in one to one correspondence with expected inflation there is a consistent lack of positive relation between stock returns and inflation in most of the countries

default and punishment in general equilibrium we extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools the equilibrating variables include expected delivery rates along with the usual prices of assets and commodities by reinterpreting the variables our model encompasses a broad range of adverse selection and signalling phenomena in a perfectly competitive general equilibrium framework perfect competition eliminates the need for lenders to compute how the size of their loan or the price they quote might affect default rates it also makes for a simple equilibrium refinement which we propose in order to rule out irrational pessimism about deliveries of untraded assets we show that refined equilibrium always exists in our model and that default in conjunction with refinement opens the door to a theory of endogenous assets the market chooses the promises default penalties and quantity constraints of actively traded assets

deposit insurance reform what are the issues and what needs to be fixed abstract the current problems in the commercial banking industry have led to widespread calls for reform of the deposit insurance contract on the grounds that it promotes moral hazard we review the empirical evidence for the significance of moral hazard as an important cause of the present crisis we then evaluate various reform proposals grouped into two broad classes proposals that seek to impose greater discipline on bank stockholders and proposals to increase the disciplinary role of bank debtholders finally we identify some issues that have received inadequate attention in the literature on bank regulation

skin in the game and moral hazard what determines securitization levels and should they be regulated to address these questions we develop a model where originators can exert unobservable effort to increase expected asset quality subsequently having private information regarding quality when selling abs to rational investors absent regulation originators may signal positive information via junior retentions or commonly adopt low retentions if funding value and price informativeness are high effort incentives are below first best absent regulation optimal regulation promoting originator effort entails a menu of junior retentions or one junior retention with size decreasing in price informativeness zero retentions and opacity are optimal among regulations inducing zero effort

the limitations of market value accounting and a more realistic alternative abstract market value accounting mva might improve market and regulatory discipline on financial institutions unfortunately there are serious conceptual measurement and incentive problems with implementing mva that have not received significant attention these problems are suggested by the theory of asymmetric information and the role intermediaries play in solving information and monitoring problems after analyzing the problems with mva we develop an alternative approach that applies mva principles where they are most feasible and uses a statistical procedure where asymmetric information problems make mva particularly problematic an empirical analysis suggests that this procedure may substantially improve the distribution of regulatory discipline

last bank standing what do i gain if you fail banks are highly leveraged institutions potentially attracted to speculative lending even without deposit insurance a counterbalancing incentive to lend prudently is the risk of loss of charter value which depends on future rents we show in a dynamic model that current concentration does not reduce speculative lending and may in fact increase it in contrast a policy of temporary increases in market concentration after a bank failure by promoting a takeover of failed banks by a solvent institution is very effective by making speculative lending decisions strategic substitutes it grants bankers an incentive to remain solvent subsequent entry policy fine tunes the trade off between the social costs of reduced competition and the gain in stability

do depositors punish banks for bad behavior market discipline deposit insurance and banking crises this paper empirically investigates two issues largely unexplored by the literature on market discipline we evaluate the interaction between market discipline and deposit insurance and the impact of banking crises on market discipline we focus on the experiences of argentina chile and mexico during the 1980s and 1990s we find that depositors discipline banks by withdrawing deposits and by requiring higher interest rates deposit insurance does not appear to diminish the extent of market discipline aggregate shocks affect deposits and interest rates during crises regardless of bank fundamentals and investors responsiveness to bank risk taking increases in the aftermath of crises

inflation and asset returns sustained inflation is detrimental to long run growth and the financial system a recent theoretical literature suggests that high inflation implies low real returns on assets these low returns exacerbate informational frictions interfering with the functioning of financial markets and the allocation of investment we investigate the plausibility of an inverse relationship between inflation and real returns inflation and nominal equity returns are negatively correlated or uncorrelated for all low to moderate inflation economies examined safe nominal rates of return and inflation are only weakly positively correlated however for high inflation economies inflation and nominal returns are strongly positively correlated

a dynamic program for valuing corporate securities abstract we design and implement a dynamic program for valuing corporate securities seen as derivatives on a firm s assets and computing the term structure of yield spreads and default probabilities our setting is flexible for it accommodates an extended balance sheet equality arbitrary corporate debts multiple seniority classes and a reorganization process this flexibility comes at the expense of a minor loss of efficiency the analytical approach proposed in the literature is exchanged here for a quasi analytical approach based on dynamic programming coupled with finite elements to assess our construction which shows flexibility and efficiency we carry out a numerical investigation along with a complete sensitivity analysis

