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3 - Fallacies and Irrelevant Facts in the Discussion on Capital Regulation
- from Part 1 - Bank Capital Regulation
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- By Anat R. Admati, Stanford University, Peter M. DeMarzo, Stanford Graduate School of Business, Martin F. Hellwig, Max Planck Institute for Research on Collective Goods, Paul Pfleiderer, Stanford Graduate School of Business
- Edited by Charles Goodhart, Daniela Gabor, Jakob Vestergaard, Ismail Ertürk
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- Book:
- Central Banking at a Crossroads
- Published by:
- Anthem Press
- Published online:
- 05 December 2015
- Print publication:
- 01 December 2014, pp 33-50
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Summary
Introduction
As the financial crisis of 2007–2008 has compellingly shown, highly leveraged financial institutions create negative externalities. When a bank is highly leveraged and has little equity to absorb losses, even a small decrease in asset value can lead to distress and potential insolvency. In a deeply interconnected financial system, this can cause the system to freeze, ultimately leading to severe repercussions for the rest of the economy. To minimize social damage, governments may feel compelled to spend large amounts on bailouts and recovery efforts. Even when insolvency is not an immediate problem, following a small decrease in asset values, highly leveraged banks may be compelled to sell substantial amounts of assets in order to reduce their leverage; such sales can put strong pressure on asset markets and prices and, thereby, indirectly on other banks.
Avoidance of such “systemic risk” and the associated social costs is a major objective of financial regulation. Because market participants, acting in their own interests, tend to pay too little attention to systemic concerns, financial regulation and supervision are intended to step in and safeguard the functioning of the financial system. Given the experience of the recent crisis, it is natural to consider a requirement that banks have significantly less leverage—that is, that they use relatively more equity funding so that inevitable variations in asset values do not lead to distress and insolvency.
A pervasive view that underlies most discussions of capital regulation is that “equity is expensive,” and that equity requirements, while offering substantial benefits in preventing crises, also impose costs on the financial system, and possibly on the economy. Bankers have mounted a campaign against increasing equity requirements. Policymakers and regulators are particularly concerned by assertions that increased equity requirements would restrict bank lending and would impede economic growth. Possibly, as a result of such pressure, the proposed Basel III requirements, while moving in the direction of increasing capital, still allow banks to remain very highly leveraged (Blundell-Wignall et al., this volume). We consider this very troubling, because, as we show below, the view that equity is expensive is flawed in the context of capital regulation.
3 - On the Economics and Politics of Corporate Finance and Corporate Control
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- By Martin Hellwig, University of Mannheim
- Edited by Xavier Vives
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- Book:
- Corporate Governance
- Published online:
- 05 June 2012
- Print publication:
- 02 October 2000, pp 95-136
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Summary
Introduction
The purpose of this essay is to call for a reassessment of the significance of corporate finance for corporate control and for a reorientation of the theory of corporate governance. The long-running repertory play “Banks versus Markets” should be taken off the playbill for a while, to be replaced perhaps by a new offering “Career Patterns, Intrigues, and Resource Allocation in Insider Systems with Mutual Interdependence.”
According to the recent authoritative survey by Shleifer and Vishny (1997), “corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” Through suitable governance mechanisms, “advanced countries … have assured the flow of enormous amounts of capital to firms, and actual repatriation of profits to the providers of finance.” This view rests on the notions that (i) the corporate sector needs external funds for investment, (ii) the financial system channels such funds to the corporate sector from the household sector, and (iii) in this system the interests of external providers of funds are safeguarded through control rights giving them scope for interfering with management misbehavior.
With this view of corporate governance, the literature has studied the incentive implications of different governance mechanisms for company management and financiers. Attention has focused in particular on the free-rider problem that arises if a company has many outside financiers and the resources that any one of them devotes to monitoring and controlling the company's management provides benefits to all of them jointly.
Discussion
- Edited by Colin Mayer, University of Warwick, Xavier Vives, Universitat Autònoma de Barcelona
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- Book:
- Capital Markets and Financial Intermediation
- Published online:
- 04 August 2010
- Print publication:
- 20 May 1993, pp 68-80
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Summary
This paper contributes to a recent literature concerned with optimal debt structure. Until very recently corporate finance theorists have mostly been concerned with agency theories or control theories of the optimal choice of debt/equity ratio. These theories do not differentiate between different forms of debt. Typically, only one form of debt instrument is considered. In practice, however, firms' liabilities are composed of many different forms of debt held by different lenders. The larger firms (e.g. Fortune 500 firms) have liabilities in the form of bank debt, trade credit, bonds (which may be callable, convertible and what not). Given this observed diversity of debt instruments and given the importance of debt financing (over 80 per cent of firms' external funding in the US in the last decade was in the form of debt), the recent literature concerned with optimal debt structure fills an important gap in the theory of corporate finance.
The specific aspect of debt structure which Diamond is concerned with here and in previous research is how the firm's liabilities can be designed so as to use future information about the firm's creditworthiness efficiently. His approach to this problem is similar to that taken in the recent literature on vertical restraints (see Tirole, 1988): he begins by characterizing the optimal principal/agent contract with full commitment and then asks how this contract can be replicated with a combination of standard debt contracts of differing maturities and a given priority rule.
3 - Banking, financial intermediation and corporate finance
- Edited by Alberto Giovannini, Colin Mayer
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- Book:
- European Financial Integration
- Published online:
- 04 August 2010
- Print publication:
- 04 April 1991, pp 35-63
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Summary
Introduction
What is the role of banks and other intermediaries in the provision of finance to industry? More generally, how do financial institutions affect the allocation of funds for investment and the evolution of production possibilities in an economy?
Until very recently, questions of this type received little attention from economic theory. Theoretical work on finance tended to rely rather heavily on the Walrasian paradigm of ‘perfect’, i.e. anonymous, frictionless markets. Within this paradigm, there is no room for a comparative analysis of different institutions because one specific set of institutions, namely the Walrasian market system, is a priori taken as given. Reliance on the Walrasian paradigm with its given set of frictionless markets involves an implicit presumption that comparative institutional analysis can be neglected – say because as a first approximation all potentially interesting institutions achieve roughly the same outcome as a Walrasian market system.
In contrast, the role of institutions in the provision of finance to industry is of great interest to economic historians and development economists. Historians observe that financial systems differ significantly across countries and across periods, so the question arises how these differences between financial systems affected the functioning of the different economies. In certain countries such as Germany, large banks seem to have played a prominent role in the industrial expansion of the late nineteenth century. In other countries such as Britain, banks do not seem to have played such a role. Did the prominence of the large banks in Germany make a positive contribution to economic growth? Does the difference between financial systems explain some of the difference between Germany and British growth rates in the late nineteenth century?