Working paper series / Institute for Monetary and Financial Stability
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35
This paper considers a firm that has to delegate to an agent, such as a mortgage broker or a security dealer, the twin tasks of approaching and advising customers. The main contractual restriction, in particular in light of related research in Inderst and Ottaviani (2007), is that the firm can only compensate the agent through commissions. This standard contracting restriction has the following key implications. First, the firm can only ensure internal compliance to a "standard of sales", in terms of advice for the customer, if this standard is not too high. Second, if this is still feasible, then a higher standard is associated with higher, instead of lower, sales commissions. Third, once the limit for internal compliance is approached, tougher regulation and prosecution of "misselling" have (almost) no effect on the prevailing standard. Besides having practical implications, in particular on how to (re-)regulate the sale of financial products, the novel model, which embeds a problem of advice into a framework with repeated interactions, may also be of separate interest for future work on sales force compensation. JEL Classification: D18 (Consumer Protection), D83 (Search; Learning; Information and Knowledge), M31 (Marketing), M52 (Compensation and Compensation Methods and Their Effects).
27
This paper presents a novel model of the lending process that takes into account that loan officers must spend time and effort to originate new loans. Besides generating predictions on loan officers’ compensation and its interaction with the loan review process, the model sheds light on why competition could lead to excessively low lending standards. We also show how more intense competition may fasten the adoption of credit scoring. More generally, hard-information lending techniques such as credit scoring allow to give loan officers high-powered incentives without compromising the integrity and quality of the loan approval process. The model is finally applied to study the implications of loan sales on the adopted lending process and lending standard.
32
We present a simple model of personal finance in which an incumbent lender has an information advantage vis-a-vis both potential competitors and households. In order to extract more consumer surplus, a lender with sufficient market power may engage in "irresponsible"lending, approving credit even if this is knowingly against a household’s best interest. Unless rival lenders are equally well informed, competition may reduce welfare. This holds, in particular, if less informed rivals can free ride on the incumbent’s superior screening ability.
33
We analyze how two key managerial tasks interact: that of growing the business through creating new investment opportunities and that of providing accurate information about these opportunities in the corporate budgeting process. We show how this interaction endogenously biases managers toward overinvesting in their own projects. This bias is exacerbated if managers compete for limited resources in an internal capital market, which provides us with a novel theory of the boundaries of the firm. Finally, managers of more risky and less profitable divisions should obtain steeper incentives to facilitate efficient investment decisions.
6
We consider an imperfectly competitive loan market in which a local relationship lender has an information advantage vis-à-vis distant transaction lenders. Competitive pressure from the transaction lenders prevents the local lender from extracting the full surplus from projects, so that she inefficiently rejects marginally profitable projects. Collateral mitigates the inefficiency by increasing the local lender’s payoff from precisely those marginal projects that she inefficiently rejects. The model predicts that, controlling for observable borrower risk, collateralized loans are more likely to default ex post, which is consistent with the empirical evidence. The model also predicts that borrowers for whom local lenders have a relatively smaller information advantage face higher collateral requirements, and that technological innovations that narrow the information advantage of local lenders, such as small business credit scoring, lead to a greater use of collateral in lending relationships. JEL classification: D82; G21 Keywords: Collateral; Soft infomation; Loan market competition; Relationship lending
5
This paper shows that investors financing a portfolio of projects may use the depth of their financial pockets to overcome entrepreneurial incentive problems. Competition for scarce informed capital at the refinancing stage strengthens investors’ bargaining positions. And yet, entrepreneurs’ incentives may be improved, because projects funded by investors with “shallow pockets” must have not only a positive net present value at the refinancing stage, but one that is higher than that of competing portfolio projects. Our paper may help to understand provisions used in venture capital finance that limit a fund’s initial capital and make it difficult to add more capital once the initial venture capital fund is raised.
29
We study a model of “information-based entrenchment” in which the CEO has private information that the board needs to make an efficient replacement decision. Eliciting the CEO’s private information is costly, as it implies that the board must pay the CEO both higher severance pay and higher on-the-job pay. While higher CEO pay is associated with higher turnover in our model, there is too little turnover in equilibrium. Our model makes novel empirical predictions relating CEO turnover, severance pay, and on-the-job pay to firm-level attributes such as size, corporate governance, and the quality of the firm’s accounting system.
30
This paper shows that active investors, such as venture capitalists, can affect the speed at which new ventures grow. In the absence of product market competition, new ventures financed by active investors grow faster initially, though in the long run those financed by passive investors are able to catch up. By contrast, in a competitive product market, new ventures financed by active investors may prey on rivals that are financed by passive investors by “strategically overinvesting” early on, resulting in long-run differences in investment, profits, and firm growth. The value of active investors is greater in highly competitive industries as well as in industries with learning curves, economies of scope, and network effects, as is typical for many “new economy” industries. For such industries, our model predicts that start-ups with access to venture capital may dominate their industry peers in the long run. JEL Classifications: G24; G32 Keywords: Venture capital; dynamic investment; product market competition
31
This paper argues that banks must be sufficiently levered to have first-best incentives to make new risky loans. This result, which is at odds with the notion that leverage invariably leads to excessive risk taking, derives from two key premises that focus squarely on the role of banks as informed lenders. First, banks finance projects that they do not own, which implies that they cannot extract all the profits. Second, banks conduct a credit risk analysis before making new loans. Our model may help understand why banks take on additional unsecured debt, such as unsecured deposits and subordinated loans, over and above their existing deposit base. It may also help understand why banks and finance companies have similar leverage ratios, even though the latter are not deposit takers and hence not subject to the same regulatory capital requirements as banks.
34
This article shows that investors financing a portfolio of projects may use the depth of their financial pockets to overcome entrepreneurial incentive problems. Competition for scarce informed capital at the refinancing stage strengthens investors’ bargaining positions. And yet, entrepreneurs’ incentives may be improved, because projects funded by investors with ‘‘shallow pockets’’ must have not only a positive net present value at the refinancing stage, but one that is higher than that of competing portfolio projects. Our article may help understand provisions used in venture capital finance that limit a fund’s initial capital and make it difficult to add more capital once the initial venture capital fund is raised. (JEL G24, G31)