Banks are comprised of contracts. For a bank to finance productive investment by issuing riskless, money-like claims, its organizational structure (e.g., sole proprietorship, partnership, or public ownership), capital structure, and its bankers' compensation contracts must be jointly designed to induce banker effort and discourage risk-taking. Our model explains why bankers receive high pay for producing mediocre outcomes, and why pure charter value (or market value of equity) is insufficient to prevent banker risk-taking. Outside shareholders, contributing book equity, are useful despite introducing another layer of agency problems. It is efficient for shareholders to create a 'big' bank with multiple bankers and their respective projects and finance those projects with joint liabilities. When bankers' incentive contracts are opaque, each banker's pay should depend on the entire bank's performance even though he exerts control only on his own project.

Banks take costly actions (such as capitalization, liquidity holding, and advanced risk management) to avoid financial distress and creditor runs. While directly affecting a bank’s risks, such actions can also signal the bank’s fundamentals. We show that prudential regulations have an informational impact: sufficiently tight regulations can eliminate inefficient separating equilibria in banks’ signaling game, thereby changing the information available to creditors and their incentives to run. When accounting for this informational impact, tightening regulations can improve banks’ payoffs and be considered bank incentive-compatible. We support this novel, information-based rationale for regulations with evidence from the US liquidity requirement.

We empirically document and theoretically investigate why non-dilutive CoCos are prevalent, even though advocates of CoCos suggest such securities should be dilutive to reduce bank risk-taking. In an agency model with two subsequent moral hazards, we show that while dilutive CoCos deter ex-ante risk-taking and prevent a bank from being undercapitalized, penalizing existing shareholders with dilution when the bank is already undercapitalized leads to risk shifting. CoCos’ designs and risk implications depend on banks’ equity capitalization, with nondilutive CoCos particularly attractive to capital-constrained banks, because such securities can maximize the banks’ financing capacity by tackling only the ex-post risk shifting.

We investigate how colluding asymmetric firms divide markets. We provide conditions under which, contrary to conventional wisdom, the efficient firm gains more from collusion, while the inefficient firm is more tempted to defect. Both anti-trust investigations and leniency policies have the intended effect of deterring some cartels, but also have unintended consequences for surviving cartels. The introduction of leniency moves surviving cartels towards a more inefficient distribution of output, worsening allocative and productive efficiency. Traditional investigation improves the efficiency of surviving symmetric cartels but may worsen the efficiency of more asymmetric surviving cartels.

Banks can take costly actions (such as higher capitalization, liquidity holding, and advanced risk management) to fend off runs. While such actions directly affect bank risks, they can also serve as signals of the banks’ fundamentals. A separating equilibrium due to such signaling, however, would involve two types of inefficiency: strong banks choose excessively costly signals, whereas weak banks are particularly vulnerable to runs. We show that minimum regulatory requirements can maintain a pooling equilibrium and eliminate the inefficiencies associated with the separation. We support this novel rationale for prudential regulations with evidence from the US liquidity requirement.

In a crisis, regulators and private investors can find it difficult, if not impossible, to tell whether banks facing runs are insolvent or merely illiquid. We introduce such an information constraint into a global-games-based bank run model with multiple banks and aggregate uncertainties. The information constraint creates a vicious cycle between contagious bank runs and falling asset prices and limits the effectiveness of traditional emergency liquidity assistance programs. We explain how a regulator can set up committed liquidity support to contain contagion and stabilize asset prices even without information on banks’ solvency, rationalizing some recent developments in policy practices. This paper was accepted by Agostino Capponi, finance. Funding: This work was supported by the National Natural Science Foundation of China [Project 71803024]. Z. Li also acknowledges financial support from “Innovation and Talent Base for Digital Technology and Finance” of China [Project B21038]. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2021.4258 .

We propose a novel rationale for the existence of bank information sharing schemes. Banks may voluntarily disclose borrowers' credit history to maintain asset market liquidity. By sharing such information, banks mitigate adverse selection when selling their loans in secondary markets. This reduces the cost of asset liquidation in case of liquidity shocks. Information sharing arises endogenously when the liquidity benefit dominates the cost of losing market power in the primary loan market competition. We show banks having incentives to truthfully disclose borrowers' credit history, even if such information is non-verifiable. We also provide a rationale for promoting public credit registries.