optimal security design how should new securities be designed traditional theories have little to say on this the literature on capital structure and general equilibrium theories with incomplete markets take the securities firms issue as exogenous this paper explicitly incorporates the transaction costs of issuing securities and develops a model where the instruments that are traded are chosen optimally and the economy s market structure is endogenous among other things it is shown that the firm s income stream should be split so that in every state all payoffs are allocated to the security held by the group that values them most this abstract was borrowed from another version of this item

risk based deposit insurance an incentive compatible plan deposit insurance provided by the federal deposit insurance corporation fdic violates a basic principle of insurance premiums are not adjusted for bank risk thus banks have the incentive to take on more risk increasing the insurer s liability but not the banks costs see keeton 1984 this incentive is heightened further by the fdic s timidity in closing failed banks if uninsured depositors and other creditors were able and willing to evaluate bank risk and demand risk adjusted returns on investments the incentive for risk taking would be weakened since in such a world deposit insurance could be fairly priced see thomson 1987 when asymmetric information concerning both bank risktaking and insurer behavior characterizes the banking market as crane 1976 avery belton and goldberg 1988 keeton and morris 1987 and brewer and lee 1986 all suggest to be the case other remedies must be sought

the informational content of subordinated debt and equity prices in the presence of bankruptcy costs the paper extends the contingent valuation framework of black and cox j finance 31 2 1976 351 to value subordinated debt by explicitly incorporating bankruptcy costs in the model we show that the information from subordinated debt prices is complementary to the information from the equity prices only when the bankruptcy costs are taken into account in fact the joint use of equity and subordinated debt prices can provide information on magnitude of expected bankruptcy costs knowing the magnitude of expected bankruptcy costs is necessary for calculating variables underlying policy objectives in particular it is illustrated that the value of expected liability of a deposit insurer would be underestimated if the bankruptcy costs were not taken into account

who pays for bank insolvency this paper discusses proposals for handling bank failures in a manner that is rapid enough to allow the business to continue respects the ranking of claims makes none of the parties worse off than under traditional insolvency and does not require taxpayer funds except to guarantee the new organization until recapitalization it considers the relationship between the regime for bank exit and the rest of the framework for regulation and supervision the role of market discipline in enabling solutions before the point of insolvency is reached the problems in assessing the costs of different exit regimes and public intervention

ownership structure speculation and shareholder intervention an institution holding shares in a firm can use information about the firm both for trading speculation and for deciding whether to intervene to improve firm performance intervention increases the value of the institution s existing shareholdings but intervention only increases the institution s trading profits if it enhances the precision of the institution s information relative to that of uninformed traders thus the ability to speculate can increase or decrease institutional intervention we examine key factors that affect the intervention decision the usefulness of short swing provisions and restricted shares in encouraging institutional intervention and implications for ownership structure across different firms institutional investors hold an ever greater fraction of corporate america s equity traditionally these institutions were stock pickers who tried to beat the market through trading if a firm whose stock they held seemed headed for trouble these investors headed for the door the wall street rule more recently some of these institutions have been using the ownership rights attached to their shares to pressure firms to act in the shareholders interest some have even argued that there is a synergy between gathering information for use in trading shares speculation and intelligently pressuring firms to improve performance intervention we argue that these motives can also conflict analyzing these motives allows us to predict which firms are most likely to attract institutional intervention which in turn has crosssectional implications for firm ownership structure recent examples suggest that institutional investors with large stakes sometimes intervene and sometimes follow the wall street rule so that there is indeed a choice to be studied in the early 1990s there was a wave of activism by a variety of large institutional investors among them calpers the california public employees pension fund putnam management a mutual fund manager and j p morgan a bank holding company these institu

evidence of bank market discipline in subordinated debenture yields 1983 1991 we examine debenture yields over the period 1983 1991 to evaluate the market s sensitivity to bank specific risks and conclude that investors have rationally reflected changes in the government s policy toward absorbing private losses in the event of a bank failure although this evidence does not establish that market discipline can effectively control banking firms it soundly rejects the hypothesis that investors cannot rationally differentiate among the risks undertaken by the major u s banking firms an increasingly important issue in the regulation of financial institutions concerns the extent to which market investors can will recognize and control the risks of banking firms although the banking act of 1933 replaced some private risk bearing with federal deposit insurance legislators were reluctant to displace market discipline very extensively flood 1992 by the early 1980s however u s regulators had come to protect virtually all bank liability holders from credit losses most visibly at large banks which were deemed too big to fail sprague 1986 o hara and shaw 1990 this extension of the government safety net largely reflects a skepticism on the part of regulators that normal market forces could adequately identify and control bank risks while u s regulators have recently shown an increased willingness to let some bank investors bear default losses an official suspicion of the efficacy of market discipline remains widespread by contrast some prominent academic economists argue that market investors in bank debentures could provide timely and effective control over banking firms risk exposures and that the social cost of supervising banks would be lower if regulators ceded greater

