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Economic Quarterly—Volume 98, Number 1—First Quarter 2012—Pages 1–31

Orderly Liquidation
Authority as an Alternative
to Bankruptcy
Sabrina R. Pellerin and John R. Walter

W

hen a large nonbank financial firm becomes troubled and in danger
of default, government policymakers traditionally have had two
options: they could 1) allow the firm to enter bankruptcy, or 2) if
policymakers believed bankruptcy is likely to produce widespread (systemwide or “systemic”) financial difficulties, the government could provide aid
(i.e., a bailout) to forestall failure. In 2010, a third option was made available
by the Orderly Liquidation Authority (OLA) provisions, contained in the Wall
Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). This
legislation authorizes the Federal Deposit Insurance Corporation (FDIC) to
pursue an agency-administered wind down for certain troubled financial firms.
The OLA provisions are modeled, in part, after the process long followed by
the FDIC for handling troubled banks.
The OLA provisions are a reaction to policymakers’ and legislators’ dissatisfaction with the two options previously available for handling failing
nonbanks. For example, Ben Bernanke, chairman of the Board of Governors
of the Federal Reserve System, argued, in 2009 testimony before the House
Committee on Financial Services, that bankruptcy was not an effective option
for certain failing financial firms (Bernanke 2009):
In most cases, the federal bankruptcy laws provide an appropriate
framework for the resolution of nonbank financial institutions. However,
the bankruptcy code does not sufficiently protect the public’s strong
interest in ensuring the orderly resolution of a nonbank financial firm

The authors would like to thank Kartik Athreya, Keith Goodwin, Michelle Gluck, Trish
Nunley, Jonathan Tompkins, Zhu Wang, and John Weinberg for their insightful comments.
The views expressed in this article are those of the authors and do not necessarily reflect
those of the Federal Reserve Bank of Richmond or the Federal Reserve System. E-mails:
sabrina.pellerin@rich.frb.org; john.walter@rich.frb.org.

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Federal Reserve Bank of Richmond Economic Quarterly
whose failure would pose substantial risks to the financial system and
to the economy. Indeed, after Lehman Brothers and AIG’s experiences,
there is little doubt that we need a third option between the choices of
bankruptcy and bailout for such firms.

In a 2010 speech, Chairman Bernanke expanded on his testimony and
noted two goals for this “third option,” or “orderly resolution” authority
(Bernanke 2010):
The government instead must have the tools to resolve a failing firm in
a manner that preserves market discipline—by ensuring that shareholders
and creditors incur losses and that culpable managers are replaced—while
at the same time cushioning the broader financial system from the possibly
destabilizing effects of the firm’s collapse.

Legislators focused on these two goals in the language of the Dodd-Frank
Act itself when explaining the purposes of the OLA provisions (or the OLA
“title”):
It is the purpose of this title to provide the necessary authority to
liquidate failing financial companies that pose a significant risk to the
financial stability of the United States in a manner that mitigates such
risk and minimizes moral hazard.

In this article we review the features of bankruptcy and the OLA. We
identify some problem areas when large nonbank financial firm failures are
resolved through bankruptcy. We then describe two important features of
the OLA that are meant to improve on bankruptcy as a means of handling
these types of failures, and discuss how they attempt to achieve the goals of
mitigating risk to financial stability while also minimizing moral hazard—
goals that are not easily achieved simultaneously.

1.

FAILURE RESOLUTION

Goals of any Failure Resolution Regime
Any resolution regime, whether bankruptcy, bailout, or OLA, must address
two fundamental problems that arise when a firm faces financial troubles and
becomes unable to repay creditors. These three regimes each take different
approaches to solving these problems, and these differing approaches are at
the core of each regime. The first problem (detailed below) is preserving “asset complementarities” and “going-concern value” in the face of detrimental
creditor incentives to rush in and grab the firm’s assets immediately upon a
firm’s default. Resolution methods must take these incentives into account and
prevent the detrimental actions. The second problem is determining whether
to “liquidate” or “reorganize” the troubled firm. Beyond addressing these two

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

3

problems, an additional concern arises when the troubled firm is a large financial firm or one with many interconnections with other financial firms: What
so called systemic effects might the liquidation or reorganization have? Will
there be a significant negative effect on other financial firms or on the macro
economy in response to actions taken to resolve the troubled firm? As noted
in the introduction, policymakers are likely to have a strong interest in any
systemic effects when deciding on the appropriate resolution method.

Preserving Complementarities and Going-Concern Value

Following a firm’s default on a debt, creditors are likely to rush to seize, and
separately sell, assets that, if sold together with other assets, could produce
a higher sale price (assets that are “complementary”). For example, one can
imagine that with numerous creditors vying for a manufacturer’s assets, individual components of an assembly line might be sold off separately, when, if
sold as a complete assembly line, these components would be of greater value
and produce a higher price. Therefore, this incentive can reduce the total
amount that creditors, as a group, receive and can also undercut productivity
and economic efficiency. Creditors who manage to be the first to seize assets
are likely to recover a higher proportion of their debts than creditors who are
slower to react. As a result, creditors have a strong individual incentive to
move quickly to undertake such seizures. Preserving complementarities can
be important whether the firm is liquidated or is preserved via a reorganization
process.
If creditors are allowed to rush in and seize assets, they are also likely
to grab those assets that are fundamental to the firm’s continued operations,
so called “going-concern assets.” Such assets might include, for example,
necessary operating equipment for a manufacturing firm, or buildings for a
financial firm. For a firm that is going to be closed and liquidated, protecting
going-concern assets is unimportant, but for firms that might be successful if
reorganized, creditors will be made better off, as a group, if their removal is
prevented. Indeed, if creditors are allowed to seize going-concern assets, a
troubled firm that might otherwise become quite productive in reorganization
could be doomed to fail by the asset seizures.
In bankruptcy, the automatic stay (discussed in detail below) prevents
immediate asset seizures, and creates a court-overseen process for allocating

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Federal Reserve Bank of Richmond Economic Quarterly

assets in a way that preserves complementarities and going-concern value.1,2
The OLA process also involves a stay, but grants the FDIC this preservation
role. Bailouts, by (typically) preventing the troubled firm’s default on debts,
remove the ability of creditors to seize the troubled firm’s assets.3
Determining Whether to Liquidate or Reorganize

When a firm becomes unable to meets its debt payments, one of two outcomes
are possible. First, as already mentioned, the firm might be closed and its
assets liquidated. Alternatively, if the firm can be returned to profitability
by restructuring (typically reducing) its debts, then, in many cases, it should
be reorganized, allowing it to continue operating after a debt restructuring
process. If the firm is unlikely to return to profitability, even with a lowered
debt burden, because the firm’s assets are unlikely to produce a market rate of
return, then the firm should be liquidated: The firm should be shut down and
its assets sold to the highest bidders. In this case, liquidation will distribute
assets to firms that can make more productive use of them, enhancing economic
1 According to Boul (2006): “Traditionally, the automatic stay has served to ‘prevent dismemberment of the [bankruptcy] estate and insure its orderly distribution.’ SEC v. First Financial
Group, 645 F.2d 429, 439 (5th Cir.1981), citing S. Rep. No. 95-989, 95th Cong., 2d Sess. 50
(1978); H.R.Rep. No. 95-595, 95th Cong., 2d Sess. 341 (1977), U.S.Code Cong. & Admin.
News 1978, pp. 5787, 5836, 5963, 6297, 6298. In that capacity, the automatic stay serves the
interests of both the debtor and the creditors of the bankruptcy estate. For the debtor, it provides
a ‘breathing spell’ by ‘stopping all collection efforts, all harassment, and all foreclosure actions.’
S. Rep. No 95-989, 95th Cong., 2d Sess. 54-55 (1978); H.R. Rep. No 95-595, 95th Cong., 1st
Sess. 340 (1977), U.S.Code Cong. & Admin. News 1978, pp. 5787, 5840, 5841, 5963, 6296,
6297. However, the stay also serves the interest of creditors, insofar as it ‘eliminate[s] the impetus
for a race of diligence by fast-acting creditors.’ SEC v. First Financial Group, at 439. The stay
ensures that assets are distributed according to the order of priorities established by Congress. Id.
at 341.”
2 Note that if the troubled firm had only one creditor, there would be no need for bankruptcy
since that one creditor would always take actions that maximize complementarities and goingconcern value. Only in the case where there are many creditors, who, because of their large
number, cannot easily coordinate with one another, is bankruptcy necessary.
3 One might imagine that an ideal solution—when a firm has suffered losses such that its
capital level is low and default seems likely, but it could be profitable with a lower debt load—
one that requires no intervention by bankruptcy courts or government agencies, is for the firm to
gather new funding by issuing new equity shares. The new funding could be used to purchase
new, profitable assets that will increase revenues available to service debt (lowering the ratio of
debt to assets) and reduce significantly the chance of default. This course may be impossible,
however, because of the so-called “debt overhang problem” and, as a result, bankruptcy and the
reorganization of debt may be the only course available. Because of the overhang problem, existing
equityholders will not vote in favor of a new equity issuance. They will not do so, at least in
many cases, because most or all of the benefit flows to the debtholders by improving the market
value of their debt, and the existing equityholders will suffer dilution because future earnings must
be shared with the new equityholders (Duffie 2011, 43–4). The likelihood that new issues of equity
might offer a solution is further reduced by an “adverse selection problem.” Weak firms issuing
new equity, and especially those firms whose assets are opaque, i.e., financial firms, will have to
offer to sell shares at a very low price, because equity investors are likely to conclude, based on
the fact that the firm wishes to issue new shares, that the firm is in exceptionally poor health
(even worse health than it really is). As a result, existing shareholders will suffer a great deal of
dilution and vote against new issues.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