In a global-games framework, we show how a dealer-of-last-resort policy can promote financial stability while traditional lender-of-last-resort policies are informationally constrained: Central banks and private investors can be uncertain whether banks selling assets to fend off runs are insolvent or illiquid. Such uncertainty leads to asset price collapses and runs and restricts central banks' role as a lender of last resort. In the presence of aggregate uncertainty, contagion and price volatility emerge as a multiple-equilibria phenomenon despite the global-games refinement. A dealer-of-last-resort policy that requires no information on individual banks' solvency can contain contagion and stabilize prices at zero-expected costs.

We find that shareholder-friendly corporate governance is associated with higher stand-alone and systemic risk in the banking sector. Specifically, shareholder-friendly corporate governance results in higher risk for larger banks and for banks that are located in countries with generous financial safety nets as banks try to shift risk toward taxpayers. We confirm our findings by comparing banks to nonfinancial firms and examining changes in bank risk around an exogenous regulatory change in governance. Our results underline the importance of the financial safety net and too-big-to-fail guarantees in thinking about corporate governance reforms at banks.

In a global-games framework, we endogenize asset fire sales, bank runs, and contagion by emphasizing a lack of information: investors can be uncertain whether banks selling assets to fend o runs are insolvent or simply illiquid. However, it is this uncertainty that leads to asset price collapses and runs in the first place. We show that a balanced-budget asset purchase program promotes financial stability by breaking down this vicious cycle. By contrast, increasing capital can exacerbate fire sales in the presence of adverse selection, because runs on well-capitalized banks signal high risks. We also derive implications regarding regulatory disclosure policies.

In a duopoly setting, this paper studies how cost asymmetry influences cartel stability and the effectiveness of leniency programs. It shows that when two firms collude to divide a market, the low-cost firm gains more from that collusion and has a stronger incentive to form a cartel than its high-cost conspirator does. When the cartel remains stable under leniency programs, the inefficient firm can gain a greater market share by threatening to self-report, which reduces both productive and allocative efficiencies. However, the efficient firm will foresee the hold-up problem and hence become reluctant to collude. The introduction of leniency programs therefore present a trade-off between ex-ante deterrence and ex-post efficiency. By contrast, traditional antitrust investigations are shown to both deter cartels and improve allocation. Leniency programs should be viewed as a second-best solution for budget-constrained antitrust authorities.

The following sections are included:IntroductionLiterature ReviewBank Insolvency and Systemic RiskBank CapitalizationConclusionReferences

This paper examines the relationship between banks’ capitalization strategies and their corporate governance and executive compensation schemes for an international sample of banks over the 2003–2011 period. Shareholder-friendly corporate governance, in the form of a separation of the CEO and chairman of the board roles, intermediate board size, and an absence of anti-takeover provisions, is associated with lower bank capitalization, consistent with shareholder incentives to shift risk towards the financial safety net. Higher values of executive option and stock wealth invested in the bank are associated with higher capitalization as a potential reflection of executive risk aversion, but the risk-taking incentives embedded in executive compensation packages are associated with lower capitalization.

This paper reexamines the classical issue of the possible trade-offs between banking competition and financial stability by highlighting different types of risk and the role of leverage. By means of a simple model we show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on banks’ liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts, and on whether the indebtness is exogenous or endogenous. In particular we suggest that, while in a classical originate-to-hold banking industry competition might increase financial stability, the opposite can be true for an originate-to-distribute banking industry of a larger fraction of market short-term funding. This leads us to revisit the existing empirical literature using a more precise classification of risk. Our theoretical model therefore helps to clarify a number of apparently contradictory empirical results and proposes new ways to analyze the impact of banking competition on financial stability.