a further investigation of the weekend effect in stock returns this study uses a longer time period and additional stocks to further investigate the weekend effect we find consistently negative monday returns 1 for the s p composite as early as 1928 2 for exchange traded stocks of firms of all sizes and 3 for actively traded over the counter otc stocks the otc results are based on bid prices and therefore appear to reject specialist related explanations for the 30 individual stocks of the dow jones industrial index the average correlation between friday and monday returns is positive and the highest of all pairs of successive days the latter finding is inconsistent with fairly general measurement error explanations some of the most puzzling empirical findings reported in recent years indicate that the distribution of common stock returns varies by day of the week most notably the average return for monday close friday to close monday is significantly negative cross 3 and french 6 find negative monday returns using the standard and poor s composite index and gibbons and hess 7 find negative monday returns for the 30 individual stocks of the dow jones industrial index 1 this negative monday return or weekend effect has yet to be explained this study undertakes a further investigation of the weekend effect in stock returns we examine additional time periods extending the total period covered to 55 years we examine additional stocks such as those of small low capitalization firms and those traded over the counter in all cases the data exhibit a weekend effect that is at least as strong as that reported in previous studies the study also readdresses potential explanations for the effect such as measurement error but concludes that none of these explanations is satisfactory the first section presents a history of the weekend effect from 1928 through 1982 based on the standard and poor s composite index we essentially double the length of the period beginning in 1953 examined by french 6 the results indicate consistently negative monday returns throughout the 55 year period during much of the 25 year period from 1928 through 1952 the new york stock exchange was open on saturdays so monday s return is then computed from saturday s close to monday s close 2 these returns for one day weekends are consistently negative and not significantly different from the two day weekend

banks and loan sales marketing nonmarketable assets theories of financial intermediation predict that bank loans should not be marketable because of moral hazard problems banks will not conduct credit risk analysis or monitor borrowers if they are not at risk for failing to perform these services throughout most of history bank loans have not in fact been marketable yet by the end of the 1980 s the amount of commercial and industrial loan sales outstanding had grown to over 250 billion from trivial amounts at the beginning of the decade to explain the opening of this loan sales market we present a model of incentive compatible loan sales that allows for implicit contractual features between loan sellers and loan buyers we then test for the presence of these features using a sample of over 800 recent loan sales

selecting an optimal portfolio of consumer loans by applying the state preference approach abstract internal models like creditmetrics and kmv implemented by banks to manage credit risk and assess regulatory capital are significant examples of how practitioners apply modern portfolio theory mpt to the management of bank loan portfolios from a theoretical perspective there are several reasons suggesting to be careful in extending mpt to the case of bank loan portfolios selection in order to avoid misleading results specifically loans log returns are non normally distributed random variables furthermore decision makers not necessarily perform a quadratic utility function because both of those reasons the traditional mean variance approach is inadequate in building up optimal loan portfolios such a conclusion is even more relevant if specific categories of loans are considered in our paper we deal with the problem of selecting optimal portfolios of consumer loans by developing a state preference model it allows us not to explicitly consider the distributional properties of loans log returns the model is a static one having the objective to select the loan portfolio maximizing the expected utility of wealth allocated by the bank managers subject to a number of constraints accounting for fundamental strategic choices implemented by the bank managers our results show that flexibility is the main characteristic of our model in fact adding constraints gives new optimal portfolios without reducing the expected utility of the decision maker we will explain that such a result does not depend on constraints misspecification but on the risk structure implied in the state preference approach

financial intermediaries and liquidity creation trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets these securities which can arise endogenously have values that do not depend on the information known only to informed agents bank debt deposits is an example of this type of liquid security which protect relatively uninformed agents and we provide a rationale for deposit insurance in this content high grade corporate debt and government bonds are other examples implying that a money market mutual fund based payments system may be an alternative to one based on insured bank deposits

