Bankruptcy Costs, Liability Dollarization, and Vulnerability to Sudden Stops

Emerging market countries that have improved institutions and attained intermediate levels of institutional quality have experienced severe financial crises following capital flow reversals. However, there is also evidence that countries with strong institutions and deep capital markets are less affected by external shocks. We reconcile these two observations using a calibrated DSGE model that extends the financial accelerator framework developed in Bernanke, Gertler, and Gilchrist (1999). The model captures financial market institutional quality with creditors. ability to recover assets from bankrupt firms. Bankruptcy costs affect vulnerability to sudden stops directly but also indirectly by affecting the degree of liability dollarization. Simulations reveal an inverted U-shaped relationship between bankruptcy recovery rates and the output loss following sudden stops. We provide empirical evidence that this non-linear relationship exists.

The Optimal Capital Structure of Banks: Balancing Deposit Insurance, Capital Requirements and Tax-Advantaged Debt

The capital structure and regulation of financial intermediaries is an important topic for practitioners, regulators and academic researchers. In general, theory predicts that firms choose their capital structures by balancing the benefits of debt (e.g., tax and agency benefits) against its costs (e.g., bankruptcy costs). However, when traditional corporate finance models have been applied to insured financial institutions, the results have generally predicted corner solutions (all equity or all debt) to the capital structure problem. This paper studies the impact and interaction of deposit insurance, capital requirements and tax benefits on a bankÇs choice of optimal capital structure. Using a contingent claims model to value the firm and its associated claims, we find that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a minimum fixed capital standard. Banks voluntarily choose to maintain capital in excess of the minimum required in order to balance the risks of insolvency (especially the loss of future tax benefits) against the benefits of additional debt. Because we derive a closed- form solution, our model provides useful insights on several current policy debates including revisions to the regulatory framework for GSEs, tax policy in general and the tax exemption for credit unions.

A Tort for Risk and Endogenous Bankruptcy

Conventional tort law bars victims of exposure to a toxic substance from filing suit until they actually develop symptoms of illness. Practically speaking, this rule often bars recovery due to bankruptcy and causal uncertainty. One solution is to allow victims to file at exposure for expected damages (a tort for risk). The trade-off is that such a rule may trigger a race to file among exposure victims, thereby itself inducing bankruptcy. This paper characterizes the conditions under which such a race will occur in equilibrium and examines the implications for social welfare.

Scaling the Costs of 404 Testing to Fit the Needs of Small Public Companies

In July of 2002, the Sarbanes-Oxley Act was passed by Congress, including section 404 which requires the auditors to test and opine on the company's internal controls. Since that time there has been much debate about whether the intended benefits of increased investor confidence and financial statement transparency trump the unexpectedly high compliance costs, especially for public companies with market-caps less than $75 million. Before these companies begin complying in the upcoming year, interest groups are calling for the requirements to be 'scaled' to better fit the needs of these companies. While auditors already are expected to scale their audit approach to each individual client, more must be done to significantly decrease the costs in order to reverse the trend of small companies foregoing listing on U.S. capital markets. Increased guidance from the PCAOB, SEC, and other related parties could help the small-cap companies and their auditors be aware of best practices. Also, exempting industries that already follow similar guidelines or are significantly injured by the compliance requirements could help. Lastly, the controversial proposal of rotational audits could be put in place if the affected parties cooperate to remove the undue burden on these small-cap companies. Without some form of significant action, the investors could soon lose the ability to buy small-cap companies in U.S. markets.

Monetary Policy Delegation, Contract Costs, and Contract Targets

We reconsider the optimal central banker contract derived in Walsh (1995). We show that if the government's objective function places weight (value) on the cost of the contract, then the optimal inflation contract does not completely neutralize the inflation bias. That is, a fraction of the inflation bias emerges in the resulting inflation rate after the central banker's monetary policy decision. Furthermore, the more concerned the government is about the cost of the contract or the less selfish (more benevolent) is the central banker, the smaller is the share of the inflation bias eliminated by the contract. No matter how concerned the government is about the cost of the contract or how unselfish (benevolent) the central banker is, the contract always reduces the inflationary bias by at least half. Finally, a central banker contract written in terms of output (i.e., incorporating an output target) can completely eradicate the inflationary bias, regardless of concerns about contract costs.

