Does uncertainty matter for loan charge-offs?

Using a stylized real options model, we show that discretion over the timing of charging off a non-performing loan could be economically justified when collateral values are uncertain and there is a chance of loan recovery. The implied hypothesis of an “uncertainty dependence” aspect in loan charge-offs is empirically tested and validated using a panel of European banks. A welfare-maximizing regulator might want to let banks pursue such discretionary loan charge-off behavior, with the problem of distinguishing it from alternative capital management and income smoothing objectives, while transparency-seeking accounting standards setters would presumably not.     

The value of extended delegation in dynamic agency

One of the main advantages of delegation is that specific department level information is used. Its main disadvantage is probably that central management looses direct control over certain actions. In this paper we challenge this widely accepted trade-off. We show that delegation might be favorable even if specific knowledge is completely absent. We consider a firm that lives for two periods. Due to its organizational structure part of the tasks and decision rights is inevitably delegated to a subordinate (agent). The agent performs the tasks assigned to him, tantamount to personal effort, in each of the two periods. Besides this effort the decision to implement a particular project has to be made at the beginning of period two. With regard to the project choice, central management can decide to delegate it to the agent (decentralization). Alternatively it can make it personally (centralization). If the project choice is decentralized it remains unobservable for central management. Along with second period effort it must be motivated via an incentive contract written on period output.We analyze two different contracting regimes: long-term commitment and long-term renegotiation-proof contracts. With full commitment we find that centralization is indeed favorable as compared to delegation if no informational advantage exists. This confirms conventional wisdom. However, the result does not necessarily hold with renegotiation-proof contracts. Renegotiation-proofness may force central management to set too low second-period incentives. Delegation counteracts this effect as it allows central management to implicitly commit to a higher second-period incentive rate. This arises as both, personal effort and the project choice, rather than effort alone need to be motivated. A necessary condition for too low second-period incentives, and thus for delegation to be favorable, is a negative intertemporal correlation of output.     

Disability Risk Management and Postinjury Employment of Workers With Back Pain

We analyze the outcomes of occupational back pain among four large employers that use one or more of the following disability management practices: aggressive return to work, claims management, medical management, or time‐limited job accommodations. Outcomes measured at 6 and 12 months postonset include: duration of initial work absence and the probability of returning to stable employment. Employment outcomes are better in firms with more proactive return‐to‐work policies than in firms with more restrictive policies. We devise a statistical test for attrition bias and conclude that sample attrition does not significantly alter our results.     

A Proposal to Improve U.S. Housing Market Incentives: A Response to the Federal Reserve White Paper of January 2012

The U.S. housing finance market has not yet recovered from the housing price bubble that peaked in late 2006. Even though prices have fallen significantly, there are still problems in clearing the market. For the last few years, a group of financial economists and practitioners who are part of the Financial Management Association's Practitioner Demand Driven Academic Research Initiative (PDDARI) have been studying the collapse of the housing market and have concluded that many market participants still have insufficient (and in some cases the wrong) incentives to take actions that would help restore the market's health. In January 2012, Ben Bernanke, Chairman of the Federal Reserve Board, released a white paper that reviewed current housing market conditions and created a framework for policy analysis designed to help reestablish the health of the U.S. housing market as part of the broader effort to foster economic recovery. Using this framework as its starting point, the PDDARI group has come up with a set of proposals whose centerpiece is an “incentive‐compatible” mortgage that encourages homeowners to rebuild their home equity as an essential step to a housing recovery. By incorporating “price appreciation rights” that would provide stronger inducements for lenders or mortgage owners to make loan modifications (particularly, forgiveness of principal), the PDDARI mortgage structure could allow more homeowners to remain in their homes and avoid foreclosures and the large associated deadweight costs (as much as 40% of a home's assessed value). Additionally, the government‐sponsored enterprises, including Fannie Mae and Freddie Mac, are also in need of radical reform, and a transition toward greater private market participation would promote the long‐term health of the mortgage market.     