debt priority structure market discipline and bank conduct we examine how debt priority structure affects bank funding costs and soundness leveraging an unexplored natural experiment that changes the priority of claims on banks assets we document asymmetric effects that are consistent with changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder the enactment of depositor preference laws which confer priority on depositors reduces deposit rates but increases non deposit rates importantly subordinating non depositor claims reduces bank risk taking consistent with market discipline this insight highlights a role for debt priority structure in the regulatory framework

the saturday effect an interesting anomaly in the saudi stock market the vast majority of empirical research on calendar anomalies has studied financial markets in countries where the western calendar is used this article investigates day of the week effects in saudi arabia s stock market where an islamic calendar is used and where saturday is the first working day of the week over the sample period considered the saudi stock market is the largest in the gulf region and we consider both total market data the tasi index and data for 15 sector indices our investigation reveals the existence of a positive saturday effect which contrasts with the results on first day of the week effects that are typically obtained for western calendar markets

incorporating equity market information into supervisory monitoring models we examine whether equity market variables such as stock returns and equity based default probabilities are useful to u s bank supervisors for assessing the condition of domestic bank holding companies we develop a model of supervisory ratings that combines supervisory and equity market information we find that the model s forecasts anticipate supervisory rating changes by up to four quarters relative to simply using supervisory variables the inclusion of equity market variables in the model does not improve forecast accuracy however we argue that equity market information should still be useful for forecasting supervisory ratings and should be incorporated into supervisory monitoring models

bank capital regulation in a barrier option framework abstract the barrier options theory of corporate security valuation is applied to the contingent claims of a regulated bank the regulator insurer of a bank owns a down and in call option on the bank assets which can be balanced against the expected coverage cost raising the regulatory barrier critical asset level triggering bank closure leads to a transfer of wealth from stockholders to the insurer and reduces stockholder incentives to increase asset risk empirical tests on a sample of 152 one bank holding companies show that regulatory barriers are priced in the stock market and are inversely related to tier 1 leverage ratios

the real output losses associated with modern banking crises this study investigates the real output losses associated with modern banking crises we find a remarkable diversity of experience in a number of instances banking crises have not been associated with any significant reduction in the growth of real per capita gdp often this has been the case in mature and developed economies on the other hand estimated output losses are extremely large for some other countriesnamounting to several years of lost gdp interestingly such large losses can be associated with banking crises that were designated as non systemic our sample mean and median output loss estimates are also big for the average sample country the estimated present discounted value of crisis related output losses is bounded between 63 and 302 of real per capita gdp in the last year before the crisis onset average loss estimates are this large primarily because we find evidence that post crisis economic slowdowns often persist long after the crisis is officially over such delayed costs have been largely overlooked in previous empirical work and resultantly our loss estimates are much larger than those that have appeared elsewhere

weekly patterns in japanese stock returns this study investigates the day of the week effect in the japanese stock returns low tuesday and high wednesday returns are observed most of the positive returns arise during the nontrading period the monday effect is also observed in the week whose previous week is closed by friday trading low tuesday returns appear to be related to low monday returns in the u s the weekly pattern is more pronounced for the returns of smaller firms a reverse size effect is observed during the trading period

which banks choose deposit insurance evidence of adverse selection and moral hazard in a voluntary insurance system this article investigates adverse selection and moral hazard in the voluntary deposit insurance system of kansas which operated from 1909 to 1929 regulations were imposed to limit risk taking and membership was made voluntary to assuage objections that insurance forces conservative banks to protect depositors of high risk institutions the authors find however that risk prone banks were the most likely to join the system at its inception using a simultaneous equations model they also detect both adverse selection and moral hazard behavior throughout the system s first ten years copyright 1995 by ohio state university press

costs of banking system instability some empirical evidence abstract this paper assesses the cross country stylised facts on empirical measures of the losses incurred during periods of banking crises we first consider the direct resolution costs to the government and then the broader costs to the welfare of the economy proxied by losses in gdp we find that the cumulative output losses incurred during crisis periods are large roughly 15 20 on average of annual gdp in contrast to previous research we also find that output losses incurred during crises in developed countries are as high or higher on average than those in emerging market economies moreover output losses during crisis periods in developed countries also appear to be significantly larger 10 15 than in neighbouring countries that did not at the time experience severe banking problems in emerging market economies by contrast banking crises appear to be costly only when accompanied by a currency crisis these results seem robust to allowing for macroeconomic conditions at the outset of crisis in particular low and declining output growth that have also contributed to future output losses during crises episodes

