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.