Liquidity and Financial Crisis

Here comes a long-awaited economics book on liquidity, which has great importance especially after having financial crisis.




In Inside and Outside Liquidity, leading economists Bengt Holmstrom and Jean Tirole offer an original unified perspective on the following questions that are center of all financial crises:

• Why do financial institutions, industrial companies, and households hold low-yielding money balances, Treasury bills, and other liquid assets?
• When and to what extent can the state and international financial markets make up for a shortage of liquid assets, allowing agents to save and share risk more effectively?

The publisher's description says:

In a slight, but important departure from the standard of finance, the authors show how imperfect pledgeability of corporate income leads to a demand for as well as a shortage of liquidity with interesting implications for the pricing of assets, investment decisions, and liquidity management.

The book surely attracts those who are interested in liquidity and financial crisis.

Theory Seminar (Sigurdsson)

Original article (link) posted: 05/10/2005

Sigurdsson (2005) "Auctions as Mechanism: An Application to Bankruptcy Reorganization" Job Market Paper

In the paper, he proposes the new mechanism of reorganization of firms in cases of bankruptcy. As a matter of fact, a firm that files for bankruptcy must either liquidate under Chapter 7 of the Bankruptcy Code or reorganize under Chapter 11. The distribution follows the absolute value priority rule (APR) which states that no creditor shall receive any value until all claims senior to his have been paid in full. Legal scholars have proposed several mechanisms as alternatives to the current system of judicially supervised bargaining, widely believed to be costly, lengthy, and to result in inefficient capital structures and violations of the APR. A major drawback of those proposals is their reliance on cash payments.
In the mechanism he proposes, the entire reorganized firm is sold in a cash auction and the proceeds are distributed to creditors according to the APR. He mentions 4 advantages of his mechanism. That is, the mechanism
1) implements the APR for far more general capital structures than the simple debt and equity structures assumed in previous mechanisms.
2) all but eliminates the need for cash payments and therefore works under tight financial constraints.
3) offers the advantage of familiarity over its more novel competitors in an auction.
4) allocates ownership efficiently when creditors do not agree on the firm's value.

It seemed that the participants of the seminar liked his paper. Hope he will get a good job!!
By the way, his main advisor is Eric Maskin. I heard a rumor that he did not take a student, but it should be wrong. I would like to talk to him about my research too.

Game Theory in Finance

What is going on in the up-front academic research in finance? I found a concise description of the field of finance from the great survey article:
"Finance Applications of Game Theory"by Franklin Allen and Stephen Morris (1998, link)

In Introduction, they say the following:

1. Introduction
Finance is concerned with how the savings of investors are allocated through financial markets and intermediaries to firms, which use them to fund their activities. Finance can be broadly divided into two fields. The first is asset pricing, which is concerned with the decisions of investors. The second is corporate finance, which is concerned with the decisions of firms. Traditional neoclassical economics did not attach much importance to either kind of finance. It was more concerned with the production, pricing and allocation of inputs and outputs and the operation of the markets for these. Models assumed certainty and in this context financial decisions are relatively straightforward. However, even with this simple methodology important concepts such as the time value of money and discounting were developed.
Finance developed as a field in its own right with the introduction of uncertainty into asset pricing and the recognition that classical analysis failed to explain many aspects of corporate finance.

Although the paper was written more than 10 years ago, game theoretical perspectives in finance has still not been widespread. If you are interested in these materials, you should definitely check this. Here is the abstract of the paper:

Abstract
Traditional finance theory based on the assumptions of symmetric information and perfect and competitive markets has provided many important insights. These include the Modigliani and Miller Theorems, the CAPM, the Efficient Markets Hypothesis and continuous time finance.
However, many empirical phenomena are difficult to reconcile with this traditional framework. Game theoretic techniques have allowed insights into a number of these. Many puzzles remain. This paper argues that recent advances in game theory concerned with higher order beliefs, informational cascades and heterogeneous prior beliefs have the potential to provide insights into some of these remaining puzzles.

