Kostas Koufopoulos

Endogenous Commitment and Nash Equilibria in Competitive Markets with Adverse Selection

In this paper, we provide a unified framework for analyzing competitive markets with adverse selection. The key feature of our model is that whether the suppliers of the contracts (uninformed) are committed to the contracts they offer or not is determined endogenously. Because of the endogeneity of the commitment, our model always has a unique Bayesian-Nash equilibrium even though we do not use any refinement to restrict beliefs off-the-equilibrium path. We show that when the Wilson pooling allocation Pareto-dominates the Rothschild-Stiglitz separating allocation the former is the unique equilibrium. We also show that both the non-existence problem in the Rothschild-Stiglitz screening model and the multiplicity of equilibria in the three-stage game of Hellwig are due to the arbitrary restrictions imposed on firms’ actions (strategies).

Managerial Compensation and Capital Structure Under Asymmetric Information

We consider project financing when the project quality is private information of the manager and, given its inherent quality, the project viability depends on the manager exerting unobservable effort. We show that capital structure matters even though managerial contracts are optimally designed. We also provide an explanation of why good firms issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). Finally, we show that the optimal financial contract can be implemented by a combination of debt and equity. Our results have a number of testable implications.

(Neutrally) Optimal Mechanism Under Adverse Selection: The Canonical Insurance Problem

This paper revisits the problem of adverse selection in the insurance market of Rothschild and Stiglitz. We extend the game-theoretic structure in Hellwig to a mechanism in which the Miyazaki-Wilson-Spence allocation is the unique perfect-Bayesian equilibrium. As is well-known, this allocation is the unique incentive-efficient and individually-rational maximizer of the utility of the profitable type. In fact, given that the informed player has only two types, it is the unique core allocation and, thus, the unique neutral optimum in the sense of Myerson.

Short-term Corporate Debt Around The World

Short-term corporate debt as a proportion of total debt issued by public firms varies greatly across countries, between 28% in the U.S. and 78% in China. This paper argues that the interaction between information asymmetry and legal protection of creditors is an important determinant of debt maturity. When short-term debt plays a dual role as signalling and commitment devices, a reduction in information asymmetry has a larger impact on debt maturity when creditor rights are weaker. We find empirical support for this prediction using firm-level data from 45 countries around the world.

Separation of Powers, Political Competition and Ecient Provision of Public Goods

In this paper we provide a political game where agents decide whether to become legislators or politicians. Legislators determine the political institutions constraining politicians’ behavior and politicians compete for gaining the power to make decisions about the level of the public good. We derive the following results: i) Political competition is a necessary but not a sucient condition for the elimination of political rents. ii) Agents utilize the separation of powers in order to endogenously select institutions which restrict the power of politicians. iii) In conjunction with political competition, these institutions implement the Lindahl allocation in the economy as a sub-game perfect Nash equilibrium of the political game. iv) As a consequence of the previous result, political rents are zero in equilibrium, in the sense that the winning politician does not extract part of the social surplus because of his power. To the best of our knowledge, this in the only citizen-candidate model with this equilibrium property.

Frictions to Political Competition and Financial Openness

In this paper we present a political economy approach in order to explain the degree of financial openness for an economy. In the model, entrepreneurs, who may have good or bad projects, vote for policies, which are proposed by selfi sh politicians. Two political frictions (ideological adherence and a super- majority requirement) impair political competition and lead to equilibria, where politicians receive corruption bribes. Furthermore, the model implies a non-monotonic relationship between financial openness and corruption and a positive relationship between financial openness and government size. Some of the model predictions are consistent with empirical findings while other predictions have not beeen tested yet.

Optimal Security Design Under Asymmetric Information and Profit Manipulation

We consider a model of external financing under ex ante asymmetric information and profit manipulation (non verifability). Contrary to conventional wisdom, the optimal contract is not standard debt, and it is not monotonic. Instead, it resembles a contingent convertible (CoCo) bond. In particular: (i) if the profit manipulation and/or adverse selection are not severe, there exists a unique separating equilibrium in CoCos; (ii) in the intermediate region, if the distribution of earnings is unbounded above there exists a unique pooling equilibrium in CoCos, otherwise debt might be issued but it is never the unique equilibrium; (iii) finally, if profit manipulation is severe, there is no financing. These findings suggest that the standard monotonicity constraint exogenously imposed in the security design literature must be reconsidered. Crucially, profit manipulation is part of the optimal contract, and non-monotonic, convertible securities mitigate the asymmetric information problem. We discuss milestone payments in venture capital as an application.

Debt Maturity and Financial Integration

This study applies the panel convergence methodology developed by Philips and Sul (2007) on the debt maturity ratios of a set of firms in developed economies, to explore the effects of credit market integration on debt maturity choices. In contrast to prior studies, our methodology allows for a formal quantification of the integration process. Therefore, we are able to track the evolution of integration over time and identify the conditions under which it is stronger. Firms that are able to integrate with international credit markets face a lower degree of informational asymmetries and have higher collateral value. Furthermore, as firms integrate with international credit markets, they extend their debt maturity. This evidence provides support to the argument that financial integration has a positive impact on firms, by facilitating access to long-term capital. On the contrary, firms not affected by credit market integration, experience a decrease in their debt maturity, as integration continues.

The Beneficial Coexistence of Banks and Markets: The Role of Capital Requirements and Underwriting

We propose a model of financial system architecture that highlights the positive interaction between banks and markets in a setting where each agent believes that she can evaluate information better than any other agent. Banks emerge endogenously and their interaction with markets is facilitated by the use of underwriting and regulatory capital requirements. Bank Capital reassures market investors that the underwriting contract will be fulfilled. The profits they make on underwriting enable banks to fund more projects in the future. Thus, a complementarity loop is achieved which results in the financing of positive NPV projects that were previously denied credit.

Why are Some Issues of Convertibles Callable and Others Not

We develop a theoretical model to explain why some issues of convertible bonds include a call feature whereas others do not and then test the predictions of the model empirically. The reasoning in the model is that good firms do not need a call feature and therefore issue straight debt or non-callable convertibles. Bad firms issue callable convertibles, because a call might help them to avoid bankruptcy costs if their prospects deteriorate in a later period. A separating equilibrium for the model is demonstrated. The model predicts that the announcement of a non-callable convertible will have a smaller negative impact on the share price than that of a callable convertible; this is confirmed by the data, for which the price effects are -3.97% and -6.15% respectively. A second prediction is that announcing a call (and forcing conversion) conveys bad news to the market; we find that there is a significant short-term effect on the share price, but only if the call is made relatively quickly. Finally, we check whether issuing or calling a convertible is associated with abnormal subsequent performance over three years and find that it is not.