5

productivity and efficiency. Any resolution regime is faced with a decision
between liquidation and resolution, and, ideally, will choose the one that
produces the most economically efficient outcome.
Addressing Systemic Risk4 and Moral Hazard

When faced with the failure of a large financial firm, or one with many connections with other financial firms, government decisionmakers will not only
wish to ensure that complementarities and any going-concern value are preserved, and that the choice between liquidation or reorganization is optimally
made, but they will also care greatly about systemic effects. Simply bailing
out the troubled firm will prevent its failure, preserve complementarities and
going-concern value, as well as avoid systemic effects. But any bailouts will
create a “moral hazard” problem: the view, among investors, that large financial firms are likely to be protected, such that in the future, creditors of such
firms will reduce their risk-monitoring efforts and these firms will be willing to
undertake an inefficiently large amount of risk-taking. Therefore, any method
employed to resolve a large or interconnected financial firm must balance systemic dangers against the danger of excessive risk-taking. Bailouts prevent
current systemic problems but are likely to lead to less efficient resource allocation choices in the future. Relying on bankruptcy can avoid future moral
hazard because, as discussed later, bankruptcy provides no source of funds
for bailouts, but the bankruptcy of a large financial firm carries the risk of
heavy current systemic problems. As such, when Congress crafted the OLA,
addressing systemic risk was a priority, but so was resolving firms in a manner
that does not simultaneously increase moral hazard. The OLA aims to address
systemic risks that may otherwise be present when resolving systemically important financial institutions (SIFIs) through bankruptcy, in part, by 1) giving
the FDIC broad discretion in how it funds the resolution process and pays
out creditors, as well as by 2) changing the way derivatives and repurchase
agreements (repos)—known as qualified financial contracts (“QFCs”)—are
treated.

Overview of Bankruptcy and OLA
When comparing bankruptcy and OLA, understanding their overarching goals
is important. The goal of a bankruptcy proceeding is to maximize recoveries
for creditors, through liquidation or the rehabilitation of the debtor. The goal
of the OLA, on the other hand, is to resolve “failing financial companies that
4 There is no clear consensus about the definition of “systemic risk” (See Taylor 2010). For
purposes of this article, we will define systemic risk as “the risk that the failure of one large
institution would cause other institutions to fail or that a market event could broadly affect the
financial system rather than just one or a few institutions” (Government Accountability Office 2011).

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Federal Reserve Bank of Richmond Economic Quarterly

pose a significant risk to the financial stability of the U.S. in a manner that
mitigates such risk and minimizes moral hazard.”
Bankruptcy achieves its goals through a court-overseen process that relies
largely on the troubled firm’s creditors and other investors to decide how best,
and most profitably, to resolve the firm’s troubles. Funding for a bankruptcy
resolution typically comes only from the assets of the troubled company and
from any funds that might be provided by private investors. See Table 1 for
an outline of the bankruptcy process.
OLA borrows several important ideas from bankruptcy, but moves beyond
bankruptcy because of policymakers’ dissatisfaction with possible outcomes
under bankruptcy. The OLA attempts to capture the firms whose resolution through bankruptcy could be detrimental to the broader financial system.
Therefore, the OLA can be differentiated from bankruptcy based on several
notable features that are designed specifically with SIFI, or covered financial
company (CFC), resolution in mind. See Table 2 for a review of OLA’s main
features.
During the 2007–2008 financial crisis, an unwillingness to trust large firm
failures to bankruptcy often resulted in government assistance to firms popularly described as “too big to fail,” such as Bear Stearns and AIG. Yet the grant
of government assistance sent strong signals to the market that other, similar firms would receive assistance as well if they were to experience trouble,
thereby expanding credit subsidies for certain firms and moral hazard. For
example, bond prices for the largest financial institutions remained relatively
high during the crisis and prices for Lehman credit default swaps (CDS) may
not have accurately reflected default risk (Skeel 2010). In contrast, allowing
Lehman to fail can be seen as an attempt to mitigate moral hazard; however,
some argue this was done at the cost of creating systemic risk.5 These objectives are inextricably linked, and focusing on the reduction of one has the likely
result of increasing the other. Therefore, the OLA, which charges the FDIC
with administering these provisions, was an attempt to address this conflict.
How does the FDIC meet this challenge?

5 The apparent worsening of the 2008 financial crisis following Lehman’s entrance into
bankruptcy provides, for many observers, an illustrative example of the deleterious effect of resolution by bankruptcy for large financial firms. Yet there is some debate about the conclusions
one should draw from the Lehman experience. Some observers maintain that the cascading losses
following Lehman’s bankruptcy filing were not a result of troubles or anticipated troubles related
to the bankruptcy process itself, but were instead the result of a shock to market expectations and
therefore to the risk assessments of those who had previously anticipated that Lehman, and firms
like Lehman, would certainly be bailed out (see Testimony from Skeel before the Subcommittee on
Commercial and Administrative Law, Committee on the Judiciary, U.S. House of Reps., October
22, 2009). Available at http://judiciary.house.gov/hearings/pdf/Skeel091022.pdf.

Types of Bankruptcy
Chapter 7

Chapter 7 bankruptcy (liquidation), the troubled firm is closed down, with the longer-run
outcome being the sale of all the company’s assets (liquidation) because creditors or
management do not believe it can be successfully reorganized.
Assets of the troubled firm are assembled by the bankruptcy trustee and then sold in a
manner that maximizes the sum of the payouts to the creditors.
The trustee typically must sell all of the bankrupt firm before distributing funds to
creditors [11 U.S.C. 704(a)1].
Chapter 11
Under Chapter 11 bankruptcy (reorganization), the troubled firm’s debts are reorganized: debt
maturities are lengthened, or interest rates or principal amounts are reduced.
Creditors will only agree to a reorganization if they believe that preserving the firm as a
going concern will produce larger payments than if the firm is liquidated.
Corporate Bankruptcies are Overseen by Federal Courts
The operating arm of the bankruptcy courts is the Justice Department’s Trustee program, so
that most bankruptcies are largely handled by trustees.
Circumstances Under which a Firm Enters Bankruptcy
Voluntary Bankruptcy
When a firm’s management petitions the court to place the firm in bankruptcy because it is unable
to pay all its creditors in full. A firm will file for bankruptcy when unpaid creditors will otherwise
seize complimentary or going-concern assets.
Involuntary Bankruptcy When a firm’s creditors petition for bankruptcy. Creditors have incentive to seek a firm’s
bankruptcy when they believe that other creditors might seize complementary or going-concern
assets or that the firm might dissipate assets.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

Table 1 Corporate Bankruptcy

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Table 1 (Continued) Corporate Bankruptcy
Automatic Stay

Federal Reserve Bank of Richmond Economic Quarterly

Immediately, upon the filing of a bankruptcy petition with the clerk of the bankruptcy court,
creditors’ are prohibited (“stayed”) from attempting to collect on their claims.
The stay allows a government-appointed trustee to ensure that assets of the bankrupt firm are
liquidated in a manner that maximizes the total pool of funds available for creditor repayment.
As a result, the stay allows the trustee to produce a better result for creditors in aggregate than
if creditors were simply acting in their own self interest. The trustee can be thought of as
solving a joint action problem. Similarly, the stay is also the means in bankruptcy by which creditors
are prevented from seizing going-concern assets.
Qualified financial contract (QFC) holders are typically exempt from the automatic stay: They can
retrieve their collateral in the event of bankruptcy.
Under bankruptcy law a number of financial instruments are QFCs, including repurchase agreements
(repos), commodity contracts, forward contracts, swap agreements, and securities contracts.
Reasons for the QFCs exemption:
Observers worry that preventing QFC holders from retrieving their collateral could create
systemic financial problems.
Some observers believe that QFCs are not complementary with one another or with other assets,
and can be removed without undercutting the troubled firm’s going-concern value.

