Dynamic Contracting with Intermediation: Operational,Governance, and Financial Engineering

Private equity funds intermediate investment and affect portfolio firm performance by actively engaging in operational, governance, and financial engineering. We study this type of intermediation in a dynamic agency model in which an active intermediary raises funds from outside investors and invests in a firm run by an agent. Optimal contracting addresses moral hazard at the intermediary and firm levels. The intermediary's incentives to affect firm performance are strongest after poor performance, while the agent's incentives are strongest after good performance. We also show how financial engineering, that is, financial contracting with outside investors, interacts with operational and governance engineering.     

THE ROLE OF CAPITAL ADEQUACY REGULATION IN THE HEDGING DECISIONS OF FINANCIAL INTERMEDIARIES

This paper identifies the effect of capital adequacy requirements, which have been ignored to date in the hedging literature, on the forward hedging decisions of financial intermediaries. Using a more general framework than has been used in the literature on intermediary behavior in forward markets, cases are developed where capital and forward contracting are substitutes as well as where increasing the capital requirement increases the volume of desired forward contracting. The model shows that the most important factors in determining the equilibrium rate and the equilibrium position of intermediaries are the statistical association between the level of the forward rate and the spread between interest rates, the level of the capital-to-assets ratio, and the degree of risk aversion of intermediaries and other participants in the forward market. To characterize whether the intermediary's optimal forward position is long or short, one must have knowledge of at least the sign of the association between the level and spread for the particular intermediary, the intermediary's capital position, and whether the forward market equilibrium corresponds to a positive or negative premium. The model also demonstrates that a full hedge of assets is always sub-optimal, and a universally applicable expression for the optimal hedge ratio when hedging is costless is derived.     

Optimal incentives and securitization of defaultable assets

We study optimal securitization in the presence of an initial moral hazard. A financial intermediary creates and then sells to outside investors defaultable assets, whose default risk is determined by the unobservable costly effort exerted by the intermediary. We calculate the optimal contract for any given effort level and show the natural emergence of extreme punishment for defaults, under which investors stop paying the intermediary after the first default. With securitization contracts optimally designed, we find securitization improves the intermediary's screening incentives. Furthermore, the equilibrium effort level and the surplus converge to their first best levels with sufficiently many assets.     

Interest Rate Uncertainty and the Financial Intermediary's Choice of Exposure

The financial intermediary's choice of operating as a broker with minimal risk exposure or as an asset-transformer with interest rate risk is modeled as a funds inventory decision made prior to the resolution of uncertainty regarding the borrowing or lending interest rates. It is shown that an increase in the interest rate uncertainty leads the intermediary to reduce its exposure, thereby offering decreased asset-transformation and more brokerage services. However, a stochastic increase in the interest rates leads to greater asset-transformation and less brokerage services.     

Customers and investors: A framework for understanding the evolution of financial institutions

Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary's credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary's credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets.     

TRANSFER PRICING IN A DEPOSIROTY FINANCIAL INTERMEDIARY: PROOF OF A CONJECTURE FOR THE CASE OF NORMALLY-DISTRIBUTED CASH WITHDRAWALS*

In an earlier paper, a source of gains from the centralization of a financial intermediary's management of its cash reserves was conjectured. This note presents a mathematical proof of the conjecture for the special case of normally-distributed cash withdrawals.     

Optimal certification policy,entry, and investment in the presence of public signals

We explore the optimal disclosure policy of a certification intermediary where (i) the seller decides on entry and investment in product quality, and (ii) the buyers observe an additional public signal on quality. The optimal policy maximizes rent extraction from the seller by trading off incentives for entry and investment. We identify conditions under which full, partial or no disclosure can be optimal. The intermediary's report becomes noisier as the public signal gets more precise, but if the public signal is sufficiently precise, the intermediary resorts to full disclosure. However, the social welfare may reduce when the public signal becomes more informative.     

Aspects of insurance,intermediation and finance

This paper is concerned with the role of the insurance company as a financial intermediary which offers securities to uninformed retail investors. The search costs of retail investors cause the demand for the securities offered by intermediaries to be inelastic, making possible an intermediary spread, the difference between the returns on primary securities and the rates offered on the secondary securities sold by intermediaries. It is argued that the intermediary spread is economically significant, and a simple model of its determination is offered: the spread is shown to be an increasing function of interest rates. The bonus policy of life insurance companies is analyzed and is shown to be inefficient under simple assumptions about asset returns.     

