Summary of the Working Papers

In “Financial Liberalisation and Capital Regulation in Open Economies” joint with Alan Morrison (SBS), Lucy White (Harvard) described how the regulator can introduce contagion into banking systems in the absence of direct intelinkages between banks. The paper shows that there is an externality introduced by the “cherry picking” of regulators. Banks will prefer to be certified by high quality regulators, which will select the best banks leaving other regulators to select from a worse pool. Banks that are certified by the better regulator will be larger, more profitable and have lower deposit rates. By imposing a level playing field through capital requirements, such as those associated with the Basle Accord, the externality can be diminished by setting requirements at the level associated with the worst regulator.


Patrick Bolton (Columbia) considered why foreign debt to sovereign borrowers is frequently in the form of bonds that include clauses that make them difficult to renegotiate. In a paper entitled “Redesigning the International Lender of Last Resort“ with David Skeel, he described how costly renegotiation discourages borrowers from engaging in strategic default and allows debt to act as a commitment device. However, these impediments to debt restructuring come at a price and the authors argue that problems of debt renegotiation would be better handled by proper bankruptcy procedures that operated at the sovereign level. Such procedures would allow a coherent and enforceable set of priority rules to be established, provide the basis on which refinancing could be sort from the private sector and offer a stronger rationale for the lender of last resort role for the IMF.

Oren Sussman (SBS) described a model of business cycles resulting from financial distress and its impact on capital goods prices in a paper entitled “Financial Distress, Bankruptcy Law and the Business Cycle”, joint with Javier Suarez (CEMFI). During a boom, firms take on large amounts of debt to meet high prices of capital goods and utilize the high value of collateral available to them. Those that fall into financial distress then have to liquidate assets, depressing prices of capital goods. This allows new firms to start with low levels of debt and collateral which in turn drives up capital goods prices and cycles result. In principle, softer bankruptcy laws should mitigate the cycles by allowing debt relief for firms in financial distress but because lenders anticipate lower recovery rates, this results in them imposing larger collateral requirements on borrowers.

Howard Rosenthal (Princeton) considered the political factors that resulted in the USA failing to implement a federal bankruptcy law for most of the 19th century. In a paper entitled “Power Rejected: Congress and Bankruptcy in the Early Republic” with Erik Berglof, he described how voting on bankruptcy law reforms in Congress followed ideological lines. The paper uses a two-dimensional measure of ideology based on a legislator’s entire voting record for all the years that the legislator served in Congress. The first dimension captures economic left-right and the second the North-South division on slavery. The authors find that the “left” undid the legislative advances of the “right” in bankruptcy reform and preferences in Congress were determined by volatile election outcomes. Attempts at reform by debt ridden frontier states in the Senate were overturned by the more populous states in the House.

Hulya Eraslan (Wharton School) presented a paper entitled “Debt Restructuring and Voting Rules” in which she described how voting rules employed by creditors in debt restructurings are frequently specified by statute. For example, in the US debt restructuring outside of bankruptcy requires unanimous agreement amongst creditors, while supermajority voting is employed in Chapter 11 bankruptcy procedures. The paper argues that where markets are liquid then the toughness associated with unanimity voting rules benefits creditors more than the risk of disagreement hurts them. However, where markets are illiquid then restructuring is almost impossible to achieve with unanimity to the detriment of both creditors and debtors.

In “Devaluation Without Common Knowledge”, Celine Rochon (Universite de Cergy-Pontoise) extends existing models of currency crises in a model of an economy with a fixed exchange rate that suffers a random adverse shock. The paper describes a game played by sequentially informed speculators that has a unique symmetric Nash equilibrium. This strategy is the unique one to survive the iterated elimination of dominated strategies. The shock provokes speculators to sell the currency which in turn can trigger an endogenous devaluation of the currency after some delay. The response of speculators to the shock is affected by the Central Bank’s holding of reserves. There is uncertainty about the initial level of reserves and the greater the uncertainty about the reserves the longer the delay before speculators respond and a devaluation is triggered.

In a paper entitled “The Effects of Biased Self-Perceptions in Teams” with Simon Gervais, Itay Goldstein (Wharton School) described how overconfidence can overcome team coordination problems. Organizations such as partnerships, syndicates, boards of directors, are subject to free rider problems of individual participants providing insufficient effort. The paper describes how in the presence of complementarities, an individual who overestimates his marginal productivity works harder to the benefit of his teammates who in turn work harder to the benefit of the first individual. The presence of a team leader is beneficial provided that the overestimation of ability does not affect the team leader.

In “Reputation Effects in Trading on the New York Stock Exchange” with Robert Battalio and Robert Jennings, Andrew Ellul (Indiana University) examined theories of how non-anonymous based trading attenuates adverse selection problems in market trading. The paper uses data on the location of specialists on the New York Stock Exchange trading floor as a way of testing reputation based theories of trading costs. In particular, the paper examines what happens when specialists relocate on the floor and break relations with some of their brokers. They report significant increases in the cost of liquidity in the days surrounding the relocations. They find that the increase is particularly pronounced for stocks with large adverse selection and greater broker turnover.

Jan Werner (Minnesota) described how market crashes can occur in rational expectations equilibrium. He showed that if there are bounds on possible levels of liquidity then as the equilibrium price of an asset decreases a critical value is reached at which the information of uninformed traders changes from partial to full and a sudden discrete drop in prices results. In essence, a point is reached where uninformed traders finally realize that the information signal that informed traders possess is low and this causes the rational expectations equilibrium price to switch from an uninformative to an informative regime.

Pete Kyle (Duke) described “A Two-Factor Model of Value and Growth with Adjustment Costs” in which one factor captures shocks to industry demand and the other growth in demand. Innovations to the first factor are assumed to command a large risk premium and the second small premia. There are quadratic adjustment costs of investment and an option to scrap capital at low valuations. Operational leverage makes the returns of firms volatile when they are losing money. The paper shows that stocks with low growth rates load strongly on the value factor and those with high growth on the growth factor. Returns on value stocks are found to correlate strongly with innovations in demand and those on growth stocks with innovations in future demand.

Eric Hughson (Colorado) presented a paper co-authored with Jonathan Black entitled “Can Boundedly Rational Agents Make Optimal Decisions? A Natural Experiment”. In an attempt to overcome the distortions of laboratory experiments, this paper looks at the behaviour of participants in a series of TV games. The paper compares the behaviour of participants with optimal strategies. They find that participants who behave suboptimally in the first game almost always behave optimally in a subsequent game. The paper implies that inferences cannot easily be drawn from laboratory experiments for the behaviour of individuals outside of laboratories.