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We show that team formation can serve as an implicit commitment device to overcome problems of self-control. In a situation where individuals have present-biased preferences, any effort that is costly today but rewarded at some later point in time is too low from the perspective of an individual’s long-run self. If agents interact repeatedly and can monitor each other, a relational contract involving teamwork can help to improve an agent’s performance. The mutual promise to work harder is credible because the team breaks up after an agent has not kept this promise – which leads to individual (under-) production in the future and reduces an agent’s future utility. This holds even though the standard free-rider problem is present and teamwork renders no technological benefits. Moreover, we show that even if teamwork does render technological benefits, the performance of a team of present-biased agents can actually be better than the performance of a team of time-consistent agents.

To maximize their impact, socially responsible households can invest responsibly (SRI), consume responsibly (SRC), or do both. The key question of this paper is, which mix of SRI and SRC leads to a desired impact with the lowest loss of utility for responsible households. In a closed micro-economic model, we show that both strategies yield a symmetric impact, proportional to the responsible behavior. For the individual household, however, one strategy dominates the other depending on a condition on risk and product parameters. If responsible households can coordinate on socially responsible action, the welfare maximizing action is to completely abstain from consuming and investing in brown production if the negative externality is high. The coordination on "abstaining" becomes more likely the more households are responsible.

During the COVID-19 pandemic, some goods suddenly became scarce due to panic purchases and stockpiling. The decision to hoard is influenced by higher-order beliefs. If an agent believes that other agents think that a good will become scarce, she concludes that these other agents will hoard, and thus tries to preempt them by hoarding herself. To capture such behaviour, we construct a model with a global game. Agents receive noisy information about some variable that influences supply or demand. They then form higher-order beliefs, and possibly panic and hoard the product. We analyze determinants of such panics. Endogenizing prices and quantities, we show that producers with market power set prices strategically to induce panics and thus boost demand. Absent market power, strong competition leads to low prices and thus little overproduction, also causing panics. We also consider firms who need the scarce good as an intermediate product in their production chain, and show that a regulator would require such firms to stockpile the product, thus increasing resilience.

A new employee may work hard to build his reputation. This effect is greatest when he starts. The longer he is employed at his job, the more the firm will already have learned about his ability. The incentives for an employee to influence the firm’s perceptions of his ability decrease over time. If rotating the employee to a different job leads to new uncertainty about his ability, this generates a fresh impulse for effort. However, job rotation also reduces the employee’s time horizon, thus reducing future rents from reputation. This trade-off leads to a unique optimum. We derive a simple rule of thumb for an optimal rotation time. Our main results still hold for cases of complete but imperfect information transmission. The incentive effects of job rotation also prevail in a setting in which skills are job-specific. We study several extensions: rotations across multiple employees, absence of commitment to a rotation time, different bargaining positions, discounting over time, and learning by doing effects.

We develop a model of rational bubbles based on leverage and the assumption of an imprecisely known maximum market size. In a bubble, traders push the asset price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. Households optimally decide whether to lend to traders with limited liability. Bubbles increase welfare of the initial asset holders, but reduce welfare of future households. We provide general conditions for the possibility of bubbles depending on uncertainty about market size, traders’ degree of leverage, and the risk-free rate. This allows us to discuss several policy measures. Capital requirements and a correctly implemented Tobin tax can prevent bubbles. Implemented incorrectly, however, these measures may create the possibility of bubbles and can reduce welfare.

This article discusses the effects of small banks on economic growth. We first theoretically show that small banks operating at a regional level can spur local economic growth. As compared with big interregional banks, small regional banks are more effective in promoting local economic growth, especially in regions with lower initial endowments and severe credit rationing. We then test the model predictions using a sample of German banks and corresponding regional statistics. We find that small regional banks are more important funding providers in regions with low access to finance. The empirical results support the theoretical hypotheses.

This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bailouts. If there is a risk-shifting problem, bailout expectations lead to steeper bonus schemes and even more risk taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bailout perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers' liability can be counterproductive.

This paper provides a comprehensive theoretical and empirical analysis of "creditor rights" and "information sharing" throughout over 1.8 million public and private firms in Europe. We show that many of the outcomes associated with greater levels of creditor rights can be obtained with higher information sharing between banks. Both theory and empirics show that creditor rights and information sharing are associated with greater firm leverage, lower profitability, as well as greater distance to default. Moreover, both theory and empirics find that creditor rights and information sharing are robust substitutes. Our analysis suggests that poor creditor rights, which tend to be sticky over time, can be substituted by improved information sharing.