stock returns and the day of the week effect in istanbul stock exchange this study investigates the existence of the day of the week effect on stock returns in the stanbul stock exchange ise for the period between 1988 and 1999 ise that was established in 1986 is a rapidly growing emerging market for which there are only a few studies that have been conducted and reported since emerging markets are becoming good diversification alternatives for international investors the analysis of stock return behaviour of ise will be of interest to all investors domestic and foreign with this purpose both ise national 100 composite index and 30 stocks of ise for which trade volume is the highest are analysed the analysis of ise national 100 composite index reveals strikingly low tuesday and dominantly high friday returns with return variances at their lowest on fridays it is also observed that for most of the stocks among the 30 highly traded stocks of ise maximum return is on fridays whereas minimum return is either on mondays or tuesdays with return variances at their highe

forced sales and house prices the market for housing differs in several important ways from the textbook model of a liquid asset market with exogenous fundamentals this implies that the price at which a house is sold can be influenced not only by general supply and demand conditions but also by idiosyncratic factors including the urgency of the sale and the effects of the ownership transfer on the physical quality of the house first houses are productive only when people are living in them owning an empty house is equivalent to throwing away the dividend on a financial asset second houses are fragile assets that need maintenance and are vulnerable to van dalism unoccupied houses are particularly vulnerable and expensive to protect third short term rental contracts involve high transactions costs resulting from the moving costs of renters and the need of homeowners to protect their property against damage fourth houses are expensive indivisible and heterogeneous assets each house has certain unique characteristics which are likely to appeal to certain poten tial buyers and not to others so selling a house requires matching it with an appro priate buyer because of the high costs of intermediation in housing this task is normally undertaken by a real estate broker rather than a dealer fifth most home owners must finance their purchases using mortgages collateralized debt contracts that transfer home ownership to the mortgage lender through a foreclosure process if the homeowner defaults the expansion of mortgage credit in the early 2000s and the recent decline in house prices have led to an unprecedented increase in foreclosures since 2006 foreclosures transfer houses to financial institutions which must maintain and pro tect them until they can be sold foreclosed houses are likely to sell at low prices both because they may have been physically damaged during the foreclosure pro cess and because financial institutions have an incentive to sell them quickly in a liquid market an asset can be sold rapidly with a minimal impact on its price but

market discipline and bank subordinated debt note a lengthy literature in banking has addressed the question of whether the market prices of liabilities respond to individual bank risk taking activity that is whether any market disciplines exists however despite the obvious importance of this question the current record has led to no consensus on the issue results have been contradictory in this journal alone hannan and hanweck 1988 conclude that the market does extract at least some price for risk taking while avery belton and goldberg 1988 find no such evidence in this study we argue that this line of inquiry has a serious f law in that it fails to use theoretical models of bank instrument valuation to determine the appropriate testing of market discipline therefore the empirical models have lacked the necessary exactness to isolate the appropriate null hypotheses to redress this shortcoming and advance the methodology of this area of the literature we use a pricing model which comes to the banking area from the options pricing literature to look at the yield spread on bank liabilities using this model it is clear that the value of large uninsured bank liabilities cannot be described as a linear monotonic function of risk moreover current bank regulation affects the assumed role risk measures play in the pricing of such debt instruments both of these complications mean that simple regressions are not likely to adequately address the relationship between the value of debt and underlying risk in the final section we empirically investigate the presence of market discipline using contingent claims pricing we find that accounting measures of bank risk still have little predictive value in explaining yield spreads and therefore offer little evidence of meaningful market discipline

a dynamic programming approach to price installment options installment options are bermudan style options where the holder periodically decides whether to exercise or not and then to keep the option alive or not by paying the installment we develop a dynamic programming procedure to price installment options we study in particular the geometric brownian motion case and derive some theoretical properties of the io contract within this framework we also characterize the range of installments within which the installment option is not redundant with the european contract numerical experiments show the method yields monotonically converging prices and satisfactory trade offs between accuracy and computational time our approach is finally applied to installment warrants which are actively traded on the australian stock exchange numerical investigation shows the various capital dilution effects resulting from different installment warrant designs

banks as monitors of other banks evidence from the overnight federal funds market this study provides evidence that banks are effective monitors of their peers by showing that the interest rate paid on federal funds transactions reflects differences in credit risk across borrowers in addition the size and relative importance in the funds market of the trading institutions are shown to affect the rates charged for overnight borrowing thereby providing insight into the nature of competition in the federal funds market transaction volume and size of transaction effects are uncovered as is evidence of relationship banking between banks these results are made possible by unique data identifying individual federal funds transactions copyright 2001 by university of chicago press

