Philip Bond

The Real Effects of Financial Markets

A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a sideshow or does it affect real economic activity? In this review, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators’ trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information that is useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.

Contracting in the Presence of Judicial Agency

While a key function of contracts is to provide incentives, the incentives of judges to enforce the terms of a contract have rarely been examined. This paper develops a simple model of judicial agency in which judges are corrupt and can be bribed by contracting parties. Higher-powered contracts expose contracting parties to more frequent and more severe corruption, which in turn lessens the incentives actually provided by the contract. Consequently the model predicts that individuals will commonly refrain from writing high-powered contracts, even when such contracts would be valuable absent judicial agency. I show that similar implications can also be obtained by considering other forms of imperfection in contract enforcement, such as variable expenditures on legal representation. I use the model to develop implications for the optimal punishment of individuals who are extorted by corrupt judges, and to establish circumstances under which a right-of-appeal is optimal.

Information-based trade

We study the possibility of trade for purely informational reasons. We depart from previous analyses (e.g. Grossman and Stiglitz (1980) [22] and Milgrom and Stokey (1982) [32]) by allowing the final payoff of the asset being traded to depend on an action taken by its eventual owner. We characterize conditions under which equilibria with trade exist.

PERSISTENT COURT CORRUPTION

Corruption among court officials varies widely across countries and exhibits considerable intertemporal persistence. I present a model of court corruption in which there are multiple equilibria, differentiated by corruption levels. In the model, courts provide incentives for individuals to take/abstain from certain actions. High corruption levels undermine incentive provision and necessitate larger penalties. Larger penalties in turn increase the potential bribes that a court official can collect and so attract more dishonest officials to court employment. This feedback effect generates multiple equilibria. Paying court officials wages sufficiently above the market-clearing rate can eliminate the high corruption equilibrium. Copyright (C) The Author(s). Journal compilation (C) Royal Economic Society 2008.

Market Run-Ups, Market Freezes, Inventories, and Leverage

We study trade between an informed seller and an uninformed buyer who have existing inventories of assets similar to those being traded. We show that these inventories could induce the buyer to increase the price (a run-up) but could also make trade impossible (a freeze) and hamper information dissemination. Competition can amplify the run-up by inducing buyers to purchase assets at a loss to prevent competitors from purchasing at lower prices and releasing bad news about inventories. In a dynamic extension, we show that a market freeze could be preceded by high prices. Finally, we discuss empirical and policy implications.

Does Junior Inherit? Refinancing and the Blocking Power of Second Mortgages

Refinancing a first mortgage puts legal principles in conflict when other, junior, liens also exist. On one hand, the principle that seniority follows time priority leaves the new refinancing mortgage junior to mortgages that were junior to the original, refinanced first mortgage. On the other hand, the principle of equitable subrogation gives the refinancing mortgage the seniority of the claim it paid down. States resolve this tension differently, thus differentiating how much a second mortgage impedes refinancing of the first. We exploit this cross-state variation to identify the impact on mortgage refinancing and find that refinancing is significantly more likely in the states following the principle of equitable subrogation when the homeowner also has a second mortgage.

Buying High and Selling Low: Stock Repurchases and Persistent Asymmetric Information

Share prices generally fall when a firm announces a seasoned equity offering (SEO). A standard explanation is that an SEO communicates negative information to investors. We show that if repeated capital market transactions are possible, this same asymmetry of information between firms and investors implies that some firms also repurchase shares in equilibrium. A subset of these firms directly profit from repurchases, while other firms repurchase in order to improve the terms of a subsequent SEO. The possibility of repurchases reduces both SEOs and investment. Overall, our analysis highlights the importance of analyzing SEOs and repurchases in a unified framework.

Market-Based Regulation and the Informational Content of Prices

Various laws and policy proposals call for regulators to make use of the information reflected in market prices. We focus on a leading example of such a proposal, namely that bank supervision should make use of the market prices of traded bank securities. We study the theoretical underpinnings of this proposal in light of a key problem: if the regulator uses market prices, prices adjust to reflect this use and potentially become less revealing. We show that the feasibility of this proposal depends critically on the information gap between the market and the regulator. Thus, there is a strong complementarity between market information and the regulators information, which suggests that regulators should not abandon other sources of information when learning from market prices. We demonstrate that the type of security being traded matters for the observed equilibrium outcome and discuss other policy measures that can increase the ability of regulators to make use of market information.

Strategic Voting Over Strategic Proposals, Second Version

Prior research on “strategic voting†has reached the conclusion that unanimity rule is uniquely bad: it results in destruction of information, and hence makes voters worse off. We show that this conclusion depends critically on the assumption that the issue being voted on is exogenous, i.e., independent of the voting rule used. We depart from the existing literature by endogenizing the proposal that is put to a vote, and establish that under many circumstances unanimity rule makes voters better off. Moreover, in some cases unanimity rule also makes the proposing individual better off even when he has diametrically opposing preferences. In this case, unanimity is the Pareto dominant voting rule. Voters prefer unanimity rule because it induces the proposing individual to make a more attractive proposal. The proposing individual prefers unanimity rule because the acceptance probabilities for moderate proposals are higher.

Silence is Safest: Non-Disclosure When the Audience's Preferences are Uncertain

We examine voluntary disclosure when the firm (“sender”) is risk-averse and uncertain about audience preferences. We show that some firms stay silent in equilibrium, in contrast to classic “unravelling” results. Silence reduces the sensitivity of a firm’s payoff to audiences’ preferences, which is attractive to risk-averse firms, i.e., “silence is safest.” Increases in firm risk-aversion reduce disclosure by firm-types who bear a higher risk under disclosure. In contrast, silence imposes risk on the audience, and consequently, increases in audience risk-aversion increase disclosure. We discuss applications to corporate non-disclosure, and to regulatory rules mandating that disclosure be entirely public.