Politicians should spend money as efficiently as possible. But what is the best method of granting state aid to firms? We use a theoretical model with firms that differ in their success probabilities and compare different types of direct subsidies with indirect subsidies through bank loans. We find that, for a large range of parameters, subsidies through banks entail higher social welfare than direct subsidies, avoiding windfall gains to entrepreneurs and economizing on screening costs. For selfish politicians, subsidizing a bank has the additional advantage that part of the screening costs are born by private banks. Consequently, from a welfare perspective, politicians use subsidized banks inefficiently often.

We analyze the relationship between bank size and risk-taking under the New Basel Capital Accord. Using a model with imperfect competition and moral hazard, we show that the introduction of an internal ratings based (IRB) approach improves upon flat capital requirements if the approach is applied uniformly across banks and if the costs of implementation are not too high. However, the banks’ right to choose between the standardized and the IRB approaches under Basel II gives larger banks a competitive advantage and, due to fiercer competition, pushes smaller banks to take higher risks. This may even lead to higher aggregate risk-taking.

Is the reputation of a firm tradable when the change in ownership is observable? We consider a competitive market in which a share of owners must retire in each period. New owners bid for the firms that are for sale. Customers learn the owner’s type, which reflects the quality of the good or service provided, through experience. After observing an ownership change they may want to switch firm. However, in equilibrium, good new owners buy from good old owners and retain high-value customers. Hence reputation is a tradable intangible asset, although ownership change is observable.

This paper revisits the debate about the appropriate differential equation that governs the evolution of knowledge in models of endogenous growth. We argue that the assessment of the appropriateness of an equation of motion should not only be based on its implications for the future, but that it should also include its implications for the past. We maintain that the evolution of knowledge is plausible if it satisfies two asymptotic conditions: Looking forwards, infinite knowledge in finite time should be excluded, and looking backwards, knowledge should vanish towards the beginning of time (but not before). Our key results show that, generically, the behavior of the processes under scrutiny is either implausible in the past and plausible in the future, or vice versa, or implausible at both ends of the time line.

We analyze capital requirements if banks compete for loans and deposits. Banks and firms are subject to a risk-shifting problem. The ambiguous effect of competition on banks’ risk-taking translates into an ambiguous effect of capital requirements on financial stability.

We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, traders drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, and traders’ degree of leverage. This allows us to discuss several policy measures. Bubbles always reduce aggregate welfare. Among others, certain monetary policy rules, minimum leverage ratios, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures backfire and facilitate bubbles.

We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, traders drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, and traders’ degree of leverage. This allows us to discuss several policy measures. Bubbles always reduce aggregate welfare. Among others, certain monetary policy rules, minimum leverage ratios, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures backfire and facilitate bubbles.

For many private firms, relationship lending is the only viable form of outside financing. Relationship lending typically relies on intertemporal loan pricing: losses from early years are recovered by information rents in later years, which stem from the lender's private information regarding the firm's creditworthiness. Our model shows that overly transparent financial reporting reduces the relationship lender's information rent such that the lender has insufficient incentive to offer early stage financing as a result. During financial distress, private firms find it easier to obtain liquidity support from relationship lenders when financial reporting is sufficiently opaque. Conservative opacity enables relationship lending more effectively than aggressive reporting. This paper seeks to explain why private firm financial reporting is (conservatively) opaque and raises concerns regarding recent regulatory efforts that require private firms to engage in more transparent financial reporting because such efforts may result in undesirable side effects.

One explanation for the poor performance of regulation in the recent financial crisis is that regulators had been captured by the financial sector. We present a micro-founded model with rational agents in which banks capture regulators by their sophistication. Banks can search for arguments of differing complexity against tighter regulation. Finding such arguments is more difficult for weaker banks, which the regulator wants to regulate more strictly. However, the more sophisticated a bank is, the more easily it can produce arguments that a regulator does not understand. Reputational concerns prevent regulators from admitting this, hence they rubber-stamp weak banks, which leads to inefficiently low levels of regulation. Bank sophistication and reputational concerns of regulators lead to capture, and thus to worse regulatory decisions.