Short Selling and Intraday Price Pressures

We study episodes of significant intraday downward price pressures in individual stocks and find that price declines during such episodes are driven mainly by liquidity demanding nonshort volume. Although short sellers during these price pressure episodes are also active and somewhat exacerbate the magnitude of price declines, their influence on prices is secondary to that of nonshort sellers. As such, our findings are inconsistent with the recently reignited allegations of systematic trading abuses caused solely by short sellers and might shed light on the debate regarding the need to reinstitute short selling restrictions.     

Did Australian Firms Choose to Switch to Reporting Operating Cash Flows Using the Indirect Method?

In 2007 Australian accounting standards were amended to allow a choice of presenting operating cash flows using either the direct or indirect method. This study investigates the number of ASX‐listed entities that switched to the indirect format. Our results indicate that between 2007 and 2009 nine companies changed their reporting format. The firms adopting the indirect method have similar leverage, liquidity and performance to industry and size‐matched controls. Given that previous research indicates that the direct method provides superior information for predicting cash flows and performance, our results will be welcomed by financial statement users and the Australian Accounting Standards Board.     

Mastering the management system

Companies have always found it hard to balance pressing operational concerns with long-term strategic priorities. The tension is critical: World-class processes won't lead to success without the right strategic direction, and the best strategy in the world will get nowhere without strong operations to execute it. In this article, Kaplan, of Harvard Business School, and Norton, founder and director of the Palladium Group, explain how to effectively manage both strategy and operations by linking them tightly in a closed-loop management system. The system comprises five stages, beginning with strategy development, which springs from a company's mission, vision, and value statements, and from an analysis of its strengths, weaknesses, and competitive environment. In the next stage, managers translate the strategy into objectives and initiatives with strategy maps, which organize objectives by themes, and balanced scorecards, which link objectives to performance metrics. Stage three involves creating an operational plan to accomplish the objectives and initiatives; it includes targeting process improvements and preparing sales, resource, and capacity plans and dynamic budgets. Managers then put plans into action, monitoring their effectiveness in stage four. They review operational, environmental, and competitive data; assess progress; and identify barriers to execution. In the final stage, they test the strategy, analyzing cost, profitability, and correlations between strategy and performance. If their underlying assumptions appear faulty, they update the strategy, beginning another loop. The authors present not only a comprehensive blueprint for successful strategy execution but also a managerial tool kit, illustrated with examples from HSBC Rail, Cigna Property and Casualty, and Store 24. The kit incorporates leading management experts' frameworks, outlining where they fit into the management cycle.     

A second-order stock market model

A first-order model for a stock market assigns to each stock a return parameter and a variance parameter that depend only on the rank of the stock. A second-order model assigns these parameters based on both the rank and the name of the stock. First- and second-order models exhibit stability properties that make them appropriate as a backdrop for the analysis of the idiosyncratic behavior of individual stocks. Methods for the estimation of the parameters of second-order models are developed in this paper.     

Capital Market Development,Competition, Property Rights,and the Value of Insurer Product‐Line Diversification: A Cross‐Country Analysis

In this article, we show that the effect of product diversification on performance is not homogeneous across countries. Diversified insurance companies perform significantly worse than their focused competitors in countries with well‐developed capital markets, high levels of property rights protection, and high levels of competition. In addition, we find that the diversification–performance relationship for insurance companies depends on company size. For large insurers operating in countries with less developed capital markets, diversification significantly increases performance. Our results suggest that the optimal organizational structure may be different for insurers operating in emerging economies than for insurers operating in developed countries.     

Accuracy of Premium Calculation Models for CAT Bonds—An Empirical Analysis

CAT bonds are of significant importance in the field of alternative risk transfer. Because the market of CAT bonds is not complete, the application of an appropriate pricing model is of high relevance. We apply different premium calculation models to compare them with regard to their predictive power. Without taking the financial crisis into account, a version of the Wang transformation model and the linear model are the most accurate ones. In contrast, under consideration of the financial crisis, all analyzed models are approximately equivalent. Furthermore, we find that CAT bond specific information does not improve out‐of‐sample results.