This paper studies a model where investors’ systemic risk-taking is driven by their need for market liquidity. By investing in the same asset of systemic risk, investors can expect homogeneous returns and thereby limit their private information on asset qualities. This mitigates adverse selection and fosters asset liquidity. Such liquidity creation, however, results in systemic risk: When the asset experiences a loss, all investors become stressed at the same time. Herding therefore presents a trade-off between systemic risk and liquidity creation. The model also suggests that systemic risk and leverage are mutually reinforcing: Investing in a systemic-but-liquid asset increases collateral value and debt capacity. Moreover, investors leveraged with short-term debt will find the systemicbut-liquid asset attractive for reducing the risk of runs. The paper offers an explanation of why banks collectively exposed themselves to mortgage-backed securities prior to the crisis, and why the exposure grew when banks were increasingly leveraged using wholesale short-term funding.

This thesis investigates various issues in regulation, with three chapters on financial fragility and banking regulation, and one chapter on competition policy. Chapter 2 studies banks’ herding driven by their need for market liquidity, highlighting a trade-off between systemic risk and liquidity creation. The model also suggests that systemic risk and leverage are mutually reinforcing, offering an explanation of why banks collectively exposed themselves to mortgage-backed securities prior to the crisis, and why the exposure grew when banks were increasingly leveraged using wholesale short-term funding. Chapter 3 examines the possible trade-off between banking competition and financial stability by highlighting banks' endogenous leverage. Competition is shown to affect portfolio risk, insolvency risk, liquidity risk and systemic risk differently. The model leads us to revisit the existing empirical literature using a more precise taxonomy of risk and take into account endogenous leverage, thus clarifying a number of apparently contradictory empirical results. Chapter 4 presents a model where fire-sales and bank runs are self-fulfilling and mutually reinforcing. With endogenous fire sale prices, the model delivers two new policy insights: First Bank capital can have unintended consequences on illiquidity and contagion, and therefore is not a panacea for financial stability. Second, as acknowledging a crisis aggravates financial contagion, full commitment to regulatory transparency can be suboptimal from a social welfare point-of-view. Chapter 5 is devoted to antitrust policy. It studies how cost asymmetry affects the effectiveness of corporate leniency programs. The analysis shows that using leniency programs involves a trade-off between ex-ante deterrence and ex-post efficiency. For traditional antitrust investigation can both deter cartels and improve allocation, leniency programs should be viewed as a second best solution for budget-constrained antitrust authorities.

The paper presents a model where fire-sales and bank runs are self-fulfilling and mutually reinforcing. When creditors anticipate low prices for a bank’s asset sales, a run is triggered, which generates fire-sales and the corresponding collapses in asset prices, thus fully justifying the panics of creditors. The reasoning extends to contagion when banks have common risk exposures. As one bank fails, asset buyers become more pessimistic and perceive all banks’ assets less valuable. The decline in asset prices precipitates runs onto all other banks. Hence runs and fire-sales fuel each other, a phenomenon that explains the extent of sub-prime crisis in spite of the small amount of sub-prime lending in the total credit supply. The model delivers two policy implications. (1) Since a run on a well-capitalized bank signals unusually high risk and can strongly reduce asset prices, high capital can have unintended consequences on bank illiquidity and contagion. (2) Regulators should be very careful about disclosing information on banks’ common risk: While favorable opinions save illiquid banks, acknowledging a crisis will cause contagion due to buyers’ pessimistic belief updating.

This paper examines how corporate governance and executive compensation affect bank capitalization strategies for an international sample of banks over the 2003-2011 period. ‘Good’ corporate governance, which favors shareholder interests, is found to give rise to lower bank capitalization. Boards of intermediate size, separation of the CEO and chairman roles, and an absence of anti-takeover provisions, in particular, lead to low bank capitalization. However, executive options and stock wealth invested in the bank is associated with better capitalization except just before the crisis in 2006. In that year stock options wealth was associated with lower capitalization which suggests that potential gains from taking on more bank risk outweighed the prospect of additional loss. Banks’ tendency to continue payouts to shareholders after experiencing negative income shocks are shown to reflect executive risk-taking incentives.

This paper reexamines the classical issue of the possible trade-o ff s between banking competition and financial stability by highlighting di ff erent types of risk and the role of leverage. By means of a simple model we show that competition can a ff ect portfolio risk, insolvency risk, liquidity risk, and systemic risk di ff erently. The e ff ect depends crucially on banks’ liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts