Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting.We show that the tradeoffs at stake in this debate are far from one-sided. While the excessive conservatism in the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial volatility that degrades the information value of prices, and induces sub-optimal real decisions. We construct a framework that can weigh the pros and cons. We find that the damage done by marking to market is greatest when claims are (i) long-lived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies.Our results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.

An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diffusion reflected at the dividend barrier and absorbed at 0. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-to-market ratios are in a non-monotonic relationship. A more severe agency problem entails lower price-earning ratios and firm liquidity and higher default risk. Copyright 2007 The Review of Economic Studies Limited.

Firms raise money from banks and the bond market. Banks sell loans in a secondary market to recycle their funds or to trade on private information. Liquidity in the loan market depends on the relative likelihood of each motive for trade and affects firms' optimal financial structure. The endogenous degree of liquidity is not always socially optimal: There is excessive trade in highly rated names, and insufficient liquidity in riskier bonds. We provide testable implications for prices and quantities in primary and secondary loan markets, and bond markets. Further, we posit that risk-based capital requirements may be socially desirable.THE TERM "COLLATERALIZED LOAN OBLIGATIONS" (CLOs) was coined in 1989, when corporate loans were first used as collateral in Collateralized Debt Obligations (CDOs).1 Since then, the growth in loan sales has been enormous. According to Lucas et al. (2006) 2 If a bank securitizes or sells a loan that it originated, it is buying insurance on credit events over which it has either more control or more information than the buyer.In the face of this informational friction, why did the secondary market for corporate loans develop in the 1990s? What effect has this had on relationship banking? In this paper, we characterize when a liquid secondary market for loans arises, when a liquid secondary loan market is socially desirable, and we provide testable predictions on the effect of the emergence of this market on prices and quantities in bond and primary loan markets. Our predictions are based on both changes in the parameters that lead to higher loan liquidity and changes in the contracts that are written between banks and firms given this higher liquidity.

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Market prices give timely signals that can aid decision making. However, in the presence of distorted incentives and illiquid markets, there are other less benign effects that inject artifi cial volatility to prices that distorts real decisions. In a world of marking-to-market, asset price changes show up immediately on the balance sheets of fi nancial intermediaries and elicit responses from them. Banks and other intermediaries have always responded to changes in economic environment, but marking-to-market sharpens and synchronises their responses, adding impetus to the feedback effects in fi nancial markets. For junior assets trading in liquid markets (such as traded stocks), marking-to-market is superior to historical cost in terms of the trade-offs. But for senior, long-lived and illiquid assets and liabilities (such as bank loans and insurance liabilities), the harm caused by distortions can outweigh the benefi ts. We review the competing effects and weigh the arguments.

A number of assets do not trade publicly but are sold to a restricted group of investors who subsequently receive private information from the issuers. Thus, the holders of such privately placed assets learn more quickly about their assets than other agents. This paper studies the pricing implications of this "learning by holding". In an economy in which investors are price takers and risk-neutral, and absent any insider trading or other transaction costs, we show that risky assets command an excess expected return over safe assets in the presence of learning by holding. This is reminiscent of the "credit spread puzzle"-the large spread between BBB-rated and AAA-rated corporate bonds that is not explained by historical defaults, risk aversion, or trading frictions. The intuition is that the seller of a risky bond needs to offer a "coordination premium" that helps potential buyers overcome their fear of future illiquidity. Absent this premium, this fear could become self-justified in the presence of learning by holding because a future lemons problem deters current market participation, and this in turn vindicates the fear of a future lemons problem. Copyright © 2009 The Review of Economic Studies Limited.

anonymous referee for very helpful comments. Errors are mine. AbstractThe reinsurance market is the secondary market for insurance risks. It has a very speci…c organization. Direct insurers rarely trade risks with each other. Rather, they cede part of their primary risks to specialized professional reinsurers who have no primary business. This paper o¤ers a model of equilibrium in reinsurance and capital markets in which professional reinsurers arise endogenously. Their role is to monitor primary insurers credibly, so that insurers can raise capital more easily. In equilibrium, the …nancial structure of primary insurers consists of a mix of reinsurance and outside capital.The comparative statics yield empirical predictions which are broadly in line with a number of stylized facts from the reinsurance market.