The severity and depth of the recent financial crisis hit many by surprise. Despite warning signs, the financial system seems to have been unable to aggregate existing information. As the events of Fall 2008 showed, many investors were caught off guard by the large number of banks collapsing worldwide. But what triggers an early warning, and what are the incentives to implement such a trigger? We construct a theoretical model of a bank that is financed with debt and equity, and a bank manager monitoring the bank’s loan portfolio. The manager must be incentivized to warn the board before a crisis. However, we show that the board may implement a contract with insufficient incentives to communicate a warning, as refinancing conditions deteriorate when lenders notice an upcoming crisis. We discuss policies to improve information efficiency and give conditions under which regulatory measures, such as capital and liquidity regulation, increase welfare.

Economic geography aims to explain agglomeration primarily through the channels of increasing returns, monopolistic competition and international factor mobility. By contrast, this paper constructs a theoretical model based on capital market frictions. Monopolistically competitive firms are run by managers who are subject to moral hazard. Endogenously, the impact of capital market frictions is smaller in industrialized regions, which makes it cheaper to incentivize managers. Consequently, firms can pay higher interest rates on capital in these regions, which in turn attracts more capital. This simple mechanism leads to a host of effects and, therefore, predictions in terms of economic development and corporate governance.

A new employee may work hard to build his reputation. However, the longer he is employed in his job, the more the firm will have learned about his ability. When there are career concerns, the incentives for an employee to influence the firm's perceptions of his ability decrease over time. Rotating the employee to a different job results in information loss regarding ability, thereby adding fresh impetus for effort. However, job rotation also reduces the time horizon, thus reducing future rents from effort. We show that a simple rule of thumb for an optimal assignment duration is 4 periods multiplied by the ratio of output uncertainty to prior type uncertainty. Then, we study several extensions: different bargaining positions, partial information loss, as well as learning by doing effects.

The severity and depth of the recent financial crisis hit many by surprise. Despite warning signs, the financial system seems to have been unable to aggregate existing information. As the events of Fall 2008 showed, many investors were caught off guard by the large number of banks collapsing worldwide. But what triggers an early warning, and what are the incentives to implement such a trigger? We construct a theoretical model of a bank that is financed with debt and equity, and a bank manager monitoring the bank's loan portfolio. The manager must be incentivized to warn the board before a crisis. However, we show that the board may implement a contract with insufficient incentives to communicate a warning, as refinancing conditions deteriorate when lenders notice an upcoming crisis. We discuss policies to improve information efficiency and give conditions under which regulatory measures, such as capital and liquidity regulation, increase welfare.

This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bail-outs. If there is a risk-shifting problem, bail-out expectations lead to steeper bonus schemes and even more risk-taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bailout perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers’ liability can be counterproductive.

This paper investigates the factors influencing banks' decision to engage in advanced risk management, from both a theoretical and an empirical perspective. In recent decades, credit risk management in banks has become highly sophisticated and banks have become more active and advanced in the management of credit risks. We identify two driving factors for risk management: bank competition and sector concentration in the loan market. We find empirical support for our hypotheses, using a unique data set of 249 German banks; parts of the data set are hand-collected. Bank competition pushes banks to implement advanced risk management. Sector concentration in the loan market promotes credit portfolio modeling, but inhibits credit risk transfer.

This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bail-outs. If there is a risk-shifting problem, bail-out expectations lead to steeper bonus schemes and even more risk-taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bailout perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers’ liability can be counterproductive.

We develop a model of rational bubbles based on the assumptions of unknown market liquidity and limited liability of traders. In a bubble, the price of an asset rises dynamically above its steady-state value, justified by rational expectations about future price developments. The larger the expected future price increase, the more likely it is that the bubble will burst because market liquidity becomes exhausted. Depending on the interactions between uncertainty about market liquidity, fundamental riskiness of the asset, the compensation scheme of the fund manager, and the risk-free interest rate, we give a condition for whether rational bubbles are possible. Based on this analysis, we discuss several widely-discussed policy measures with respect to their effectiveness in preventing bubbles. A reduction of manager bonuses or a Tobin tax can create or eliminate the possibility of bubbles, depending on their implementation. Monetary policy and long-term compensation schemes can prevent bubbles.

