Federal Reserve Bank of New York Economic policy review 

About: Federal Reserve Bank of New York Economic policy review is an academic journal. The journal publishes majorly in the area(s): Interest rate & Monetary policy. Over the lifetime, 312 publications have been published receiving 17082 citations.

Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature

Abstract: 1. INTRODUCTION Most organizations are governed by a board of directors. In fact, having a board is one of the legal requirements for incorporation. Many nonincorporated entities also have a governing board of some sort, such as a state university's board of regents. Given the myriad boards in place today, it is reasonable to ask, Why do they exist? What do they do? Can they be "improved"? These questions are at the heart of governance and, to a certain extent, management. As such, they have motivated much of the research on this topic. This paper surveys the research on boards of directors in the economics and finance literature. Boards of directors are an economic institution that, in theory, helps to solve the agency problems inherent in managing an organization. Although boards satisfy numerous regulatory requirements, their economic function is determined by the organizational problems they help to address. Yet formal economic theory on boards has been quite limited. For example, the characteristics of agency problems that could lead to boards being the equilibrium solution have not yet been specified. Similarly, the conditions under which regulation of boards will lead to improvements are unknown. Despite the absence of formal theory, we have a strong intuitive sense of the problems facing boards. A major conflict within the boardroom is between the CEO and the directors. The CEO has incentives to "capture" the board, so as to ensure that he can keep his job and increase the other benefits he derives from being CEO. Directors have incentives to maintain their independence, to monitor the CEO, and to replace the CEO if his performance is poor. To some extent, the vacuum in formal theory has been filled by empirical work on boards. The "cost" associated with this approach, however, is that little of the empirical work on boards has been motivated by formal theory. Rather, it has sought to answer one of three questions: 1. How do board characteristics such as composition or size affect profitability? 2. How do board characteristics affect the observable actions of the board? 3. What factors affect the makeup of boards and how do they evolve over time? A key issue in this empirical work is how to proxy for the board's degree of independence from the CEO. Much of this work starts from the sometimes implicit assumption that observable board characteristics such as size or composition are related to the level of board independence. (1) Research thus far has established a number of empirical regularities. First, board composition, as measured by the insider-outsider ratio, (2) is not correlated with firm performance. (3) However, the number of directors on a firm's board is negatively related to the firm's financial performance. Second, board actions do appear to be related to board characteristics. Firms with higher proportions of outside directors and smaller boards tend to make arguably better--or at least different--decisions concerning acquisitions, poison pills, executive compensation, and CEO replacement, ceteris paribus. Finally, boards appear to evolve over time depending on the bargaining position of the CEO relative to that of the existing directors. Firm performance, CEO turnover, and changes in ownership structure appear to be important factors affecting changes to boards. Two important issues complicate empirical work on boards of directors, as well as most other empirical work on governance. First, almost all the variables of interest are endogenous. The usual problems of joint endogeneity therefore plague these studies. For instance, firm performance is both a result of the actions of previous directors and itself a factor that potentially influences the choice of subsequent directors. Studies of boards often neglect this issue and thus obtain results that are hard to interpret. Second, many empirical results on governance can be interpreted as either equilibrium or out-of-equilibrium phenomena. …

Determinants and Impact of Sovereign Credit Ratings

Abstract: n recent years, the demand for sovereign credit rat-ings—the risk assessments assigned by the creditrating agencies to the obligations of central govern-ments—has increased dramatically. More govern-ments with greater default risk and more companiesdomiciled in riskier host countries are borrowing in inter-national bond markets. Although foreign government offi-cials generally cooperate with the agencies, ratingassignments that are lower than anticipated often promptissuers to question the consistency and rationale of sover-eign ratings. How clear are the criteria underlying sover-eign ratings? Moreover, how much of an impact do ratingshave on borrowing costs for sovereigns?To explore these questions, we present the firstsystematic analysis of the determinants and impact of thesovereign credit ratings assigned by the two leading U.S.agencies, Moody’s Investors Service and Standard andPoor’s.