loan sales and relationship banking firms raise money from banks and the bond market banks sell loans in a secondary market to recycle their funds or to trade on private information liquidity in the loan market depends on the relative likelihood of each motive for trade and affects firms optimal financial structure the endogenous degree of liquidity is not always socially optimal there is excessive trade in highly rated names and insufficient liquidity in riskier bonds we provide testable implications for prices and quantities in primary and secondary loan markets and bond markets further we posit that risk based capital requirements may be socially desirable the term collateralized loan obligations clos was coined in 1989 when corporate loans were first used as collateral in collateralized debt obligations cdos 1 since then the growth in loan sales has been enormous according to lucas et al 2006 1 1 trillion of cdos were outstanding as of 2005 and 50 of their collateral was comprised of loans in addition to pooled securities banks also trade first loss positions on single names through direct sales of individual loans in the united states loan sales have grown from 8 billion in 1991 to 154 8 billion by 2004 2 if a bank securitizes or sells a loan that it originated it is buying insurance on credit events over which it has either more control or more information than the buyer in the face of this informational friction why did the secondary market for corporate loans develop in the 1990s what effect has this had on relationship banking in this paper we characterize when a liquid secondary market for loans arises when a liquid secondary loan market is socially desirable and we provide testable predictions on the effect of the emergence of this market on prices and quantities in bond and primary loan markets our predictions are based on both changes in the parameters that lead to higher loan liquidity and changes in the contracts that are written between banks and firms given this higher liquidity

a reexamination of the over or under pricing of deposit insurance this study shows how fair deposit insurance premia can be calculated using data on bank stock prices interest rate movements and income and balance sheet accounts fair insurance premia are estimat ed under the alternative assumptions that the fdic provides either a limited term variable rate or unlimited term insurance cont ract to banks the paper s results suggest that for nearly all of the large commerical banks in the sample the actual insurance premium c harged by the fdic falls between the bounds of fair limited term and unlimited term insurance premia copyright 1987 by ohio state university press

does the debt market assess large banks risk time series evidence from money center cds abstract uninsured bank liabilities should offer a promised yield that compensates depositors for their expected default losses however the conjectural guarantees available to large u s banking firms makes it questionable whether large depositors should or do feel themselves exposed to credit risk prior papers have evaluated the determinants of bank risk premia using cross sectional data with relatively inconclusive results this paper investigates the same issue in a methodologically independent fashion using time series data on specific banks daily offering rates during the period may 1982 through july 1988 we find that cd rates paid by large money center banks include significant default risk premia

deposit insurance market discipline and off balance sheet banking risk of large u s commercial banks abstract the market discipline of off balance sheet banking activities obsas is examined by employing contingent claims valuation techniques to derive implied asset variances from bank equity and from risk premia for bank subordinated debt specifically implied asset variances have been calculated from market and on and off balance sheet information using options pricing techniques theoretically these implied asset variances are better than equity variance or risk premia in proxying bank risk because they capture portfolio effects as well as the non linear nature of contingent claims model and the impact of closure rules empirical results suggest the existence of market discipline of obsas market participants price these obsas as risk reducing

building an incentive compatible safety net abstract bank safety nets originally proposed as a means of stabilizing financial systems have become an important destabilizing influence government protection of bank debts encourages banks to undertake excessive risk particularly in response to adverse shocks to asset values reforms that would remove the destabilizing moral hazard consequences of government protection are considered both from the perspective of economic desirability and political feasibility requiring banks to maintain a minimal proportion of subordinated debt finance and restricting the means by which government recapitalization of insolvent banks occurs are the central features of promising reforms to the safety net

a binomial lattice method for pricing corporate debt and modeling chapter 11 proceedings the pricing of corporate debt is still a challenging and active research area in corporate finance starting with merton 1974 many authors proposed a structural approach in which the value of the assets of the firm is modeled by a stochastic process and all other variables are derived from this basic process these structural models have become more complex over time in order to capture more realistic aspects of bankruptcy proceedings the literature in this area emphasizes closed form solutions that are derived by either partial differential equation methods or analytical pricing techniques however it is not always possible to build a comprehensive model with realistic model features and achieve a closed form solution at the same time in this paper we develop a binomial lattice method that can be used to handle complex structural models such as ones that include chapter 11 proceedings of the u s bankruptcy code although lattice methods have been widely used in the option pricing literature they are relatively new in corporate debt pricing in particular the limited liability requirement of the equity holders needs to be handled carefully in this context our method can be used to solve the leland 1994 model and its extension to the finite maturity case the more complex model of broadie chernov and sundaresan 2005 and others