Disclosure of information triggers immediate price movements, but it mitigates price movements at a later date, when the information would otherwise have become public. Consequently, disclosure shifts risk from later cohorts of investors to earlier cohorts. Hence, disclosure policy can be interpreted as a tool to control the variance of interim price movements, and to allocate risk intertemporally. This paper shows that a policy of partial disclosure (and, hence, of intertemporal risk sharing) can maximize, but also minimize, the market value of the firm. Partial disclosure of interim information and intertemporal risk sharing minimizes the ex ante market value of the firm if investors are relatively risk averse, and if the distribution of cash flow exhibits a large variation or a positive skewness. Regarding the disclosure policy, the firm, the early investors cohort, and the late investors cohort all have conflicting interests. Our model also applies to a setting where a central bank chooses the quality and frequency of the disclosure of macroeconomic information.

This paper empirically investigates the effect of government bail-out policies on banks outside the safety net. We construct a measure of bail-out perceptions by using rating information. From there, we construct the market shares of insured competitor banks for any given bank, and analyze the impact of this variable on banks’ risk-taking behavior, using a large sample of banks from OECD countries. Our results suggest that government guarantees strongly increase the risk-taking of competitor banks. In contrast, there is no evidence that public guarantees increase the protected banks’ risk-taking, except for banks that have outright public ownership. These results have important implications for the effects of the recent wave of bank bail-outs on banks’ risk-taking behavior.

This paper empirically investigates the effect of government bail-out policies on banks outside the safety net. We construct a measure of bail-out perceptions by using rating information. From there, we construct the market shares of insured competitor banks for any given bank, and analyze the impact of this variable on banks' margins and risk-taking behavior, using a large sample of banks from OECD countries. Our results suggest that government guarantees to some banks strongly increase the risk-taking of the competitor banks not protected by such guarantees. In contrast, there is no evidence that public guarantees increase the protected banks' risk-taking.

We present a banking model with imperfect competition in which borrowers’ access to credit is improved when banks are able to transfer credit risks. However, the market for credit risk transfer (CRT) works smoothly only if the quality of loans is public information. If the quality of loans is private information, banks have an incentive to grant unprofitable loans that are then transferred to other parties, leading to an increase in aggregate risk. Higher competition increases welfare in the presence of CRT with public information. In contrast, welfare eventually decreases for high levels of competition in the presence CRT with private information due to the expansion of unprofitable loans. This finding coincides with the decrease in credit quality observed during the late years of the credit boom preceding the subprime crisis.

We present a banking model with imperfect competition in which borrowers’ access to credit is improved when banks are able to transfer credit risks. However, the market for credit risk transfer (CRT) works smoothly only if the quality of loans is public information. If the quality of loans is private information, banks have an incentive to grant unprofitable loans in order to transfer them to other parties, leading to an increase in aggregate risk. Nevertheless, the introduction of CRT generally increases welfare in our setup. However, under private information, higher competition induces an expansion of loans to unprofitable firms, which in the limit offsets the welfare gains from CRT completely.

In the current recession, politicians grant state aid of yet unknown dimensions. But what is the most efficient measure for granting such aid‘ We use a theoretical model with firms that differ in their creditworthiness and compare different types of direct subsidies with indirectly subsidized loans. We find that, in a large parameter range, politicians prefer subsidized loans to direct subsidies, because these avoid windfall gains to entrepreneurs, and they economize on screening costs. For similar reasons, subsidized loans may increase social welfare relative to subsidies. From a welfare perspective, politicians use subsidized loans inefficiently often.

The long-run evolution of per-capita income exhibits a structural break often associated with the Industrial Revolution. We follow Mokyr (2002) and embed the idea that this structural break reflects a regime switch in the evolution of technological knowledge into a dynamic framework, using Airy differential equations to describe this evolution. We show that under a non-monotonous income-population equation, the economy evolves from a Malthusian to a Post-Malthusian Regime, with rising per-capita income and a growing population. The switch is brought about by an acceleration in the growth of technological knowledge. The demographic transition marks the switch into the Modern Growth Regime, with higher levels of per-capita income and declining population growth.