Table 1 (Continued) Corporate Bankruptcy

Payouts coming from asset sales are divided among creditors based upon the creditor’s location in
the priority order, which is established in the Bankruptcy Code.
Secured creditors are repaid from the assets that secure their debts prior to payments to
unsecured creditors.
A secured creditor will be fully repaid if the value of his security exceeds the amount he is owed.
If not, he joins unsecured creditors and must depend on the sale of other assets for repayment.
Unsecured claimants are paid based on the following priority list (White 1998, 1):
First to be repaid are those owed any administrative expenses produced by the bankruptcy
process.
Second, claims are given statutory priority, such as taxes owed, rent, and unpaid wages and benefits.
Third are unsecured creditors’ claims, including trade creditors’ claims, long-term bondholders, and
holders of damage claims against the bankrupt firm.
Last, equityholders receive any remaining funds.
In Reorganization Payments to creditors and equityholders will often differ from those that would arise based simply on
priority rules, because reorganization payments typically arise from negotiation between creditors and
equityholders (White 1998, 8).
Reorganization negotiations are driven by two rules: 1) each class of creditors and equityholders must
consent to the bankruptcy plan adopted in the negotiation, and 2) if the negotiation produces no plan
that is acceptable to all classes, then the firm is liquidated and payments are determined by the priority
rules listed above.
Because of the mutual consent requirement, some classes can be expected to receive more than would
be expected if the priorities rules were strictly followed. For example, if assets are insufficient to repay
all creditors, abiding by the priority rule would mean equityholders could expect to receive nothing.
But creditors are likely to allow equityholders to receive payments in exchange for the investors’
agreement to a plan that allows reorganization rather than liquidation, because the reorganization
preserves some going-concern value for all classes. In other words, an equityholder agreement is
achieved by paying them more than they would get if they held up the plan.
Debtor-in-Possesion (DIP) Loans
Loans made to a firm in reorganization, post-bankruptcy filing.
Such loans are often senior to all pre-bankruptcy debts.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

Priority Rules
In Liquidation

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Federal Reserve Bank of Richmond Economic Quarterly

When the FDIC is appointed as the receiver of a failing financial firm
designated as a CFC, it assumes complete financial and operational control
of the institution. The FDIC has the authority to manage, sell, transfer, or
merge all the assets of the failing firm, as well as provide the funds needed
for an orderly liquidation, giving it broad discretion.6 The FDIC’s guiding
principles in carrying out these responsibilities include using its best efforts
to maximize returns, minimize losses, and, unique to this regime, mitigate
the potential for serious adverse effects to the financial system and minimize
moral hazard.7 Moreover, the language of the OLA forces the FDIC to balance
two competing interests. On one hand, it is to pay creditors no more than what
they would receive in bankruptcy8 and ensure that creditors bear losses in order
to promote market discipline. On the other hand, it is to minimize adverse
effects on financial stability. In bankruptcy, creditors only inject additional
funds when the firm seems viable. The FDIC, on the other hand, may find it
necessary to prop up a firm or perhaps protect certain creditors, at least for
a time, to prevent any potential systemic consequences even though the firm
may not be viable. The Dodd-Frank Act granted the FDIC a line of credit from
the Treasury to fund these efforts. Because the FDIC has broad discretion over
the way in which it balances these competing objectives, market participants
may find it difficult to predict which objective might receive more weight in
any given failure.

2.

KEY FEATURES OF BANKRUPTCY, ITS WEAKNESSES,
AND OLA AS AN ALTERNATIVE

In the United States, the failure of a business firm typically results in that
firm entering bankruptcy, and actions taken by the firm shift from being determined by management to being guided by rules established under federal
law, specifically under the U.S. Bankruptcy Code. What are the core features
of bankruptcy? What features lead observers to conclude that bankruptcy is
not an appropriate way to handle a SIFI whose failure could pose substantial
risk to the financial system? What are the alternative resolution arrangements
created by Dodd-Frank’s OLA provisions?

6 The OLA gives the FDIC authority to operate the company “with all of the powers of
the company’s shareholders, directors and officers, and may conduct all aspects of the company’s
business.” Dodd-Frank Act § 210(a)(1)(B).
7 Dodd-Frank Act § 204(a) and § 210(a)(9)(E).
8 Dodd-Frank Act § 210(d)(2). Under § 210(d)(4)(A) additional payments (in excess of what
would be received in bankruptcy) are authorized only with approval of the Treasury Secretary and
only if determined to be necessary or appropriate to minimize losses to the receiver.

Who Qualifies as a “Covered Financial Company” (CFC)?
A “financial company” whose failure would have serious adverse effects on financial stability.
Process for Designating a Firm as a CFC
1. Recommendation by Federal Reserve and either FDIC, Securities and Exchange Commission, or Federal Insurance Office,
based on their findings that the following is true for the financial company:
- It is in default or in danger of default
- A resolution under the Bankruptcy Code would produce serious adverse consequences
- There is no viable private-sector alternative
2. Determination made by the Treasury Secretary in consultation with the President
3. Appointment of FDIC as receiver of CFC
The FDIC’s Powers and Duties
- They can 1) sell the CFC, or any portion of the assets or liabilities to a third party; 2) establish a temporary bridge financial
company to preserve the company’s value prior to being sold to a third party; or 3) liquidate the company.
- Use their best efforts to maximize returns, minimize losses, and mitigate the potential for serious adverse effects to the
financial system.
- Must ensure unsecured creditors bear losses and ensure the directors and management team responsible for the company’s
condition are removed.
- Has authority to make additional payments to certain creditors (over what their priority would demand and possibly more
than similarly situated creditors) if determined to maximize value or limit losses (excess may be “clawed back”), see below.
FDIC’s Access to Funding
- Treasury: FDIC may immediately borrow funds from the Treasury (up to 10 percent of the CFC’s pre-resolution
book-value assets within first 30 days; 90 percent once fair-value is determined and liquidation and repayment
plan is in place and approved by Treasury)
- If funds from disposition of failed firm’s assets are insufficient to repay Treasury:
- Creditors (who were paid more than they would in bankruptcy) would have to return excess funds (“claw backs”)
- Large financial institutions can be assessed

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

Table 2 OLA

Notes: “Financial Company” includes bank holding companies, nonbank financial firms, and securities broker-dealers. Nonbank
financial firms are characterized as firms that are supervised by the Fed (because of SIFI designation) or that derive at least
85 percent of their revenues from activities that are financial in nature.

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Federal Reserve Bank of Richmond Economic Quarterly

Key Bankruptcy Feature: The Automatic Stay
The “automatic stay” is a primary component of bankruptcy and one that
underlies many of the complaints raised against bankruptcy as a means of
handling SIFI failures. The stay works as follows. Immediately upon the
filing of a bankruptcy petition with the clerk of the bankruptcy court, creditors
are enjoined from attempting to collect on their claims.9 This feature of
bankruptcy allows a government-appointed trustee to ensure that assets of
the bankrupt firm are liquidated in a manner that maximizes the total pool of
funds available for creditor repayment. Without the stay, as discussed earlier,
creditors can be expected to rush in, grab, and then sell the bankrupt firm’s
assets. In so doing, creditors could destroy asset complementarities. The stay
typically lasts for the length of the bankruptcy process, though the courts may
grant exceptions.
In a Chapter 7 bankruptcy (liquidation),10 the type of corporate bankruptcy
in which the troubled firm is closed down (liquidated), the court-appointed
trustee typically must sell all of the assets of the bankrupt firm before distributing funds to creditors.11 The goal of the trustee is to sell the assets in
a manner that maximizes the sum of payouts to creditors. Achieving this
maximization goal can result in a lengthy process, so that creditors’ funds
may be inaccessible for an extended period. Based on a study of all corporate bankruptcies from two federal bankruptcy court districts between 1995
and 2001, the average liquidation lasts 709 days (Bris, Welch, and Zhu 2006;
1,270). It seems likely that for the largest, most complex financial firms the
process will take at least as long as average or perhaps longer.
Compared to liquidation, a corporate Chapter 11 bankruptcy (reorganization) process tends to last longer still, 828 days on average according to
Bris, Welch, and Zhu (2006), though in reorganization creditors will often be
repaid well before this process ends. In reorganization, the troubled firm’s
debts are rescheduled or cut—but it continues to operate.12 A corporation
that finds itself unable to repay all creditors in full can seek protection from
creditors’ claims by petitioning the bankruptcy court to enter reorganization.
This protection from creditors, which includes a stay of claims, is important
when a firm is being reorganized because the stay prevents creditors from seizing “going-concern” assets (assets that might be necessary to keep the firm
running). The stay can mean that, in aggregate, creditors receive more than
9 11 U.S.C. § 362
10 In the remainder of the article, for the sake of simplicity, we will typically replace the

phrase Chapter 7 bankruptcy with “liquidation” and the phrase Chapter 11 bankruptcy with “reorganization.” We will use the phrase “orderly liquidation” or the acronym OLA when referring to
a Dodd-Frank Orderly Liquidation Authority process.
11 11 U.S.C. 704(a)1
12 The airline industry provides many well-known examples of reorganization, in which planes
continue to fly and contracts are renegotiated with creditors and employees.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