Executive Equity Compensation and Incentives: A Survey

Abstract: 1. INTRODUCTION Corporate governance is generally considered to be the set of complementary mechanisms that help align the actions and choices of managers with the interests of shareholders. Monitoring actions by the board of directors, debtholders, or institutional blockholders can have an important impact on the economic performance of an organization (for example, Jensen [1989], Mehran [1995], Core, Holthausen, and Larcker [1999], and Holderness [2003]). Another important and often debated component of the governance structure is the compensation contract selected for providing remuneration to managers (for example, the level of remuneration or choice of performance measures). Executive compensation has been the subject of extensive prior research, and excellent general reviews already exist for the interested reader (for example, Murphy [1999]). For our purposes here, we will not reproduce this discussion but rather focus on the more narrow, but crucial, topic of stock-based compensation and incentives. Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. Not surprisingly, many fundamental questions remain unanswered, and one of our goals is to highlight topics that seem especially appropriate for future research. Within the corporate governance literature, and more specifically within the executive compensation literature, there are alternative views on the efficiency of observed contracting arrangements between firms and their executives. For the purposes of this survey and as an organizing principle of our literature review, we follow a traditional agency-theory framework and define an efficient contract as one that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees. An equivalent way of saying this is that we assume that contracts minimize agency costs. Clearly, the types of contracts that are efficient at any particular time or in a particular sector of the economy are a function of various transaction costs. For instance, a contract that was efficient in the United States fifty years ago may not be efficient today because information costs have fallen greatly and the optimal organizational form has changed as a result. Over time, optimal contracting arrangements evolve with changes in contracting technology. As part of this evolutionary process, firms are experimenting with new contracting technologies. Some experiments succeed and others fail as firms update their beliefs and learn about the efficiency of their governance structures. Throughout this process, firms may be uncertain about the optimal contracting technology. As a result of this uncertainty and because of differences in beliefs about optimal incentive levels, one would expect variation in the observed contracts across firms. However, unless beliefs are systematically biased, we expect that compensation contracts are efficient, on average, and that average equity incentive levels across firms are neither "too high" nor "too low." (For an example and discussion of how an evolutionary process converges to an efficient outcome, see Lazear [1995, pp. 8-10].) In contrast to this economic perspective, a number of scholars and practitioners either implicitly or explicitly take the view that contracting arrangements are largely inefficient and do not minimize agency costs (for example, Morck, Shleifer, and Vishny [1988], Crystal [1991], and Jensen [1993]). A view that sees most firms behaving inefficiently is hard to support. At the opposite extreme is the view that transaction costs in the labor market, the stock market, and the market for corporate control are so small that all agency costs are eliminated. …

A Survey of Blockholders and Corporate Control

Abstract: 1. INTRODUCTION The notion of diffuse stock ownership is well entrenched among economists. It started with Adam Smith's legendary warning in Wealth of Nations about the "negligence and profusion" that will result when those who manage enterprises are "rather of other people's money than of their own." A century and a half later, another lawyer, Adolf Berle, along with a journalist, Gardiner Means, returned to the theme of diffuse stock ownership. Since the dawn of capitalism, Berle and Means reasoned, most production had taken place in relatively small organizations in which the owners were also the managers. Beginning in the nineteenth century with the Industrial Revolution, however, technological change had increased the optimal size of many firms to the point where no individual, family, or group of managers would have sufficient wealth to own a controlling interest. As a result, enterprises faced "the dissolution of the old atom of ownership into its component parts, control and beneficial ownership" (Berle and Means 1932, p. 8). Ultimately, this separation of ownership from control threatens "the very foundation on which the economic order of the past three centuries has rested." The arguments of Berle and Means on the dangers of diffuse stock ownership, written during the depths of the Great Depression, had an immediate and profound impact. (1) Most notably, their arguments helped to shape the federal securities legislation of the 1930s. That legislation was intended to protect diffuse shareholders from professional managers, and it remains the primary federal securities law to this day. The notion of diffuse ownership has also had a profound influence on contemporary economists. This can perhaps best be seen in one of the pivotal papers of the postwar era, Jensen and Meckling's (1976) agency paper. Much of the focus of that paper is on the conflict between diffuse shareholders and professional managers: Since the relationship between the stockholders and manager of a corporation fit the definition of a pure agency relationship, it should be no surprise to discover that the issues associated with the "separation of ownership and control" in the modern diffuse ownership corporation are intimately associated with the general problem of agency. We show ... that an explanation of why and how the agency costs generated by the corporate form are born leads to a theory of the ownership (or capital) structure of the firm. As economists started to employ this agency perspective, it was mainly in the context of diffuse shareholders and professional managers. This, for example, can be seen in the papers in a special issue of the Journal of Financial Economics on the market for corporate control in 1983. Many of these papers have become widely cited. It is illuminating, however, that among the sixteen papers in the special issue, there is little mention of large-percentage shareholders or managerial stock ownership. (2) In the issue's review article (Jensen and Ruback 1983), stock ownership, be it by mangers or by outsiders, was not listed as a direction for future research. After the volume was published, researchers began to discover that some public corporations had large-percentage shareholders, many of whom were top managers or directors. Researchers also discovered that some of these corporations were large and well known. Concentrated stock ownership, it appeared, was not limited to a few anomalous firms. Soon, academics began to study the impact of large-block shareholders. Three empirical papers in the mid-1980s set the tone and the agenda for much of the research into ownership structure that has ensued over the following fifteen years. Demsetz and Lehn (1985) address the question of the types of public corporations that are likely to have high levels of managerial stock ownership. Holderness and Sheehan (1988) address the question of whether major corporate decisions are different when a corporation has a large-percentage shareholder. …