IO Seminar (Kadyrzhanova)

Original article (link) posted: 28/09/2005

Kadyrzhanova "The Leader-Bias Hypothesis: Monopolization and Industry Structure under Imperfect Corporate Control" Job Market Paper

The paper examines the effect of the imperfect corporate control in a dynamic oligopoly market with cost reducing R&D investments. The managers are assumed to have an over-producing incentive ("empire-building" hypothesis), and hence, they do not maximize firms' short-run profit without intervention of the shareholders. Corporate control serves to shift managers' preference from "empire-building" to "profit maximization".
The key observation is that shareholders may want to choose imperfect control because of the commitment benefit of the over-producing derived by "empire-building" preference of the manager. Indeed, she shows that even if there is no cost of corporate control, shareholders do not choose full control. Moreover, it is shown that shareholders are more willing to leave discretionary authority to managers when ahead of rivals, which results in lower turnover, higher concentration, persistently monopolized markets, and significantly lower consumer surplus.

Comments
I found the paper quite interesting. However, there were so many things she put in her presentation and the relationship among those are not clear enough for me. I am afraid that audiences also got little because her focus of the talk is vague. I think her presentation could have become much better if she had tried the followings:
1) Stress and make clear the contribution to the literature
2) Put more intuitive explanation of the main results
3) Be more confident on mathematical parts
4) Mention some actual story in markets or empirical facts as a motivation
5) Explain which element of the model is a key to derive the corresponding result

Interesting Papers in Reference

Athey and Schmutzler (2001) "Investment and Market Dominance" RAND 32 (1): 1-26
Bagwell, Ramey and Spulber (1997) "Dynamic Retail Price and Investment
Competition" Rand, 28(2), 207-227
Bolton, Brodley, and Riordan (2000) "Predatory Pricing: Strategic Theory and Legal Policy" Georgetown Law Journal, 88, pp. 2239-2330
Bolton and Scharfstein (1990) "A Theory of Predation Based on Agency Problems in Financial Contracting" American Economic Review 80(1): 93-106
Cabral and Riordan (1994) "The Learning Curve, Market Dominance and Predatory Pricing" Econometrica, 62, pp. 1115-1140
Fershtman and Judd (1987) "Equilibrium Incentives in Oligopoly" American Economic Review, 77(5), 927-940

Risk and Liquidity

Hyun Song Shin (Hughes-Rogers Professor of Economics at Princeton University)'s awaited book on financial crises came out recently, titled "Risk and Liquidity":


The book is based on his 2008 Clarendon Lectures (in Finance). The table of contents and sample of a few sections are available from his website (link). Let me quote the comments by Roger Myerson and Franklin Allen, which seem to illuminate the feature and importance of  this outstanding book very well.

In the Great Recession, the world has looked for leading economists to offer a new and better understanding of macroeconomic instability, as Keynes did in the Great Depression. In this book, Hyun Song Shin delivers what was needed. Step by step, he develops as new comprehensive understanding of how macroeconomic booms and busts can be derived from microeconomic forces in the banking system. This book should be recognized as a major contribution to macroeconomic theory.
Roger Myerson, Nobel Laureate in Economics 2007, Chicago University

Hyun Song Shin is one of the leading scholars on financial stability in the world. His experience in this field is not confined to his academic work. He has also advised the President of Korea, the Bank of England and many other institutions on these issues. The recent crisis has underlined how important it is to understand the boom-bust cycle. During the boom asset prices rise, this allows financial institutions to borrow and expand their balance sheets and drive prices up more. Similarly, in the bust part of the cycle they reduce their debt, their balance sheets shrink, they sell assets and prices fall more. Hyun Song Shin done the foundational theoretical and empirical research on this leveraging and deleveraging amplification mechanism. This book provides a very accessible summary of this work. It is essential reading for all academics and practitioners interested in financial crises.
Franklin Allen, The Wharton School of the University of Pennsylvania