We consider default by firms that are part of a single clearing mechanism. The obligations of all firms within the system are determined simultaneously in a fashion consistent with the priority of debt claims and the limited liability of equity. We first show, via a fixed-point argument, that there always exists a "clearing payment vector" that clears the obligations of the members of the clearing system; under mild regularity conditions, this clearing vector is unique. Next, we develop an algorithm that both clears the financial system in a computationally efficient fashion and provides information on the systemic risk faced by the individual system firms. Finally, we produce qualitative comparative statics for financial systems. These comparative statics imply that, in contrast to single-firm results, even unsystematic, nondissipative shocks to the system will lower the total value of the system and may lower the value of the equity of some of the individual system firms.Credit Risk, Default, Clearing Systems

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Under corporate and personal taxation, we demonstrate that the relation between optimal debt level and business risk is roughly U-shaped. This result follows from the fact that the tax liability is an option portfolio that is long in the corporate tax option and short in the personal tax option. Therefore, the net effect of a change in business risk on the optimal debt level depends upon the relative magnitudes of the resultant marginal changes in the values of these two options. Results of empirical tests offer support for the predicted U-shaped relationship. DESPITE THE CONCENSUS THAT business risk is one of the primary determinants of a firm's capital structure, existing theoretical and empirical research does not provide an unambiguous answer to the question of whether an increase in a firm's business risk should lead it to lower the level of debt in its capital structure. Most finance textbooks casually assert an inverse relationship between optimal debt level (ODL) and business risk (BR).1 The basis for this argument is that the existence of debt in the capital structure increases the probability of bankruptcy, and firms with more variable cash flows, that is, higher business risk, have a higher probability of bankruptcy for a given level of debt. Therefore, assuming that the marginal tax rate is the same for all firms, firms with higher BR should have less debt. However, it has been noted that "the existence of positive bankruptcy costs is not sufficient to ensure that the TS-BC (tax shields-bankruptcy costs) hypothesis will predict an inverse relationship (between business risk and ODL)."2 Indeed, Jaffe and Westerfield (1987) prove that, given the appropriate choice of parameters, ODL will be an increasing function of business risk.3 Empirical evidence can be found to support "increasing" as well as "decreasing" 2 Castanias (1983). 3On the other hand, Castanias (1983) derives a decreasing ODL-BR relationship over a certain range of BR when cash flows are normally distributed. 1694The Journal of Finance relationships. Additionally, some empirical studies find no relationship between ODL and BR.4 These studies, however, have generally proceeded by specifying a linear ODL-BR relationship.5 Mikkelson (1984) points out that the lack of a properly specified functional form is an important weakness of empirical research in this area.The main contribution of this paper is to derive the functional form of the ODL-BR relation within the classic personal and corporate taxation framework of optimal capital structure. We show that the ODL-BR relationship is roughly U-shaped; initially decreasing and ultimately increasing, in the DeAngelo and Masulis (1980) framework (henceforth referred to as D-M) in which bankruptcy need not be costly.6 The basic intuition underlying this result is that most models, in which the value-maximizing firm trades off the costs and benefits of debt, can be conceptualized in terms of minimizing the value of the competing claims of non-owners, many of which can be described as options. In the...

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This article investigates investor activism when a number of investors are capable of expending resources to exercise a role in corporate governance. Strategic investors make monitoring decisions and trade in anonymous financial markets with other agents whose trades are motivated by liquidity considerations. In this setting, a core group of monitoring investors emerges endogenously to curtail managerial opportunism. These core activist investors pursue activist policies and engage in heavy trading on both the buy and the sell sides of the market. In addition, a fringe group of monitoring investors, who are somewhat active and trade only on the buy side, may emerge. Although the smallest investors are passive, there is no monotonic relationship between shareholdings and activism. In fact, among those investors who choose to monitor with positive probability, those with smaller holdings are the most active. In addition to characterizing the emergence of monitoring activity in the presence of numerous potential activist investors, we also develop some comparative statics. Some of these comparative statics are counterintuitive from the perspective of models that fail to endogenize both security market structure and investor activism. For example, it is shown that increasing the size of the shareholdings controlled by informed, strategic investors may reduce bid-ask spreads.I would like to thank seminar participants at 1999 European Finance Meetings, Carnegie Mellon University, the University of Pittsburgh, Rice, the University of Texas, and the University of Texas at Dallas for helpful comments. I am also especially grateful to Laura Starks, Ernst Maug, and an anonymous referee, and the editor, Michael Fishman, for detailed comments on earlier drafts of this paper. The usual disclaimer applies.

We examine voting by a board designed to mitigate conflicts of interest between privately informed insiders and owners. Our model demonstrates that, as argued by researchers and the business press, boards with a majority of trustworthy but uninformed "watchdogs" can implement institutionally preferred policies. Our laboratory experiments strongly support this conclusion. Our model also highlights the necessity of penalties on insiders when there is dissension among board members. However, penalties for dissent appeared to have little impact on the experimental outcomes. CONSIDER THE SITUATION OF OWNERS of a corporation when they entrust the fate of their institution to groups of insiders. Because the owner-preferred allocation may be contingent on private information possessed by the insiders, owners need a mechanism to mitigate conflicts of interest with insiders. In practice, owners entrust the governance of corporations and other institutions to boards and committees consisting of a mix of insiders and outsiders. Corporate boards are increasingly being dominated by independent outside directors (see, e.g., Spencer Stuart (1997)), a trend mirroring the recommendations of the National Association of Corporate Directors and The Business Roundtable.1The advocacy of independent outsider-dominated boards is surprising as research has produced weak or mixed results on the effectiveness of outsiders on boards. For example, Weisbach (1988) finds that, when there is a majority of outside directors, CEO turnover is greater. However, the likelihood of CEO replace-* Gillette and Rebello are on the faculty of Georgia State University, and Noe is on the faculty of Tulane University. We would like to thank Rick Green The Journal of Finance ment is only slightly higher for these firms. Mikkelson and Partch (1997) also find little evidence of a relationship between CEO tenure and board composition. In a corporate control context, Byrd and Hickman (1992) document a more favorable response to acquirers with majority-outsider boards, while Subrahmanyam, Rangan, and Rosenstein (1997) find the opposite tendency for bank acquisitions. Studies of the direct relationship between board composition and firm performance have also produced mixed results. For example, while Baysinger and Butler (1985) document a positive relation between outsider membership on boards and return on equity relative to industry, Yermack (1996) reports a negative relation between the proportion of outside directors and Tobin's q. Further, a number of other studies find no significant relation between the mix of directors and same-year firm performance (see, e.g., Hermalin and Weisbach (1991) and Mehran (1995)).A lack of clear evidence for the effectiveness of outside directors has fueled the continuing debate on the effectiveness of outsider-majority boards. This lack of support for the effectiveness of outsider-majority boards could be the result of impediments to empirical research pointed out by a number of authors, including Hermalin and Weisbach (1991), Bh...