Publications

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No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

February 1 2021 | Financial Engineering |
This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.

Commentary: 5 ways to make the SECURE Act meet participants’ needs

August 21 2020 | Life-Cycle Savings/Investment, Retirement Planning |
In late 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act. Section 203 of the SECURE Act introduces lifetime income disclosures, and on Aug. 18, the Department of Labor's Employee Benefits Security Administration announced an interim final rule for compliance with this provision of the SECURE Act...

3 policy proposals to bolster the post-lockdown economy

June 3 2020 | Retirement Planning | Presentations
MIT Sloan economists say the government’s efforts during COVID-19 are a good start but not enough to restart the economy. Here are their recommended next steps.

Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions

July 2019 | Miscellaneous | Paper
with Richard T. Thakor. Abstract Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary's credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary's credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets.

Volume 4: Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk

March 2019 | Risk Management/Stocks | Book
Dale F Gray, Robert C Merton and Zvi Bodie. World Scientific Reference on Contingent Claims Analysis in Corporate Finance. Vol. 4 Volume 4 focuses on the application of the contingent claim approach to banks and other financial intermediaries. Regulation of the banking industry led to the creation of new financial securities (e.g., CoCos) and new types of stakeholders (e.g., deposit insurers).

Robert Merton and the effect of time on portfolio choice

June 15 2019 | | Article, Interview
A Nobel prizewinner on when investment horizons matter. Interview for Buttonwood, The Economist.