Transaction Costs, Production Costs, and the Passage of Time

No abstract available.

Varying Injurer Costs of Care, Negligence, and Self-Selection

Standard economic models of negligence set a single standard of care to which all injurers must conform. When injurers differ in their costs of care, this leads to distortions in individual care choices. This paper derives the characteristics of a negligence rule that induces optimal care by all injurers by means of self-selection. The principal features of the rule are (1) the due standard is set at the optimal care of the lowest cost injurer, and (2) liability increases gradually rather than abruptly as care falls below this standard. The results are consistent with the gradation in liability under certain causation rules and under comparative negligence.

Bilateral Accidents with Intrinsically Interdependent Costs of Precaution

The standard economic model of bilateral precaution postulates an interdependency between the care taken by injurers and victims that operates through the effects of each on the expected accident loss. This paper considers situations in which each party's precaution affects not only expected accident loss, but also directly affects the other party's cost of taking precaution. Generalizing the economic model of tort law in this way allows for a more complete analysis of when standard tort rules can and cannot induce optimal precaution. When this additional externality is introduced into a model of unilateral harm (where all accident losses are borne by the victim), none of the standard tort liability rules induces socially optimal behavior by both parties. Moreover, under a contributory negligence rule, the only equilibrium is in mixed strategies; this gives rise to the possibility of litigation in equilibrium. A 'tort-like' liability rule that induces socially optimal behavior by both parties is then characterized; this involves a payment by victims to non-negligent injurers whenever an accident occurs. The model is then extended to consider the case of bilateral harm (where both parties suffer accident losses). It is shown that, as long as both parties can sue to recover their accident losses, all negligence-based tort rules lead to socially optimal behavior by both parties.

Do Exposure Suits Produce a 'Race to File'? An Economic Analysis of a Tort for Risk

Conventional tort law does not allow victims of exposure to a toxic substance to seek compensation until they develop actual symptoms of illness. This may effectively bar recovery because at the time the illness arises, injurers may be judgment proof. One possible response is to allow a tort for risk that allows victims to seek expected damages at the time of exposure. However, critics charge that this could create a 'race to file' wherein victims rush to file suit to ensure that they will get a share of the injurer's limited assets. We show that such a race may or may not occur in equilibrium, and that when it does occur, not all victims choose to file at exposure if bankruptcy is an inevitable result. If bankruptcy is not inevitable, it is possible that a tort for risk will trigger bankruptcy, although a no-bankruptcy equilibrium always exists and Paretodominates the bankruptcy equilibrium. We examine the consequences of the various tort-for-risk equilibria on the compensation of exposure victims, litigation costs, and injurer care.

The Secret Life of Mundane Transaction Costs

Transaction costs, one often hears, are the economic equivalent of friction in physical systems. Like physicists, economists can sometimes neglect friction in formulating theories; but like engineers, they can never neglect friction in studying how the system actually does let alone should work. Interestingly, however, the present-day economics of organization also ignores friction. That is, almost single-mindedly, the literature analyzes transactions from the point of view of misaligned incentives and (especially) transaction-specific assets. The costs involved are certainly costs of running the economic system in some sense, but they are not obviously frictions. Stories about frictions in trade are not nearly as intriguing as stories about guileful trading partners and expensive assets placed at risk. But I will argue that these seemingly dull categories of cost what Baldwin and Clark (2003) call mundane transaction costs actually have a secret life. They are at least as important as, and quite probably far more important than, the more glamorous costs of asset specificity in explaining the partition between firm and market. These costs also have a secret life in another sense: they have a secret life cycle. I will argue that these mundane transaction costs provide much better material for helping us understanding how the boundaries among firms, markets, and hybrid forms change over time.

Risk, Transaction Costs, and Tax Assignment: Government Finance in the Ottoman Empire

Risk and transaction costs often provide competing explanations of institutional outcomes. In this paper we argue that they offer opposing predictions regarding the assignment of fixed and variable taxes in a multi-tiered governmental structure. While the central government can pool regional risks from variable taxes, local governments can measure variable tax bases more accurately. Evidence on tax assignment from the mid-sixteenth century Ottoman Empire supports the transaction cost explanation, suggesting that risk matters less because insurance can be obtained in a variety of ways.