This paper yields a rationale for why subsidized public banks may be desirable from a regional perspective in a financially integrated economy. We present a model with credit rationing and heterogeneous regions in which public banks prevent a capital drain from poorer to richer regions by subsidizing local depositors, for example, through a public guarantee. Under some conditions, cooperative banks can perform the same function without any subsidization; however, they may be crowded out by public banks. We also discuss the impact of the political structure on the emergence of public banks in a political-economy setting and the role of interregional mobility.

A common perception about the neoclassical growth model is that an economy devoid of capital cannot evolve to strictly positive levels of output if capital is essential. We challenge this view by positing a broad class of production functions, encompassing the neoclassical production function, that—surprisingly—show that a take-off is possible even though the initial capital stock is zero and capital is essential. Since the marginal product of capital is initially infinite, the "trivial" steady state becomes so unstable that the solution to the equation of motion involves the possibility of a take-off. When it happens, the take-off is spontaneous: there is no causality, not even randomness.

Money markets have two functions, the allocation of liquidity and the processing of information. We develop a model that allows us to evaluate the efficiency of different money market derivatives regarding these two objectives. We assume that due to its size, a large bank receives a more precise signal about the overall liquidity development in the banking sector. In an upcoming liquidity shortage this large bank can exploit its informational advantage in the spot money market by rationing liquidity. Using forward contracts, the large bank can credibly commit not to squeeze small banks in the event of a liquidity shortage. But forward contracts do not provide incentives for the large bank to pass on its information to other banks. In contrast, lines of credit between the large and the small banks ensure that the large bank provides its information to other banks.

If capital is an essential input, the neoclassical growth model has a steady state with zero capital. From this, one is inclined to conclude that an economy starting without capital can never grow. We challenge this view and claim that, if the production function satisfies the Inada conditions, a take-off is possible even though the initial capital stock is zero and capital is essential. Since the marginal product of capital is initially infinite, the ‘trivial’ steady state becomes so unstable that the solution to the equation of motion involves the possibility of a take-off, even without capital. When it happens, the take-off is spontaneous; there is no causality.

This paper discusses the relationship between bank size and risk-taking under Pillar I of the New Basel Capital Accord. Using a model with imperfect competition and moral hazard, we find that small banks (and hence small borrowers) may profit from the introduction of an internal ratings based (IRB) approach if this approach is applied uniformly across banks. However, the banks' right to choose between the standardized and the IRB approaches unambiguously hurts small banks, and pushes them towards higher risk-taking due to fiercer competition. This may even lead to higher aggregate risk in the economy.

Summary: The privatization of the Italian savings banks is often described as a success story. Proponents of privatization argue that a similar reform could cure the current problems in the German banking sector. In this paper, we ask whether the Italian experience can really serve as a role model for Germany. Our analysis confirms that the Italian reforms of the 1990s were a success. Banks’ profitability increased, without impairing competition or the availability of banking services and loans. However, this success has to be attributed to a broad set of reforms, which went far beyond the privatization of savings banks. Moreover, Italy had a different starting point before the reforms, and the structure of the public banking sector differed markedly from Germany’s. Therefore, one may question the transferability of the Italian experience to Germany. The costs and benefits of privatization should be weighed carefully against each other before abandoning the three-pillar system. Zusammenfassung: Die Privatisierung italienischer Sparkassen wird haufig als Erfolgsgeschichte bezeichnet. Befurworter einer Privatisierung argumentieren, dass die gegenwartigen Probleme im deutschen Bankensystem auf ahnlichem Wege behoben werden konnten. In diesem Aufsatz stellen wir die Frage, ob das italienische Beispiel wirklich als Vorbild fur Deutschland dienen kann. Unsere Analyse bestatigt, dass die italienischen Reformen der 90er Jahre ein Erfolg waren. Die Banken wurden profitabler, ohne dass der Wettbewerb oder die Verfugbarkeit von Bankleistungen oder Krediten eingeschrankt wurden. Dieser Erfolg ist jedoch das Ergebnis eines breiten Reformprozesses, der weit uber die Privatisierung der Sparkassen hinausging. Auserdem war der Ausgangspunkt vor den Reformen ein anderer als in Deutschland, und der offentliche Bankensektor wies andere Strukturen auf. Daher kann man die Ubertragbarkeit der italienischen Erfahrung auf Deutschland in Frage stellen. Kosten und Nutzen einer Privatisierung sollten sorgfaltig gegeneinander abgewogen werden, bevor man das „Drei-Saulen-System“ aufgibt.