13

they would if individual creditors had been allowed to seize assets to protect
themselves. Because creditors must agree to the troubled firm’s proposed reorganization plan—if not, the firm is likely to proceed to a liquidation—firms
receiving reorganization treatment are those for which creditors, as a group,
believe going-concern value exceeds the value of firm assets if such assets are
sold, i.e., if the firm is liquidated (White 1998, 2–3).
While reorganization can last longer than liquidation, payouts to creditors
will often be made well before the end of the reorganization process. As part
of the reorganization, creditors may agree to lower repayments and some may
receive these repayments quickly. Further, additional funding can flow into
the troubled firm fairly quickly to help keep it afloat.
A source of funding often available to a firm in reorganization is “debtorin-possession” (DIP) funding. In reorganization, the troubled corporation, the
debtor, continues to operate, or “possess,” the troubled entity. Any loans to
the troubled corporation are therefore loans to the DIP. Such loans are often
senior to all former—prior to the bankruptcy filing—debts of the bankrupt
firm. The prospect of being senior to other creditors allows funding to flow
as long as creditors can be convinced that the firm is likely to survive and
therefore repay.

Key Bankruptcy Feature: Limited Sources
of Funding
Repayment of a bankrupt firm’s creditors and funds to sustain a firm reorganized under bankruptcy can only derive from two sources: the assets of
the troubled firm, and, in the case of reorganization, added (DIP) loans that
might flow to the troubled firm. While bankruptcy law and practice do not
prohibit government aid to troubled firms, such funding is not typically available. As a result, creditors have an incentive to carefully evaluate the riskiness
of any firm prior to providing funding and to monitor its activities once funding has been provided. Such monitoring will tend to ensure that the firm
undertakes only those risks with a positive expected return. Yet, the government has often provided aid to troubled firms because of the sluggishness
with which creditors are often repaid following failure and because of the
apparent difficulty of lining up DIP funding. In some cases this aid has been
provided prior to bankruptcy, in others during bankruptcy.13 Therefore, the
13 Bear Stearns and AIG provide examples of financial firms that received government aid
prior to bankruptcy. In 2009, both General Motors and Chrysler received aid from the federal
government during their reorganizations. Earlier cases of government aid include Penn Central
Railroad in 1970, Lockheed Aircraft in 1971, and Chrysler in 1980.

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Federal Reserve Bank of Richmond Economic Quarterly

monitoring advantage offered by bankruptcy can be diminished by the expectation of government aid for certain (especially large) financial firms.14
There is no DIP financing in a liquidation. In liquidation, a “bankruptcy
estate” is created, including all of the assets of the bankrupt firm. One of the
responsibilities of the trustee is to locate all assets and gather them into the
estate. The estate assets are sold by the bankruptcy trustee and the proceeds
of the sale provide the funds from which creditors are repaid. Funds from
no source beyond the assets of the failed firm are available to the trustee and
therefore to the creditors.
In a reorganization proceeding, debts are restructured in a manner such
that the firm can continue operating. For example, the creditors of a firm might
come together and all agree to reduce the amounts the bankrupt firm owes each
of them by 30 percent, and extend the maturity of all debts by two years. As
a result, the bankrupt firm faces lower monthly debt payments, payments that
it might successfully manage. The creditors will only agree to such a plan if
they believe that sustaining the operations of the firm is likely to mean larger
payments than if the firm descends into liquidation. The debt restructuring
and the mode of future operation is called the “reorganization plan” and is
subject to court review and creditor appeal to the bankruptcy court. Typically
the current management of the troubled firm operates the reorganized firm. If
the firm’s liabilities exceed its assets, owners are wiped out and the creditors
inherit the decisionmaking rights formerly enjoyed by owners. The debtor can
acquire funding for the reorganized firm because it can offer very favorable
terms to the lenders who provide DIP funding because the new lenders have a
claim that is senior to all other creditors. Thus, lenders will have an incentive
to provide DIP funding if they believe that the reorganized firm is likely to be
able to repay their loans from future earnings—that the reorganized firm will
be profitable.

Weaknesses of Bankruptcy
A Weakness of Bankruptcy for Financial Firms: The Stay
Threatens Short-Term Debtholders

While the automatic stay, in liquidation or reorganization, may cause no
spread of losses when the creditors of the troubled firm are typically longterm debtholders (who are not counting on quick receipt of their funds), in the
14 One might argue that there could be times in which government aid is appropriate, for
example if credit standards have become inefficiently (or irrationally) strict, as in a financial panic.
If market participants believe that government aid will only be forthcoming at such times, and will
only provide the amount of funding that private lenders would provide if they had not become
irrationally strict, then the expectation of government aid will not diminish private investors’ riskmonitoring efforts.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

15

case of a failing financial firm, creditors are likely to include a large contingent
of those with very short-term claims. Funds invested in financial firms (such
as investment banks) often have maturities of one or a few days. Creditors
with such short maturity claims are likely to be dependent on the immediate
access to their funds in order to pay their own creditors. If funds are tied up for
an extended period, as assets are gathered and sold in a liquidation process or
as a reorganization agreement is negotiated, the bankrupt firm’s creditors may
find themselves unable to make payments to their own creditors. As a result,
the bankruptcy of one firm may result in the failure of some of its creditors,
especially if some of these creditors are also financial firms with their own
very short-term debts to repay. Therefore, while the automatic stay may have
significant value in preventing creditors from separating complementary assets in liquidation and preserving going-concern value in reorganization, the
stay, if it continues more than a very short time, may cause financial distress to
spread. The importance of short-term funding, which is often present for nonbank financial firms, may make policymakers unwilling to rely on bankruptcy
when such firms become troubled.
A Weakness of Bankruptcy for Financial Firms: Opacity
Reduces Availability of DIP Financing

New funding, quickly available, will often be necessary in order for a troubled
firm to be successfully reorganized. After all, funds from former sources may
have dried up because of the losses these creditors suffered on former loans
to the troubled firm. But, financial firms may find it to be relatively difficult,
compared to nonfinancial firms, to quickly obtain DIP funding. Such firms
often have quite opaque assets: assets that are difficult for outsiders, such as
lenders, to value. For example, assets of financial firms often include a heavy
concentration of loans to other firms. The value of such loans may depend
importantly on information that can be gathered only by performing detailed
analyses of the financial condition of the borrowing firms.15 As a result, DIP
loans may be available only after lenders spend a great deal of time reviewing
the troubled firm’s assets. Further, DIP loans made to financial firms are likely
to involve unusually high interest rates to compensate for time spent in asset
review and for the potential risk of lending to a firm with highly opaque assets.
15 Using statistical analysis to measure firm opacity, by comparing the frequency of bond
rating disagreements, Morgan (2002, 876) finds that banks and insurance firms are the most opaque
of major industry groups. Large nonbank SIFIs are likely to have a portfolio of assets that are
fairly similar to bank asset portfolios so can be expected to be similarly opaque. Interestingly,
Morgan notes that the industry grouping “Other Finance and Real Estate” seems to be among the
least opaque, though, according to Morgan, this is likely because the securities being analyzed for
this group are “asset-backed bonds backed by a pool of specific, homogeneous assets ‘locked’ up
in special purpose vehicles. This structure, which reduces the risk of asset substitution, seems to
make the securities relatively safe and certain to outsiders” (2002, 877).

