(joint with Philip Dybvig)
Asset substitution by firms is gambling implemented by switching to inefficient and risky projects. Gambling using derivatives is more precise, gambling only to what is needed, with negligible efficiency loss. Optimal gambling can be small-scale “Gambling for redemption,” which is socially beneficial, or large-scale “gambling for ripoff,” which is socially inefficient, benefiting firm owners at the expense of bondholders. Gambling at scale is available with weak property rights, or in the U.S. through Qualified Financial Contracts (QFCs) with “superpriority” exemptions from bankruptcy provisions. Availability of gambling at scale reduces firm borrowing and value due to anticipation of gambling for ripoff.
Does limited liability on damages improve social efficiency? I show that optimal liability rules trades off tort damages against benefits to outside stakeholders. Full liability promotes care but raises marginal costs, inducing less-than-efficient scale. Limited liability enhances scale but reduces care, proving more efficient than full liability when outside stakeholder value is high. As market competition grows, liability’s impact on scale diminishes, and internalizing more damages would increase efficiency. We conclude that limited liability is not one-size-fits-all; tailored policies like requiring insurance for contractors and nuclear decommissioning trusts (NDTs) can help adjust for cross-firm differences.
Guanxi (relationship-building in China) has a mixed reputation. It can be used to implement corruption, e.g. to get a job for an underqualified relative, but it can also be used to facilitate beneficial trade. In this paper I compare guanxi to direct transfers. Both facilitate transactions, good and bad. The results show that if most projects are bad, it could be good to ban both guanxi and transfers. Otherwise, guanxi alone can be more helpful in facilitating beneficial transaction than a direct transfer alone, but having both channels can be even better for useful self-selection and therefore blocking transfers can be bad. Specifically, blocking transfer causes a decreased reliance on guanxi if the official’s motive is aligned with the rest of the world, but it causes an increased reliance on guanxi if the official’s motive is not so aligned.
We analyze the impact of investors’ financial depth, referred to as “deep pockets,” on decision-making in investments with significant downside. In a non-cooperative equilibrium, a free-rider problem can appear. A deep-pocket investor who do not want to “hold the bag” would avoid firms with substantial liabilities, leading to investments at lower scales and liability uncovered. Conversely, in a cooperative equilibrium, deep-pocket investors form partnerships or limited partnerships, allowing for the shared distribution of liability and risk. This leads to more efficient operational scale and aligns investors’ interests by ensuring no single party is left “holding the bag.” The partnership structure also further aligns the interests of the investors by providing protection since it must be dissolved and reformed if a partner exits.