Interest Rates in Trade Credit Markets

All things equal, interest rates should increase with the borrower's risk. And yet, Klapper, Laeven, and Rajan (2012) cannot find such a positive relation in a broad sample of trade credit contracts. We shed some light on this puzzle by arguing that competition between informed and uninformed suppliers weakens the link between the trade credit cost and the borrower's creditworthiness. Our model implies that trade credit rates are more likely to increase with the borrower's risk if suppliers are less profitable, have high cost of funds, or sell inputs to firms plagued by moral hazard and financial distress.     

Flying under the radar: The real effects of anonymous trading

Using unique data on TSX Attributed Trading and a new proxy of Tobin's Q that accounts for intangible capital (Peters and Taylor, 2017), we investigate the impact of anonymous trading (AT) on managers' ability to use feedback conveyed by stock prices to improve investment efficiency. We show that AT reduces investment efficiency and that both anonymous buyer-initiated and seller-initiated trades have comparable effects. The negative effect of AT on managerial learning from stock prices is significant only for tangible investments and when disagreement among anonymous traders is high. Taken together, our new evidence indicates that AT distorts investment sensitivity to Tobin's Q, plausibly because anonymity attracts additional (uninformed) liquidity trading, which negatively impacts the effectiveness of asset prices in aggregating private information and in revealing fundamentals.     

Bond Covenants and Delegated Monitoring

This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants based on noisy indicators of the firm's financial health and loan contracts enforced by a monitoring specialist. In one interpretation, the specialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indicators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring.     

Do firms' relationships with principal customers/suppliers affect shareholders' income?

In this paper, we examine whether a firm's relationship with its principal customers/suppliers affects its payout policies. A firm has customer–supplier relationships when its business depends on a small number of major customers/suppliers. The extant literature indicates two channels through which customer–supplier relationships might negatively affect a firm's dividend payments: 1) the high financial distress costs associated with relationship-specific investments and 2) the information certification effect of the principle customer. Consistent with expectations, our study reveals a negative relationship between a firm's dependence on customer–supplier relationships and its dividend payments. This result is robust to various model specifications and consistent with evidence regarding the time-series properties of dividends. Moreover, we find that high financial distress costs associated with relationship-specific investments are the key channel through which a firm's customer–supplier relationship affects its dividend payments. Overall, our results suggest that a firm's relationship with its non-financial stakeholders, such as principal customers/suppliers, is an important determinant of its shareholders' income.     

Do Investors Perceive the Link Between Equity Method Earnings and Future Earnings? The Role of Supplemental Disclosures

Equity method investments are commonly a material component of a firm's corporate structure, yet these investments are presented to financial statement users through opaque financial reporting. This study demonstrates that the link between equity method earnings and future earnings is stronger than the link between consolidated earnings and future earnings, consistent with the synergistic and diversification benefits of equity method investments. Next, this study demonstrates a limitation in the opaque reporting of equity method investments by revealing that the market fails to fully incorporate into prices the link between equity method earnings and future earnings. Further, this study contributes to the active debate among practitioners and regulators about the usefulness of supplemental disclosure requirements related to equity method investments. Results indicate that supplemental equity method investment disclosures aid the market in impounding the persistence of equity method earnings into share price.     

Lending Policies of Financial Intermediaries Facing Credit and Funding Risk

This paper compares the optimal lending decisions of financial intermediaries that differ in their risk exposure. All intermediaries are assumed to face a loan demand described by a random applicant arrival process with each applicant offering a unique risk-adjusted rate of return; loan demand is therefore uncertain in both quantity and quality. The intermediaries differ in terms of their risk exposure because of disparate funding practices. Intermediaries functioning as brokers minimize their exposure by borrowing funds only as demand is realized, whereas those behaving as asset-transformers borrow in advance of realizing loan demand, thereby maintaining a loanable funds inventory and sustaining the related exposure. The optimal sequential lending policy is shown to involve setting a credit standard that becomes stricter with the length of the intermediary's planning horizon and the volume of loans outstanding. Most importantly, it is shown that brokers adopt stricter credit standards than asset-transformers and therby reduce their volume of lending.     