16

Federal Reserve Bank of Richmond Economic Quarterly

The opacity of financial firm assets contributes to the desire to employ some
method (i.e., bailouts or OLA) for their resolution instead of bankruptcy.16

Key Features of OLA and OLA’s Weaknesses
As in bankruptcy, when a troubled financial firm enters the OLA process,
creditors—with the exception of holders of QFCs, discussed below—are
stayed (prevented) from collecting their debts. The stay lasts the duration
of the period in which the financial firm is in the OLA process. During the
stay, the FDIC will typically establish a receivership estate into which most
assets and liabilities will be placed. Assets placed in the receivership will be
sold by the FDIC in the manner that results in the largest returns to creditors—
so that the receivership may last, and creditors wait, an extended period while
the FDIC lines up buyers. In addition, some of the bankrupt firm’s assets and
liabilities can be moved into a “bridge entity,” a separate company formed
by the FDIC, which might be sold off as a whole entity to a private buyer or
might even be capitalized by some of the creditors of the bankrupt firm, and
continue as a going concern.17 One purpose of a bridge can be to preserve
going-concern value of portions of the troubled firm.18
The Dodd-Frank OLA process also abides by a priority schedule similar to
the one defined in bankruptcy law (see Table 1 for an overview of bankruptcy
priorities). But Dodd-Frank authorizes the FDIC to violate the priority list established in OLA under certain circumstances. Specifically, section 210(d)(4)
of the Dodd-Frank Act permits the FDIC to pay a creditor more than priority
rules might otherwise allow “if the Corporation determines that such payments
or credits are necessary or appropriate to minimize losses to the Corporation
as receiver from the orderly liquidation of the covered financial company.”
According to the FDIC’s discussion of its proposed rules related to this section of the Dodd-Frank Act, such additional payments may be made if they
are necessary to “continue key operations, services, and transactions that will
16 An alternative to bailouts or OLA that would address the problem of a lack of DIP funding
as a result of SIFI opacity is to allow a troubled SIFI to enter reorganization, and permit the
government to make DIP loans to the bankrupt firm. The government could quickly provide DIP
funds to keep the firm operating but the bankruptcy process could handle all other aspects of the
resolution.
17 See Acting Chairman Martin J. Gruenberg’s (2012) presentation before the Federal Reserve
Bank of Chicago Bank Structure Conference for a discussion of how a bridge bank might be
capitalized and continue operations as a private entity.
18 Acting FDIC Chairman Gruenberg (2012) discussed the formation of a bridge, and noted
its advantages for protecting going-concern (franchise) value: “. . . the most promising resolution
strategy from our point of view will be to place the parent company into receivership and to pass
its assets, principally investments in its subsidiaries, to a newly created bridge holding company.
This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm
to remain open and avoid the disruption that would likely accompany their closings... In short,
we believe that this resolution strategy will preserve the franchise value of the firm and mitigate
systemic consequences.”

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

17

maximize the value of the firm’s assets and avoid a disorderly collapse in the
marketplace.”19
Beyond the authority to, in some cases, make greater payments to creditors
than their priority might allow, the Dodd-Frank Act also provides the FDIC
with Treasury funding that might be used to make payments to creditors.
The Act provides that the FDIC can borrow, within certain limits, from the
Treasury. Immediately upon their appointment as receiver of a firm, the FDIC
can borrow 10 percent of the value of the firm’s pre-resolution assets. For
a large financial firm, this initial amount can be significant. In the Lehman
failure, for example, 10 percent of assets would have amounted to $63.9 billion.
Once the fair value of the failing firm’s assets is determined and a liquidation
and repayment plan is in place, the FDIC may borrow an additional 90 percent
of the value of the firm’s assets (with approval from the Treasury). The Act
provides that these funds are to be repaid to the Treasury from the sale of the
liquidated firm’s assets. But, importantly, the Act also specifies a means of
repayment if such assets are not sufficient for repayment, first by attempting to
“claw back” any “additional payments” (payments beyond what would have
been received in a liquidation) made to creditors, and, if that is insufficient, by
taxing all large bank holding companies and other SIFIs (Dodd-Frank Act §
210(o)(1)(A)).20,21,22 The fact that assets might not be sufficient to repay the
Treasury in full, and that the legislation authorizes taxes (on large financial
19 http://edocket.access.gpo.gov/2011/pdf/2011-1379.pdf; 4,211
20 The Dodd-Frank Act § 210(o) specifies that assessments (taxes) to repay the Treasury

are to be imposed on bank holding companies with assets greater or equal to $50 billion and
on nonbank financial companies supervised by the Board of Governors of the Federal Reserve
(meaning nonbank SIFIs). Assessments are to be sufficient to repay the Treasury within 60 months,
with the opportunity for extension if repaying in 60 months would have a “serious adverse effect on
the financial system.” Assessments are to be graduated based on company size and riskiness. When
determining assessment amounts, the FDIC, in consultation with the Financial Stability Oversight
Council, should take account of “economic conditions generally affecting financial companies so
as to allow assessments to increase during more favorable economic conditions and to decrease
during less favorable economic conditions...the risks presented by the financial company [being
assessed] to the financial system and the extent to which the financial company has benefitted, or
likely would benefit, from the orderly liquidation of a financial company under this title,” and any
government assessments already imposed on the firm under such government programs as deposit
insurance or securities investor protection insurance.
21 The Dodd-Frank Act § 210(o)(1)(D)(i) prohibits the FDIC from imposing claw backs on
creditors who receive “additional payments” if such payments are “necessary to initiate and continue
operations essential to implementation of the receivership or any bridge financial company.” The
FDIC’s implementing regulation, at 12 CFR 380.27, seems to imply that a good portion of any
additional payments made by the FDIC will be for such essential purposes so will be protected
from claw back. Note that if all additional funds could be clawed back, there might be little
reason to be concerned about the potential moral hazard problem created by FDIC payments. But,
given that the FDIC is likely to be prohibited from imposing claw backs on some significant
portion of payment recipients, the moral hazard concern seems to be in play.
22 Analysts (Acharya et al. 2009, 31–2; Acharya et al. 2011, 10–1) have noted that it would
be more appropriate to impose this tax prior to any failure, and base the tax rate on a firm’s
riskiness. Such a tax would discourage risk-taking. The current tax does not discourage risktaking, since the failing firm does not pay it. In fact, because it is paid by survivors, it punishes,
and therefore discourages, caution.

18

Federal Reserve Bank of Richmond Economic Quarterly

firms) to repay the Treasury, implies that creditors may be repaid more than
the sum of funds generated by asset sales—more than they would have been
repaid in liquidation.
It seems likely that Congress intended to provide the FDIC with a good
bit of discretion to bypass strict priority as well as discretion over whether
to borrow Treasury funds in order to mitigate systemic risk. For example,
given the FDIC’s ability to pay some creditors more than they would receive
in bankruptcy, these creditors may be less likely to pass on losses to other
firms, lowering the risk of a systemic problem.
One might argue that legislators’intention for providing the FDIC with the
authority to borrow from the Treasury was simply to allow the FDIC the ability
to move quicker than bankruptcy courts. By providing an immediate source of
funds, the FDIC could gather funds, which it could then use to make payments
equivalent to what would be paid in bankruptcy. In this way creditors would
not be denied access to their funds for months or years (as in liquidation), and
the FDIC could slowly sell the assets of the failing firm such that fire sales
are avoided. Under such an arrangement, legislators could have required the
FDIC to immediately estimate the value of the failing firm’s assets (similar to
the type of analysis currently performed by the FDIC when it determines—and
announces in a press release—the cost to the FDIC of a bank’s failure), and
then limit itself to paying creditors no more than their pro-rata share (given
priorities) of this estimated amount. Yet, Congress did not choose this course,
i.e., it did not require the FDIC to limit the sum of its payments to be no more
than the estimated value of the failing firm’s assets. Instead it left the FDIC to
determine payments to creditors and authorized taxes on large financial firms
if payments exceed the liquidation value of assets. Therefore, it seems clear
that Congress intended for some creditors of a failing firm to receive larger
payments than bankruptcy allowed, as a means of mitigating systemic risk.
Investors certainly realize that the OLA provisions provide the FDIC with
the authority to make larger-than-bankruptcy payments to creditors. As a result, they will tend to under price risk-taking by nonbank firms that might get
OLA treatment and such firms will engage in more risk-taking than if they did
not enjoy the potential benefits of receiving government aid.23 Congress was
aware that larger payments would have this moral-hazard-exacerbating impact on firm risk-taking and took steps to mitigate the impact in the OLA
provisions of the Dodd-Frank Act. Broadly, the legislation requires that
the FDIC attempt to liquidate SIFIs “in a manner that . . . minimizes moral
23 Some authors, such as Jackson (2011), argue that a modified bankruptcy procedure can
address this excessive risk-taking weakness and better resolve SIFIs. According to them, a system
of established rules, judicial oversight, and full public disclosure has a better chance of both
reducing bailouts and making the costs of them known than does a non-bankruptcy resolution
authority.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

19

hazard.”24 More specifically, the law calls on the FDIC to ensure that any
member of the management or the board of directors of the failed firm who
is deemed responsible for the failure is fired. Similarly, the OLA provisions
require the FDIC to “ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the Fund are fully
paid and ensure that unsecured creditors bear losses...”25,26 The provisions
requiring the removal of management and directors are likely to encourage
these corporate leaders to limit risk-taking. However, the OLA contains provisions for certain creditors to receive better treatment than they might in
bankruptcy, even if some creditors suffer losses, so that creditor oversight is
likely diminished by the prospect of OLA treatment.

