We develop a model in which the absolute priority of secured debt leads to conflicts among creditors, but can be optimal nonetheless. The option to use collateral to dilute unsecured debt, even in violation of covenants, helps borrowers to avoid under-investment problems. But covenants embed an option to accelerate that helps creditors avoid over-investment problems.
With Jason R Donaldson
We present a banking model in which, as in practice, bank debt is both a financial security used to raise funds and a kind of money used to facilitate trade. This dual role of bank debt provides a new rationale for why banks do what they do. In the model, banks endogenously perform the essential functions of real-world banks: they transform liquidity, transform maturity, pool assets, and have dispersed depositors. And they are endogenously fragile.
Non-depository financial intermediaries ("non-banks") have a higher cost of capital than depositories ("banks") do, because they do not benefit from government safety nets. How do they still compete with banks? Non-banks use their high cost of capital as a commitment device not to fund traditional projects, inducing entrepreneurs to innovative efficiently.
RFS Editor’s Choice article
ASU Sonoran Wfinter Finance Conference 2018 Best Paper Award
In a dynamic model of board decision making, directors strategically block proposals that benefit other directors. Such deadlock on the board explains CEO entrenchment and strategic inertia. We study how board composition affects deadlock, and find, for example, that board diversity can exacerbate it.
We develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment---there is a collateral overhang.
Using a search model, we find that levered households protected by limited liability suffer from a household-debt-overhang problem that leads them to require high wages to work. Firms respond by posting high wages but few vacancies. The equilibrium level of household debt is inefficiently high due to a household-debt externality.
I show that venture capitalists’ career concerns can have beneficial effects in the primary market: they can mitigate information frictions, helping firms go public.
We develop a theory of banking that explains why banks started out as commodities warehouses. Our theory helps to explain how modern banks create funding liquidity and why they combine warehousing (custody and deposit-taking), lending, and private money creation within the same institutions.
With Jason R Donaldson
Delegated asset managers frequently refer to public information, such as credit ratings and benchmark indices, in the contracts they offer their investors. However, regulators have advised against this. Why do asset managers refer to public inforamtion in their contracts? We show that it is a way for asset managers to compete for flows of investor capital, even though it is socially inefficient.
With Amil Dasgupta
Many blockholders are money managers. We show that, when money managers compete for investor capital, the threat of a block sale ("exit") loses credibility, weakening its governance role.
Assets pledged as collateral for secured debt cannot be sold unless the debt is paid or otherwise renegotiated. We develop a model of this role of collateralization. We find that debt market frictions (alone) can cause the asset market to fail, causing misallocation.
Interbank debt is money-like, but not a perfect substitute for cash: it can be hard to convert to cash to fund new investments. Hence, interbank lending comes with an opportunity cost that generates positive spreads even absent any credit risk. These spreads enter banks’ collateral constraints, generating a feedback between the opportunity cost in the credit market and the price of collateral in the asset market. This results in instability in the form of multiple equilibria, casting light on repo runs. We provide a new rational for counter-cyclical capital regulation.
With Jason R Donaldson
Banks hold gross debts without netting them out. Why? These gross debts implement valuable contingent transfers via the option to dilute. Proposition 1 of this paper is superseded by Debt Maturity in Financial Networks (above).
(Largely subsumed by Venture Capital and Capital Allocation)