Optimal financial education

When agents first invest in financial markets, they are relatively inexperienced. The agents best positioned to educate the inexperienced stand to earn trading profits at the expense of inexperienced agents. Owing to this phenomenon, we show that the equilibrium amount of financial education does not fully correct the biases of the inexperienced agents. In a dynamic setting, large levels of uninformed trading volume may be generated by the inexperienced agents. This is because, in equilibrium, the experienced intermediaries may delay educating the inexperienced in order to earn commissions in earlier rounds of trade.     

Analysis of Stigma and Bank Credit Provision

Bank rescue programs are designed to provide assistance to struggling financial intermediaries during financial crises. A complicating factor is that participating banks are often stigmatized by accepting assistance from the government. This paper investigates stigma in two ways: (i) it examines how stigma changes a bank's decision to seek assistance from the rescue program, and (ii) it analyzes how stigma affects a bank's ability to operate as a financial intermediary using a joint model for bank‐level application, approval, and lending decisions. The empirical results indicate that stigma hinders the objectives of the rescue program and slows the production of credit.     

Strategic ex ante contracts: rent extraction and opportunity costs

This article cosiders the possibility that a seller can contract with one uninformed buyer prior to an auction involving two potential buyers. The seller's optimal strategic ex ante contract more accurately reflects joint opportunity costs of the seller and the contracted buyer, and therefore extracts more rent from the entrant. Moreover, this ex ante contract mitigates the seller's ex post rent seeking vis‐à‐vis the contracted buyer. Accordingly, it may create more social welfare than the absence of ex ante contracts, depending upon the contracted buyer's financial constraint and the distributions of trade surplus. Implementation of the optimal strategic ex ante contract and policy implications are discussed.     

Financial Intermediaries and Interest Rate Risk: II

The current work extends and updates the previous survey ( Staikouras, 2003 ) by looking at other aspects of the financial institutions' yield sensitivity. The study starts with an extensive discussion of the origins of asset‐liability management and the subsequent work to identify effective ways of measuring and managing interest rate risk. The discussion implicates both regulatory and market‐based approaches along with any issues surrounding their applicability. The literature is enriched by recognizing that structural and regulatory shifts affect financial institutions in different ways depending on the size and nature of their activities. It is also noted that such shifts could change the bank's riskiness, and force banks to adjust their balance sheet size by altering their maturity intermediation function. Besides yield changes, market cycles are also held responsible for asymmetric effects on corporate values. Furthermore, nonstandard investigations are considered, where embedded options and basis risk are significant above and beyond the intermediary's rate sensitivity, while shocks to the slope of the yield curve is identified as a new variable. When the discount privilege is modeled as an option, it is shown that its value is incorporated in the equities of qualifying banks. Finally, volatility clustering is further established while constant relative risk aversion is not present in the U.S. market. Although some empirical findings may be quite mixed, there is a general consensus that all forms of systematic risk, risk premia, and the risk‐return trade‐off do exhibit some form of variability, not only over time but also across corporate sizes and segments.     

Equity Financial Assets: A Tool for Earnings Management—A Case Study of a Chinese Corporation

With China’s adoption of principles-based international accounting standards and its convergence with International Accounting Standard 39 (IAS 39), Chinese companies have discretion under the original Accounting Standards for Enterprises 22 (CAS 22) as to how they account for the initial measurement, sale, and subsequent reclassification of financial assets. We use a Chinese company (‘Company A’) as a case study to illustrate how earnings are managed to exploit this discretion. We document that the company re-classifies its available for sale equity investments as long-term equity investments to decrease the volatility of the company’s apparent profits. We also make some predictions regarding how the company will handle its financial assets under the new standard, which is the same as IFRS 9. Our research contributes to the continuous improvement of China’s accounting standards and has implications for regulators of the capital market.     

Early indicators of fundraising success by venture capital firms

We show how a venture capital firm's fundraising is affected by its investment choices. We investigate three leading indicators that are calculated from the types of investments the venture capital firms make: style drift investments, follow-on investments, and investments in which the venture capital firm is not the lead investor in the portfolio company. We find that these investment characteristics are associated with lower fundraising. Characteristics and the reaction of fundraising to characteristics are both moderately stable through time. We also find some evidence that information about investment characteristics is more important for fundraising during bad states of the world and that ex-ante characteristics are related to eventual exit outcomes and financial performance.