Dealing With Systemic Risk in Failure Resolution:
Exceptions to the Automatic Stay
The class of financial contracts, which are exempt from the automatic stay, are
commonly referred to as “qualified financial contracts” (QFCs).27 Therefore,
investors who are holding QFCs have the ability to immediately terminate and
net-out their contracts or liquidate the collateral on their claims once a party
has defaulted or filed for bankruptcy. Today, under bankruptcy law, a number
of financial instruments are QFCs, including repos, commodity contracts,
forward contracts, swap agreements, and securities contracts.28 The treatment
of QFCs in bankruptcy (and under OLA provisions) has been the focus of a
great deal of public debate.
A possible explanation for exempting QFCs is that the collateral that typically backs QFCs is not directly tied to the defaulting firm’s going concern
value. A primary objective of the automatic stay in bankruptcy is to prevent
24 Dodd-Frank Act § 204(a)
25 Dodd-Frank Act § 206(1-5)
26 The Dodd-Frank Act includes other provisions intended to minimize moral hazard including

1) a requirement that SIFIs create resolution plans (“living wills”) to increase the likelihood that
they would be resolved through bankruptcy [Dodd-Frank Act § 165(d)]; and 2) a requirement that
the FDIC have a plan in place, before borrowing greater than 10 percent of the failing firm’s
asset, for repaying the Treasury [Dodd-Frank Act § 210(n)(9)(B)].
27 In the Bankruptcy Code, contracts exempt from the automatic stay are referred to as “safe
harbor contracts.” The Federal Depository Institution Act and the Dodd-Frank Act refer to the
safe harbor contracts as QFCs. Since safe harbor contracts and QFCs generally refer to the same
types of contract, we will use the term “QFC” to refer to both, which is consistent with industry
practice.
28 The types of contracts exempt from the stay are listed in the following sections of the
Bankruptcy Code: 11 U.S.C. § 362(b)(6), (b)(7), (b)(17), 546, 556, 559, 560. All terms are defined
in 11 U.S.C. § 101 with the exception of a “securities contract,” which is defined as “the purchase,
sale, or loan of a security, including an option for the purchase or sale of a security, certificate
of deposit, or group or index of securities (including any interest therein or based on the value
thereof), or any option entered into on a national securities exchange relating to foreign currencies,
or the guarantee of any settlement of cash or securities by or to a securities clearing agency” (11
U.S.C. § 741).

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Federal Reserve Bank of Richmond Economic Quarterly

the separation of complementary assets (an important goal of the trustee in
liquidation) or to preserve the going-concern value of a firm (typically a goal
in reorganization). QFCs can be immediately closed out because the collateral
backing them will typically not be complementary to other assets of the firm,
nor will QFC collateral be important to the firm’s going-concern value. For
instance, collateral consisting of highly marketable or cash-like securities (for
example Treasury bills or mortgage-backed securities) can be removed from
the firm without necessarily undercutting the firm’s ability to produce loans
or other financial products, since the production of these products depends on
such resources as the skill of lending staff, staff contacts with possible borrowers, IT assets, office space and equipment, and funding (liabilities) from
which to make loans. However, some argue that the collateral backing certain QFCs can be firm-specific (e.g., a pool of mortgage cash flows used as
repo collateral) and therefore not all QFCs should be treated equally (Jackson
2011).
Another possible explanation for exempting QFCs is that the markets in
which QFCs trade are special, such that delaying creditor recovery attempts
in these markets (by imposing a stay on QFC counterparties) is especially
destructive, compared to staying creditors operating in other markets. More
specifically, proponents who hold this view seem to be arguing that staying
QFCs is more likely to create systemic problems than staying the collection
of other debts. This explanation for special treatment—what we will call
the “systemic risk” rationale—appears to stand out as the argument used by
policymakers supporting the expansion of the list of QFCs that took place
over several decades through numerous reforms to the Bankruptcy Code. The
rationale offered by those supporting the exemption is that in a fast-paced,
highly interconnected market, a counterparty to a QFC may need the proceeds
from the contract to pay off other debts in a timely manner. If this counterparty
is unable to meet other obligations as a result of having its contracts held up in
bankruptcy, other firms relying on that counterparty may become exposed and
experience financial distress, which could bleed to other counterparties, and
so on, causing a ripple effect and possibly “destabilizing” markets (Edwards
and Morrison 2005).29
Today, the transactions and agreements covered under the definition of a
QFC include a wide range of instruments. However, when the automatic stay
29 In a letter dated September 30, 1998, to Hon. George W. Gekas, Chairman, Subcommittee on Commercial and Administrative Law, Committee on the Judiciary, Robert Rubin,
former Treasury Secretary, argued that applying traditional insolvency laws, such as the stay,
to QFCs could cause a “possible domino effect that could turn the failure of one market
participant into a failure of the market.” See www.wilmerhale.com/files/Publication/eacecfbd0400-4cb1-80a0-cf3a2c3f1637/Presentation/PublicationAttachment/29b1ce6d-1ce1-4544-a3ec63ecd65d11e1/Bankruptcy%20%20Derivatives%20outline%20-%20 final .pdf.

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

21

Figure 1 History of QFC Exemptions from the Stay
1982
Securities contracts
(QFCs expanded
to include)

1978
QFCs (commodities
and futures) first
exempt from the stay

1990
Swaps (expanded definition)

1984
Repos (QFCs expanded
to include netting, setoff,
and liquidation of)

2006
Financial netting improvements

2005
Cross-product netting; derivatives
products (expanded definition);
repos (expanded qualified
collateral---stock, bond, mortgage,
or other securities)

was first created as part of the new Bankruptcy Code in 1978,30 only commodities and futures contracts were exempt.31 At the time, these protections were
intended to “prevent the insolvency of one commodity firm from spreading to
other brokers or clearing agencies and possibly threatening the collapse of the
market.”32 In the decades to follow, various reforms to the Bankruptcy Code
expanded the types of contracts classified as QFCs, as well as expanding the
types of collateral that could be used to back them (see Figure 1 timeline).
Legislation enacted in 2005 and 200633 expanded the safe harbor treatment significantly by broadening the definition of a QFC to such an extent
that it would capture any newly created derivatives product that may otherwise not be explicitly included.34 Moreover, the most recent reforms also expanded contractual netting rights to allow for “cross-product netting” of QFCs
(Figure 1). Netting occurs when a non-defaulting counterparty of a defaulting
bankrupt firm is allowed to offset debts it owes to the defaulting firm against
debts owed it by the defaulting firm.35 Cross-product netting allows contracts
30 The stay existed as a fundamental feature of bankruptcy before 1978. The Bankruptcy
Reform Act of 1978, however, created the “automatic stay,” which takes effect immediately upon
the filing of a bankruptcy petition. Prior to the Bankruptcy Reform Act of 1978, the stay typically
took effect only after the grant of an injunction by a court. Such grants were typical, but were
often not immediate, and certainly not automatic (Jessup 1995).
31 U.S.C. §362(b)(6)
32 See H.R. Rep. No. 97-420, at 2 (1982).
33 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Pub. L. 109-8,
119 Stat. 23) and the Financial Netting Improvements Act of 2006 (Pub. L. 109-390, 120 Stat.
2692).
34 The following language was added to the definition of commodities, forward, repo, and
securities contracts: “any other agreement or transactions referred to” in the definition and “any
combination of the agreements or transactions referred to” in the definition.
35 For example, in the simplest case of two contracts, the non-defaulting firm is owed $1,000
by the bankrupt firm on, say, an interest rate swap (derivative) contract, and owes the defaulting

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Federal Reserve Bank of Richmond Economic Quarterly

of differing types to be netted against one another, for example a debt owed
on a swap to be netted against a debt owed on an option contract. Netting,
whether the netting of like product contracts or cross-product contracts, can
reduce the credit exposure of firms that use financial contracts. In turn, the
chance that the bankruptcy of one firm might lead to large losses for its financial contract counterparties is reduced, which some observers argue could
reduce systemic risk (Jones 1999).36
Observers explain that the expansion of special treatment for QFCs occurred in order to account for the considerable growth in the number and
diversity of complex financial products over the previous decade (Jones 1999,
Skadden 2010). These instruments grew in popularity as they served as mechanisms for financial firms to insure and hedge against risk, helping to reduce
uncertainty and stabilize earnings. This increasingly expansive protection for
derivatives and repos was intended to achieve the goal of “minimizing the
systemic risks potentially arising from certain interrelated financial activities
and markets.”37,38
Some Possible Weaknesses of Bankruptcy’s QFC Exemption

