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In the financial economics literature debt contracts provide optimal solutions for addressing managerial moral hazard problems. We analyze a model with multiple projects where the manager obtains private information about their quality after the contract with investors is agreed. The likelihood of success of each project depends on both its quality and the level of effort exerted on it by the manager. We find distributions of the quality shock such that the optimal financial contract requires the investor to hold an equity claim. Our model addresses issues that are relevant for financial intermediation and corporate governance .

When designing schemes to help SMEs survive crises, the government typically faces asymmetric information, so that it cannot target the SMEs most worth saving. We show that the government can exploit the information in the borrower loan demand to improve policy targets compared with existing programmes. If the aim is employment protection, optimal policy should fully subsidise the funding cost of only those SMEs whose loan size is below a threshold. If the aim is economic efficiency, the government should target SMEs whose loan size is above a threshold. In general, public policy should utilise private sectors' information and expertise.

A key feature of Information and Communication Technologies (ICT) is that they increase the size of the market – or the “scale of operation” – for workers in some occupations. We model the scale of operation as the limit up to which the production technology displays increasing returns to scale. We then explore the implications of this feature of ICT for the income distribution within affected occupations, as well as for individuals' occupational choices. Within occupations, an increase in the scale of operation intensifies competition between workers and increases inequality. It also drives the lowest-ability workers out of the occupation while reducing the earnings of the next lowest-ability workers when the substitutability between the output of the affected occupations and that of the rest of the economy is low.

This paper considers the issue of "Too Connected to Fail" (TCTF) for a system of banks endogenously interconnected with both credit and insurance claims. The interbank credit network results from the circulation of banks' liabilities as a means of payment. By tracking their circulation, this paper considers the general equilibrium effect of bank lending for households' incomes and deposits. Thereby, we find that the network of banks interconnected with credit claims alone, while of a star structure, has no issue of TCTF. If the interbank insurance is introduced, the bank at the center becomes the sole provider of insurance to all the other banks. It then becomes systemically important. In some contingencies, it fails and that triggers bank run to almost all the other banks. There exists early warning for this event of system meltdown. Lastly, we show that the effect of the interbank interest rate for banks' lending depends on their positions in the network; and that the premium of the insurance is negatively related to the interbank interest rate and can be so low as to generate losses to the insurer.

Banks are special in that their liabilities are widely accepted as a means of payment, thereby often needed by real sectors to obtain resources. This paper studies this interaction between the banking sector and real sectors on competitive markets and the policy response of the central bank to market inefficiency, which is determined by the aggregate wealth of banks. In the circumstance of a credit crunch, the central bank improves efficiency by allowing banks to borrow its fiat money at zero interest up to a limit. This policy bears the flavor of quantitative easing policies (QE). It produces real effects in the absence of surprises and nominal rigidity. The mechanism in which it works depends on a difference in nature between bank-created money and fiat money. Furthermore, this policy, while expanding the money supply, induces deflation under the positive productivity shock. Lastly, this paper explains when interest rate policy and capital adequacy regulation are among the optimal policies within a unified model.

This paper presents a new approach to endogenize interbank credit networks, based on banks' specialty that their liabilities are accepted as a means of payment. This approach takes into account how borrowing on banks' asset side affects depositing on their liability side in general equilibrium. This approach is applied to endogenize a star structured interbank network with the aim of studying the issue of too connected to fail (TCTF) and systemic risk. In the model the banking system melts down on equilibrium path. Moreover, (1) the resources are inefficiently concentrated at the center of the network, and more so if the interbank rate is higher; (2) interbank credit claims alone are insufficient to drive the issue of TCTF, which, however, arises if interbank insurance is introduced; (3) early news matters more for systemic stability than late one; and (4) there is a zone of news based on which the event of system meltdown is likely to happen, but has not happened yet. This type of news provides an early warning of the event.

This paper offers a new approach, based on risk sharing, to endogenize the leverage of financial intermediaries. It endogenizes debt as the optimal contract for external financing, thereby capturing two features of leverage: debt serves to boost the return on equity, and equity provides “safety net” for debt. The paper derives a novel prediction that when the asset-side risk rises, the leverage ratio is reduced, but the profit margin of leveraging is actually widened.

The article studies reputation of names and its dynamics. First, the article shows that names backed by nothing intrinsic can bear reputation. Although the context is purely of adverse selection, a mechanism in the spirit of Kreps (1990) helps to sustain reputation. Second, it examines how the dynamics of the reputation affects the extent of sorting and the level of social efficiency and derives the dynamics in the equilibria with the highest efficiency. Finally, it empirically predicts that brand names can be fully established sooner in an industry where high-end products have larger profit margins.

