Abstract: This paper develops a theory that generates an equilibrium relationship between product complexity, transparency, and trust in firms. Complexity, transparency, and the evolution of trust are all endogenous, and equilibrium transparency is nonmonotonic. The least-trusted firms choose the lowest product complexity, remain opaque, and substitute ex ante third-party verification for information disclosure and trust. Firms with an intermediate level of trust choose an intermediate level of complexity and transparency through disclosure, with more trusted firms choosing greater complexity and lower transparency. The most-trusted firms choose maximum complexity while remaining opaque, eschewing both verification and disclosure.
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.
Robert C. Merton's contributions are current. Regarding the design of retirement plans, in a framework of pension deficient systems, the investigations of Merton (1969) and (1971) on optimal consumption and portfolio rules during and after working life acquire contemporary validity. Likewise, Bodie and Merton (2002) propose the use of derivative products, at the international level, to diversify the risks of pension systems just at the moment when these systems of many underdeveloped and industrialized economies are on the verge of collapse; knowing that several of these systems only provide a meager proportion of the salary. Finally, Merton's theory of rational option pricing is retaken to create synthetic oil pipelines and power plants through the use of contingent claims. This paper aims to review the trends and perspectives in financial science and mathematical finance, within the framework of the pioneering contributions of Robert Cox Merton, highlighting priority areas that offer opportunities for research with social and global impacts.
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...
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.
with Richard T. Thakor.
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.
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).