The onset of the financial crisis led many observers to reexamine whether
this systemic risk rationale was consistent with the events that occurred when
financial markets became severely stressed during the recent financial crisis. Therefore, the idea that QFCs should be exempt from the stay was revisited in the lead up to Dodd-Frank and ultimately addressed in the OLA.
The systemic risk argument is the prominent justification given by those supporting the expansion of the special treatment given to QFCs. However,
there is another cohort, which argues that any reduction in systemic risk,
because of QFC exemptions, may be offset by another form of systemic risk
firm $800 on a different interest rate swap contract. Under bankruptcy law, the creditor firm may
net the two contract debts such that the $800 it owes the defaulting firm is cancelled (netted against
the $1,000) and the defaulting firm ends up owing only $200 to the non-defaulting firm. The nondefaulting firm will have to wait for the bankruptcy process to proceed before being repaid any
portion of the remaining $200 it is owed. This outcome is superior for the non-defaulting party
compared to the case in which netting were not allowed. Here the non-defaulting party would be
required to pay the defaulting party the $800 it owed, but wait for the bankruptcy process to be
completed before getting any of the $1,000 defaulting party owes it. Of course, in reality, the
defaulting firm and the non-defaulting firm are likely to have many contracts outstanding with one
another at the time of default, all of which might be netted (Mengle 2010).
36 This may have magnified the concentration of the derivatives industry according to Bliss
and Kaufman (2006, 67–8), who argue that “by explicitly protecting these netting agreements, the
2005 bankruptcy changes reinforced the competitive advantage of the biggest counterparties.”
37 See Jones 1999.
38 “Immediate termination of outstanding contracts and liquidation of collateral facilitates the
acquisition of replacement contracts, reduces uncertainty and uncontrollable risk, improves liquidity
and reduces the risk of rapid devaluation of collateral in volatile markets” (Yim and Perlstein 2001,
3).

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

23

involving runs on repos39 and fire sales40 of the collateral underlying closedout derivatives contracts (Edwards and Morrison 2005, Taylor 2010, Acharya
et al. 2011). The simultaneous termination and liquidation of numerous QFCs
(which is allowed by the exemption of QFCs from the stay) may lead to fire
sales and possibly further insolvencies. In Lehman’s case, of their 930,000
derivatives counterparties, 733,000 sought to terminate their contracts upon
their bankruptcy filing on September 15, 2008 (Miller 2009).
Additionally, some observers note that the 2005 bankruptcy laws, which,
among other things, extended QFC protections to repos backed by all types of
collateral, including all mortgage-related securities, may have encouraged use
of mortgage-backed securities as repo collateral (Lubben 2010), and thereby
contributed to losses during the financial crisis (Skeel 2010, Government Accountability Office 2011). As Skeel (2010) points out, mortgage values could
have spiraled down even more had AIG’s counterparties been forced to sell
a significant amount of the mortgage-related securities they had posted as
collateral on their QFCs (which was avoided when AIG was bailed out).
The idea that QFC fire sales might result from their exemption is not
new. In fact, it appears to be what led the Federal Reserve to step in and
encourage private firms to come to the aid of Long-Term Capital Management
L.P. (LTCM), preventing it from entering bankruptcy (Edwards and Morrison
2005).41
As discussed, the bankruptcy process can be long, but among other things,
this is intended to give the troubled financial firm and its creditors the time to
develop plans to salvage the value of the firm. However, with the exemption
from the stay, a large financial firm facing possible default (because of a
number of factors, such as a recent credit downgrading or an overall crisis of
confidence) has a strong incentive not to file for bankruptcy since doing so
would likely trigger simultaneous termination of all QFCs (Skeel and Jackson
2012). Thus, a troubled firm may put it off until the last moment and be forced
into a rapid liquidation that significantly depresses values to the detriment of
other market participants. These arguments suggest that bankruptcy’s current
treatment of QFCs may not be optimal.
Observers also find that the special treatment given to QFCs—in order
to prevent the perceived systemic risks that arise when these instruments are
39 By “runs on repos” we mean when counterparties, en masse, seize the collateral underlying

these deposit-like instruments.
40 The phrase “fire sale” typically refers to the possibility that the sale of an asset might yield
a lower-than-typical price if holders of one type of asset attempt to sell en masse. In comparison,
the “typical” (non-fire sale) price will result if sales are distributed over time.
41 Krimminger (1999, 1) notes that, “[i]n the case of LTCM, the absence of any mechanism
under the Bankruptcy Code to ‘slow’ the liquidation of assets and collateral, [a power granted to
the FDIC under the Federal Deposit Insurance Act] and the resulting ‘dump’ upon the markets,
was a key motivation for the pre-insolvency facilitation provided by the Federal Reserve Bank of
New York.”

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Federal Reserve Bank of Richmond Economic Quarterly

subjected to the automatic stay—not only create a different form of systemic
risk, but weaken market discipline (Edwards and Morrison 2005, Scott 2011).
The special treatment awarded to QFC counterparties in bankruptcy essentially places them ahead of all other creditors in the bankruptcy repayment
line, allowing QFC counterparties to get out of their contracts when all other
creditors cannot. As a result, their incentive to monitor the debtor prior to
bankruptcy and base their pricing and investment decisions on the perceived
risk of the counterparty may be significantly reduced, increasing moral hazard
(Edwards and Morrison 2005, Roe 2011). It is argued that this leads to market
distortions whereby debtors favor short-term repo financing over traditional
sources of funding, encouraging a more fragile liability structure (Edwards
and Morrison 2005, Skeel and Jackson 2012). For example, at the time of
Bear Stearns’ failure, a quarter of its assets (approximately $100 billion) were
funded by repos (Roe 2011). Roe (2011) suggests that, without the priority
given to these instruments in bankruptcy, it is plausible that Bear would have
financed a much larger proportion of its assets with longer-term debt, which
would have allowed for a more stable funding structure during the financial
turmoil.
Some observers who support these arguments maintain that QFCs should
be subject to the automatic stay provisions in the Bankruptcy Code, although
there are a range of views concerning the length of the stay and whether all
QFCs should be treated equally. According to Harvey Miller (2009), lead
bankruptcy attorney for the Lehman bankruptcy, the automatic stay, as originally contemplated, is intended to provide a firm with the “breathing space”
to find a third party source of liquidity or to carry out an “orderly, supervised
wind down of its business assets.” Miller argues that, had the special treatment given to QFCs not applied, Lehman’s failure may have been avoided
and certainly would not have been as “systemically challenging.” For instance, Lehman suffered a significant loss of value when nearly 80 percent of
their derivatives counterparties terminated their contracts upon their filing of
bankruptcy (Miller 2009).

The OLA’s One-Day Automatic Stay for QFCs

Given the controversy—with some experts arguing the exemption from the
stay is necessary to prevent systemic risk and others arguing that the exemption creates systemic risk—it is natural that Congress chose a solution that
leaves the FDIC with discretion to determine the treatment of QFCs for covered financial companies. Under Congress’s solution, QFCs are subject to a

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

25

one-day automatic stay upon appointment of the FDIC as receiver, whereas
QFCs are subject to no stay in bankruptcy.42
During the one-day stay under the OLA, the FDIC, as receiver of the
failing financial company, must quickly identify how to manage the SIFI’s
QFC portfolio. The one-day stay is aimed at addressing fears associated
with a failing firm’s QFC counterparties cancelling their contracts all at once
and driving asset prices down. Instead, counterparties’ rights to cancel their
contracts are put on hold for one day while the FDIC determines how to treat
these contracts. The FDIC has this same type of authority when dealing with
bank failures. Under the OLA, during this short period, the FDIC has the
option to retain the QFCs in receivership, transfer QFCs to another financial
institution (to an outside acquirer or to a bridge company created by the FDIC),
or reject the QFCs.43 However, in all instances, the FDIC must retain, reject,44
or transfer all of the QFCs with a particular counterparty and its affiliates.45,46
Each action taken by the FDIC has different implications for QFC counterparties of the debtor, as well as the failing firm. Retaining the QFCs in
receivership is most similar to bankruptcy in that after the one-day stay expires, QFC counterparties may terminate or net-out their contracts.47 What
differs significantly from bankruptcy, but is very similar to the FDIC’s resolution process for depository institutions, is the FDIC’s ability to transfer or
reject QFCs. If the FDIC chooses to transfer all of the QFCs with a particular
counterparty and its affiliates to a third party (including a bridge company),
the counterparty is not permitted to exercise its rights to terminate or close
out the contract.48 This awards the FDIC an opportunity to possibly preserve
the value of the contracts by removing the ability of counterparties to terminate contracts early and sell off the collateral at fire sale prices (Cohen 2011).
42 The one-day stay lasts until 5:00 p.m. on the business day following the date the FDIC is
appointed as receiver. Therefore, the “one-day” stay could last four days if the FDIC is appointed
as receiver on a Friday.
43 For the most part, the FDIC’s powers under the OLA to reject or transfer a QFC during
their limited one-day stay are much like the powers of the FDIC and bankruptcy trustees under
the Federal Deposit Insurance Act and the Bankruptcy Code, respectively, with the exception that
they are not supervised by a court nor do they receive counterparty input (Skadden 2010).
44 In bankruptcy, only contracts or leases that are executory—a contract where both parties
have unperformed obligations—may be rejected.
45 Dodd-Frank Act § 210(c)(9)(A). This is intended to eliminate “cherry picking” (selective
assumption and rejection) of QFCs by the debtor.
46 This differs from the Bankruptcy Code’s setoff provision, which allows a creditor to offset
all obligations under a single master agreement but not all of the contracts with a single counterparty and its affiliates (Skeel 2010, Cohen 2011). When Lehman filed for bankruptcy, they
were a counterparty to 930,000 derivatives transactions documented under 6,120 master agreements
(Summe 2011).
47 If a nondefaulting counterparty has an unsecured claim after terminating a QFC and liquidating any collateral, the claim would then be subject to the same claims process as other
unsecured creditors.
48 If the counterparty were to default at a later time on a separate occasion, they may exercise
their close-out rights.