The paper presents a general equilibrium model of signaling through bank finance, in which the bigger the bank loan a firm obtains, the lower the book rate of the loan and the higher the firm's quality signaled, which captures well empirical findings. Based on the model, the paper examines how the size of the banking sector is related to banks' incentive of investing in the expertise of discerning risks. The paper shows that so long as ex post risk shifting is contained, (a) banks over-invest in the expertise; (b) the bigger the banking sector, the lower the investment; hence the sector is never too big; (c) but the lower the investment, the worse the risk-discerning expertise; hence the sector's size is inversely related to its asset risks. Empirically, the paper predicts that (i) the relative profit of the banking sector to the real sectors decreases with the dispersion of project quality, thus lower in the emerging markets than in the developed economies; (ii) across individual banks, the bigger the asset of a bank, the smaller the default risks of its loans; but (iii) across economies, the bigger the assets of the banking sector (relative to the GDP), the greater the default risk of the assets. Lastly, the paper suggests that a universal payment cap upon the financial sector could improve social efficiency. The paper is the first to examine the signaling function of bank finance and the effects of the banking sector size.

The paper shows that collusion between the CEO of a firm and outside expert generates a conflict between ex-ante provision of effort and ex-post disclosures of bad news if the alliance tends to hide early warning signals that call for restructuring of firm’s assets. This tension is resolved by a compensation scheme that incorporates both bonus and golden parachutes or severance payments for the CEO. The latter exacerbates incentive problems and imposes extra costs on shareholders and makes the process of reorganization based on such information costlier. A greater bargaining power of the expert, however, reduces overall CEO pay and also preserves incentives. On the other hand, public information such as stock price, media reports serve as second opinion about firm’s disclosure of information that make it harder for the collusive alliance to earn larger amount of information rents. The paper also derives direct empirical implications linking management compensations to voluntary disclosures of bad news and frequency of restructurings of assets for both private and public firms.

This paper first presents a new approach to examine the leverage of financial intermediaries. It is driven by differing risk preferences and captures two features: Debt serves to boost the return of equity, and equity to safe net debt. Then the paper shows, for the first time, that if unregulated, financial intermediaries are leveraged over the social best level, whereas the leverage of real sectors is not subject to the market failure. The market failure is expounded for the first time. It is fixed by proper capital adequacy regulation. The regulation raises the profit of the finance sector as a whole, but individual financial intermediaries have incentive to circumvent the regulation.

The paper presents a theory that large scales are necessary to establish reputation. In the model, each producer yields one widget and chooses the quality investment each period. Low quality widgets always fail and high quality ones perform with some probability. Due to noisiness of single performance, a producer cannot establish reputation in market. Free of production constraint, a middleman is able to sell many widgets per period. By the Law of Large Numbers their average performance is informative of the average quality. However, as the scale is large, shirking in a small number decreases hardly average quality and thus looks undetectable, which, if true, will break the equilibrium expectation of the market. Applying Central Limit Theorem the paper ensures that is not true. Thus the middleman is always able to establish reputation if the scale is big enough. Moreover, the probability of the reputation being continued goes to one with the scale going to infinity. The theory sheds light on the existence of professional firms and middlemen.

The literature starting from Diamond (1984), justifying Financial Intermediation (FI) from the viewpoint that it accommodates additionally monitoring service, mis-targets the existence problem of FI, since direct fiances could also accommodate monitoring by hiring a specialist-monitor. This paper considers the problem through the perspective of how to allocate the liability to the investors. For an economy consisting of entrepreneurs, potential monitors (MBAs) and investors, the paper lists all possible allocations of the liability and then for each one finds the optimal contractual arrangements. Under the best direct finance, called HSwM, the entrepreneurs hold each other to take the liability against their projects pool and hire an MBA as the specialist-monitor. Under FI, the MBA alone takes the liability against the asset formed by her investment in the entrepreneurs, and also monitors them. Two effects of the allocations are figured out. First, FI has Number Advantage since if necessary the investors only audit one intermediary firm under FI but many entrepreneur projects under HSwM; HSwM has Collateral Advantage since the liable asset under it is the projects pool and thus contains always as a part that under FI. Second, the allocation affects the optimal contractual arrangements. FI has two types of optimal arrangements that define it as Bank and Fund respectively and the arrangement of Fund is different in nature from the optimal arrangement for HSwM

The brand-names are believed to represent the reputation of a firm. However, often it was created long ago by the glories of the members physically unrelated to the firm now. How could it survive the dealth of the founding members? To address this problem, the paper presents an OLG model where an organization is purely a brand-name shared consecutively by sellers, each working for one period only, and its reputation is driven by market competition. I find that the value dynamics of brand-names are necessary part of the mechanism effecting the reputation and decides the social efficiency. I spell out fully the dynamic in the second best, in which the remote past matters for the present reputation, and the value of a brand-name increases after a success; decreases after a failure; is destroyed totally by it if the value is already low enough; and is immune to failures for a top name if it is found following honest-price norm. And I find an inverse relation between one-period profit of a firm and the time it needs to develop its brand-name fully.