investing to access an adverse selection market abstract i analyse a market with asymmetric information and interdependent values accessing the market is costly and stochastic e g requires lobbying licences or r d for a range of parameter values interventions that raise production or entry costs for all seller types increase trade investment and payoff for all types this effect is driven by a novel feedback loop between the market composition and the investment in access

standby letters of credit and bank capital evidence of market discipline abstract market discipline if it exists and is important should link bank decisions together and have an impact on the way decisions are made the relationship between the issuance of standby letters of credit and primary capital is modeled in the context of market discipline and then estimated the hypothesis that market discipline causes a joint relationship between bank capital and standby letter of credit decisions for banks that are active participants in the standby market or that rely heavily on purchased funds is tested and cannot be rejected

the lender of last resort abstract this paper develops a model of the lender of last resort lolr from a central bank cb viewpoint the model in a static setting suggests that the cb would only rescue banks which are above a threshold size consistent with the insight of too big to fail in a dynamic setting cb s optimal policy in liquidity support depends on the trade off between contagion and moral hazard effects our results show that contagion is the key factor affecting cb s incentives in providing lolr and they also provide a rationalization for constructive ambiguity

simulation based stress tests of banks regulatory capital adequacy abstract banks holding of reasonable capital buffers in excess of minimum requirements could alleviate the procyclicality problem potentially exacerbated by the rating sensitive capital charges of basel ii determining the sufficient buffer size is an important risk management task for banks which the basel committee suggests should be approached via stress testing we present here a simulation based approach to stress testing of regulatory capital adequacy where rating transitions are conditioned on business cycle phase and which takes into account business cycle dynamics our approach is an extension of a typical credit portfolio analysis in that we simulate actual bank capital and minimum capital requirements simultaneously actual bank capital absent mark to market accounting is driven by bank income and default losses whereas capital requirements within basel ii are driven by rating transitions the joint dynamics of these determine the necessary capital buffers given a confidence level for regulatory capital adequacy chosen by bank management we provide a tentative calibration of this confidence level to data on actual bank capital ratios which enables a ceteris paribus extrapolation of bank capital under the current regime to bank capital under basel ii

subordinated debt market discipline and bank risk this paper demonstrates that subordinated debt subdebt thereafter regulation can be an effective mechanism for disciplining banks by reducing the chance that managers of distressed banks can take value destroying actions to benefit themselves subdebt regulation may encourage banks to lower asset risk moreover subdebt regulation and bank capital requirements can be complements for alleviating the banks moral hazard problems to make subdebt regulation effective regulators may need impose ceilings on the interest rates of subdebt prohibit collusion between banks and subdebt investors and require subdebt to convert into the issuing bank s equity when the government provides assistance to the bank

who pays for bank insolvency in transition and emerging economies abstract this paper explores the equity of the way losses from bank insolvencies and their avoidance through intervention by the authorities have been distributed over creditors depositors owners and the population at large in transition and emerging economies it suggests a number of regulatory reforms that would alter the balance between seeking to avoid insolvency and lowering the costs of insolvency should it occur it considers whether a lex specialis for dealing with problem banks by prompt corrective action and if necessary resolving them if their net worth falls to zero at little or no cost to the taxpayer can be applied in the circumstances of transition and emerging economies

market discipline and deposit insurance cross country evidence presented in this paper suggests that explicit deposit insurance reduces required deposit interest rates while at the same time it lowers market discipline on bank risk taking internationally deposit insurance schemes vary widely in their coverage funding and management this reflects that there are widely differing views on how deposit insurance should optimally be structured to inform this debate we use a newly constructed data set of deposit insurance design features to examine how different design features affect deposit interest rates and market discipline

a multi attribute comparative evaluation of relative risk for a sample of banks abstract this paper proposes a comparative analysis of five different attributes of commercial banks liabilities that may be thought of as either directly measuring the default risk or are perceived by the market as impacting upon that default risk two of these attributes are credit ratings assigned by moody s and standard and poor s to debt issues the third attribute that we consider is yield to maturity which is typically assumed to be positively related to default risk the fourth attribute that is proposed is the fair value risk adjusted deposit insurance premium derived from option theoretic modeling and estimated from the daily data on equity prices finally we propose a term structure adjusted difference in yield between the risky debt and default free government debt as a more precise and theoretically sound measure of the default risk premium and develop a methodology for eliciting it on a composite basis for a given bank from the market prices of its various bond issues this term structure adjusted risk premium provides an analytical approximation to the valuation of corporate bonds call features and sinking fund provisions in view of the ordinality of the credit ratings given by the investment agencies spearman s rank correlation coefficient is employed as an analytical tool the analysis