This paper revisits the debate about the appropriate differential equation that governs the evolution of knowledge in models of endogenous growth. We argue that the assessment of the appropriateness of an equation of motion should not only be based on its implications for the future, but that it should also include its implications for the past. We maintain that the evolution of knowledge is plausible if it satisfies two asymptotic conditions: Looking forwards, infinite knowledge in finite time should be excluded, and looking backwards, knowledge should vanish towards the beginning of time (but not before). Our key results show that, generically, the behavior of the processes under scrutiny is either plausible in the future and implausible in the past or vice versa, or implausible at both ends of the time line.

Consider a two-product firm that decides on the quality of each product. Product quality is unknown to consumers. If the firm sells both products under the same brand name, consumers adjust their beliefs about quality subject to the performance of both products. We show that if the probability that low quality will be detected is in an intermediate range, the firm produces high quality under umbrella branding whereas it would sell low quality in the absence of umbrella branding. Hence, umbrella branding mitigates the moral hazard problem. We also find that umbrella branding survives in asymmetric markets and that even unprofitable products may be used to stabilize the umbrella brand. However, umbrella branding does not necessarily imply high quality; the firm may choose low-quality products with positive probability.

Lecture on the first SFB/TR 15 meeting, Gummersbach, July, 18 - 20, 2004The explicit or implicit protection of banks through government bail-out policies is a universal phenomenon. We analyze the competitive effects of such policies in two models with different degrees of transparency in the banking sector. Our main result is that the bail-out policy unambiguously leads to higher risk-taking at those banks that do not enjoy a bail-out guarantee. The reason is that the prospect of a bail-out induces the rotected bank to expand, thereby intensifying competition in the deposit market and depressing other banks’ margins. In contrast, the effects on the protected bank’s risk taking and on welfare depend on the transparency of the banking sector.

Is the reputation of a firm tradeable when the previous owner has to retire even though ownership change is observable? We consider a competitive market in which a share of owners must retire in each period. New owners, observing only recent profits, bid for the firms on sale. Customers are concerned with the owners’ type, which reflects the quality of the good or service provided. When a customer observes an ownership change, he may have an incentive to switch to a different firm even if his past experience was good. However, we show that, in equilibrium, customers believe that also the new owner is of the good type. Hence reputation is tradeable, although ownership change is observable. In our model, reputation is an intangible asset, embodied in an attractive customer base. Firms owned by a good type sell at a premium.

The explicit or implicit protection of banks through government bail-out policies is a universal phenomenon. We analyze the competitive effects of such policies in two models with different degrees of transparency in the banking sector. Our main result is that the bail-out policy unambiguously leads to higher risk-taking at those banks that do not enjoy a bail-out guarantee. The reason is that the prospect of a bail-out induces the protected bank to expand, thereby intensifying competition in the deposit market and depressing other banks' margins. In contrast, the effects on the protected bank's risk-taking and on welfare depend on the transparency of the banking sector.

Risk management, although of major importance in the banking industry in practice, plays only a minor role in the theory of banking. We reduce this gap by putting forward a model in which risk managers – specialists that can find out correlations between risky assets – endogenously take over typical functions of banks. They grant loans, they consult on financial questions with firms that are threatened by bankruptcy, and they sign tailor-made hedge transactions with these firms. Delegation costs are innately low if banks assume the function of risk managers in an economy. Risk management can be seen as a core competence of banks.

This paper yields a rationale for why subsidized public banks may increase regional welfare in a financially integrated economy. We present a model with credit rationing and heterogeneous regions in which public banks prevent a capital drain from poorer to richer regions by subsidizing local depositors, for example, through public guarantees. Under some conditions, cooperative banks can perform the same function without any subsidies; however, they may be crowded out by public banks. We also discuss the influence of the political structure on the emergence of public banks in simple political-economy settings and the role of interregional mobility.

We study the interdependence of optimal tax and expenditure policies. An optimal policy requires that information on preferences is made available. We first study this problem from a general mechanism design perspective and show that efficiency is possible only if the individuals who decide on public good provision face an own incentive scheme that differs from the tax system. We then study democratic mechanisms with the property that tax payers vote over public goods. Under such a mechanism, efficiency cannot be reached and welfare from public good provision declines as the inequality between rich and poor individuals increases.