Portfolio Credit Risk

Abstract: INTRODUCTION AND SUMMARY Financial institutions are increasingly measuring and managing the risk from credit exposures at the portfolio level, in addition to the transaction level. This change in perspective has occurred for a number of reasons. First is the recognition that the traditional binary classification of credits into "good" credits and "bad" credits is not sufficient--a precondition for managing credit risk at the portfolio level is the recognition that all credits can potentially become "bad" over time given a particular economic scenario. The second reason is the declining profitability of traditional credit products, implying little room for error in terms of the selection and pricing of individual transactions, or for portfolio decisions, where diversification and timing effects increasingly mean the difference between profit and loss. Finally, management has more opportunities to manage exposure proactively after it has been originated, with the increased liquidity in the secondary loan market, the increased importance of syndicated lending, the availability of credit derivatives and third-party guarantees, and so on. In order to take advantage of credit portfolio management opportunities, however, management must first answer several technical questions: What is the risk of a given portfolio? How do different macroeconomic scenarios, at both the regional and the industry sector level, affect the portfolio's risk profile? What is the effect of changing the portfolio mix? How might risk-based pricing at the individual contract and the portfolio level be influenced by the level of expected losses and credit risk capital? This paper describes a new and intuitive method for answering these technical questions by tabulating the exact loss distribution arising from correlated credit events for any arbitrary portfolio of counterparty exposures, down to the individual contract level, with the losses measured on a marked-to-market basis that explicitly recognises the potential impact of defaults and credit migrations.(1) The importance of tabulating the exact loss distribution is highlighted by the fact that counterparty defaults and rating migrations cannot be predicted with perfect foresight and are not perfectly correlated, implying that management faces a distribution of potential losses rather than a single potential loss. In order to define credit risk more precisely in the context of loss distributions, the financial industry is converging on risk measures that summarise management-relevant aspects of the entire loss distribution. Two distributional statistics are becoming increasingly relevant for measuring credit risk: expected losses and a critical value of the loss distribution, often defined as the portfolio's credit risk capital (CRC). Each of these serves a distinct and useful role in supporting management decision making and control (Exhibit 1). [Exhibit 1 ILLUSTRATION OMITTED] Expected losses illustrated as the mean of the distribution, often serve as the basis for management's reserve policies: the higher the expected losses, the higher the reserves required. As such, expected losses are also an important component in determining whether the pricing of the credit-risky position is adequate: normally, each transaction should be priced with sufficient margin to cover its contribution to the portfolio's expected credit losses, as well as other operating expenses. Credit risk capital, defined as the maximum loss within a known confidence interval (for example, 99 percent) over an orderly liquidation period, is often interpreted as the additional economic capital that must be held against a given portfolio, above and beyond the level of credit reserves, in order to cover its unexpected credit losses. Since it would be uneconomic to hold capital against all potential losses (this would imply that equity is held against 100 percent of all credit exposures), some level of capital must be chosen to support the portfolio of transactions in most, but not all, cases. …