interest risk sensitive deposit insurance premia stable ach estimates abstract the parameters of interest rate uncertainty are estimated by maximum likelihood for the period 1952 1982 and used to evaluate bank or thrift deposit insurance as a function of duration mismatching capital asset ratio and the recent history of interest rate forecasting errors homoskedasticity is overwhelmingly rejected in favor of adaptive conditional heteroskedasticity ach even after removing this heteroskedasticity normality gives much lower likelihood than paretian stable distributions with characteristic exponent in the range 1 614 to 1 714 the conditional deposit insurance values fluctuate by factors in excess of 300 for some duration gaps over the past three decades

public trading and private incentives this article studies the link between public trading and the activity of a firm s large shareholder who can affect firm value public trading results in the formation of a stock price that is informative about the large shareholder s activity this increases the latter s incentives to engage in value increasing activities indeed if he has to liquidate part of his stake before the effect of his activity is publicly observed a more informative price rewards him for his activity implications are derived for the decision to go public capital structure and security design we consider a firm with a large shareholder and otherwise dispersed shares which are publicly traded the block holder is an insider in the sense that he can undertake actions that directly affect the firm s value moreover the insider might not take all value increasing actions as at least some of them involve a private cost for him in other words there is an incentive problem the article s main premise is that public trading as part of the price formation process generates information not only about exogenous factors affecting firm value but also about the insider s activity for instance as a result of public trading a firm s stock price will incorporate the market s evaluation of how a controlling shareholder allocates corporate resources we identify two sources of incentives for the insider to engage in activities that will increase firm value the first one is his stake in the firm since the insider participates in a value increase in proportion to his equity stake a larger stake increases the benefit to him from the firm value being high the view that large shareholders affect firm value is indeed widespread shleifer and vishny 1997 they alleviate the free rider problem pervasive in firms with passive dispersed investors unable or unwilling to affect the firm s operations that is outsiders

statistical default models and incentives the likelihood that a bank loan will default is of interest to both regulators and investors under the basel ii regulatory guidelines a bank must hold capital in proportion to the riskiness of its assets the probability of default is a pri mary determinant of the riskiness of a loan investors in turn price a loan in the secondary market based on its expected cash flow which again depends on the default probability how should market participants assess the default probability on a pool of bank loans it is natural to consider historical data on loan condi tions and default rates and to estimate a statisti cal model that can be used to predict defaults going forward such statistical models have been widely used across the financial markets to enhance market liquidity and impose capital requirements on financial institutions the accuracy of predictions from statistical models was especially poor in the subprime mortgage market in the period from august 2007 onwards 1 we argue that one cause for this failure was that these models relied entirely on hard information variables and ignored changes in the incentives of lenders to collect soft infor

information production dilution costs and optimal security design abstract we investigate the problem of a firm wishing to finance a project by issuing securities under asymmetric information we find that when outside investors can produce noisy information on the firm s quality the degree of information asymmetry resulting in equilibrium is endogenous and depends on the information sensitivity of the security issued thus in contrast to the prediction of the pecking order theory see e g myers and majluf j financial econom 13 1984 187 a security with low sensitivity to private information such as debt does not always dominate one with high information sensitivity such as equity a firm s preference for equity rather than debt depends on the costs of information production the precision of the information production technology and the extent of the information asymmetry we also study the optimal security design problem and find that depending on the cost and precision of the information production technology risky debt or a composite security with a convex payoff emerges as optimal securities

market discipline of subordinated debt in banking the case of costly bankruptcy abstract this paper extends the contingent claim valuation framework of subordinated debt by explicitly incorporating bankruptcy cost in the model the model is then used to investigate the role of subordinated debt in alleviating the moral hazard problem in banking the incorporation of bankruptcy cost in the framework of the analysis provides new evidence about subordinated debt the reaction of subordinated debt prices can completely remove risk shifting incentives of equityholders only when bankruptcy costs are accounted for the extent of subordinated debt s discipline is shown to depend critically on the relative magnitude of subordinated debt senior debt and bankruptcy costs

a closed form solution to the risk taking motivation of subordinated debtholders abstract black and cox 1976 claim that the value of junior debt is increasing in asset risk when the firm s value is low we show using closed form solution that the junior debt s value is hump shaped this has interesting implications for the market discipline role of banks junior debt