26

Federal Reserve Bank of Richmond Economic Quarterly

Moreover, a QFC counterparty may find that their contracts are held with a
new, and presumably more stable, counterparty or a temporary bridge bank
following the one-day stay and, therefore, may have no incentive to terminate (in addition to the fact that it has no ability to terminate), leaving the
market undisrupted by their original counterparty’s failure while also maintaining what are possibly valuable hedge transactions. Finally, the FDIC may
reject (or repudiate) the QFCs of a given counterparty to the debtor, effectively
closing them out at the current market value, if they determine that they are
somehow burdensome or doing so would otherwise promote orderly administration.49 However, counterparties may recover, from the FDIC, any damages
suffered as a result of the FDIC’s rejection of QFCs.50
Possible Weaknesses of OLA’s One-Day Stay

Some commentators find that the one-business-day stay does not provide the
FDIC with sufficient time to identify the potential recipients of the failed firm’s
derivatives portfolio (Skeel 2010, Bliss and Kaufman 2011, Summe 2011).
Given this time constraint coupled with the “all or nothing” approach to the
treatment of QFCs (where the FDIC must retain, reject, or transfer all QFCs
with a particular counterparty) and the potential systemic risks from its failure
to protect a SIFI’s QFCs, some suggest that the FDIC is highly likely to transfer
all QFC contracts of a given counterparty to a bridge financial institution (i.e.,
protecting or guaranteeing them in full) (Skeel 2010). After all, if the FDIC
does not protect all contracts, then the non-defaulting counterparties may
close out and liquidate their contracts upon the expiration of the one-day stay,
effectively resulting in the systemic problems previously discussed related to
the QFC exemption—closing out the contracts and selling collateral at fire sale
prices. Thus, even if various QFC counterparties have differing risk exposures
to the defaulting firm, they are all likely to be treated the same and “bailed out.”
If counterparties believe that their QFCs are likely to be protected by placement
in a well-funded bridge company, they are likely to provide more funding (or
provide lower-cost funding) to a risky firm than they otherwise would. Further,
counterparties may care little about the differing risks associated with the
various types of QFCs, because all QFCs of a given counterparty are treated
the same. Therefore, while bridge company placement of QFCs may limit
systemic risk, it is likely to do so at the cost of increasing moral hazard.
In response to the concern that a one-day stay is likely to lead to the
protection of most QFCs, some observers, such as Thomas Jackson, author
of a proposal to create a new chapter in the Bankruptcy Code tailored to the
49 Dodd-Frank Act § 210(c)
50 Damages are calculated as of the date of repudiation. The word “damages” is defined as

the “normal and reasonable costs of cover or other reasonable measures of damages utilized in
the industries for such contract and agreement claims” Dodd-Frank Act § 210(c)(3)(C).

S. R. Pellerin and J. R. Walter: Orderly Liquidation Authority

27

resolution of SIFIs (Chapter 14), proposes an extension of the duration of
the automatic stay for QFCs to three days. Jackson and others argue that a
longer stay duration will give the FDIC additional time to make an informed
decision regarding how to handle the failing firm’s QFC portfolio (Jackson
2011). Jackson’s three-day stay appears to be an attempt to balance the desire
to give the FDIC more time, against the danger of producing QFC counterparty
failures.51
Moreover, the protections for derivatives contracts have broadened over
the last several decades and this legislation does not account for the differences
across QFC products (such as between repos and swaps), or the types of
collateral backing QFCs, which some observers believe should be considered.
For instance, several observers find that special treatment (i.e., exemption
from the stay) should be limited to derivatives collateralized by highly liquid
collateral, such as short-term Treasury securities, since there is little reason
to assume that such instruments are important for the going-concern value of
the bankrupt firm (Herring 2011, Jackson 2011). In Jackson’s 2011 Chapter
14 proposal, highly liquid, or otherwise highly marketable, instruments with
no firm-specific value remain exempt from the stay so that creditors who rely
on the immediate availability of their funds can get them back quickly and
without disruption upon the failure of a firm. On the other hand, the exemption
is removed (i.e., the stay would apply) for less liquid instruments, such as
CDS, in an effort to prevent these creditors from running on the troubled firm.
Clearly, there remains a good bit of controversy about the best way to handle
the QFC exemption, in both bankruptcy and the OLA, with no obvious best
solution.

3.

CONCLUSION

While bankruptcy probably provides the ideal failure resolution mechanism for
most corporations, it may not be optimal for some financial firms (i.e., SIFIs).
Financial firms are typically more heavily dependent on short-term funding,
often including a heavy reliance on QFCs, and their balance sheets are opaque.
Because of this dependence on short-term funding, a long stay, while the
bankruptcy process plays out, is likely to result in financial difficulties for some
of the troubled firm’s counterparties. Moreover, DIP funding, which is the
usual means of keeping a troubled, but viable, firm alive during reorganization,
is likely to be quite difficult to arrange, given the opacity of most financial firms.
Because of these weaknesses, handling a SIFI through bankruptcy is likely
51 While the three-day stay may not provide significantly more time than one day to make
such valuations, the Dodd-Frank requirement that SIFIs create resolution plans or “living wills”
and provisions forcing swaps to be traded on exchanges could expedite the QFC valuation process,
improving the ability of the FDIC to make appropriate decisions within a three-day stay period.

28

Federal Reserve Bank of Richmond Economic Quarterly

to result in significant risks to financial stability. Policymakers are therefore
understandably reluctant to allow SIFIs to enter bankruptcy, given that these
risks can be mitigated through bailouts. But bailouts, or the expectation that
they could be forthcoming, drive down economic efficiency by exacerbating
moral hazard problems.
In an effort to address these difficulties, the OLA was created with the
explicit goals of mitigating risk to the financial system and minimizing moral
hazard. Specifically, the OLA adjusts the way that QFCs are handled and how
creditors are paid out. Despite the attempt to achieve these well-founded goals,
because they are conflicting, reducing one inevitably leads to an increase in
the other. The one-day QFC exemption does not clearly resolve potential risks
to financial stability and it also does not go far to ameliorate the moral hazard
problem that is apparent when giving QFCs special treatment. Additionally,
the ability to pay some creditors more than they would be likely to receive
in bankruptcy may reduce systemic risk, but at the cost of increasing moral
hazard. In conclusion, the threat of a SIFI’s failure, or the failure itself, presents
policymakers with a daunting challenge that neither bankruptcy nor the OLA
seems capable of fully resolving.

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Acharya, Viral, Thomas Cooley, Matthew Richardson, and Ingo Walter.
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Bliss, Robert R., and George G. Kaufman. 2011. “Resolving Large Complex
Financial Institutions: The Case for Reorganization.” Available at
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Bliss, Robert R., and George G. Kaufman. 2006. “Derivatives and Systemic
Risk: Netting, Collateral, and Closeout.” Journal of Financial Stability 2
(April): 55–70.
Boul, Harry. 2006. “Repeat Filings under BAPCPA: Stays, Multiple
Discharges and Chapter 20.” ABI Committee News Volume 4, Number 6
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Bris, Arturo, Ivo Welch, and Ning Zhu. 2006. “The Costs of Bankruptcy:
Chapter 7 liquidation versus Chapter 11 Reorganization.” The Journal of
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Cohen, Hollace T. 2011. “Orderly Liquidation Authority: A New Insolvency
Regime to Address Systemic Risk.” University of Richmond Law
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Duffie, Darrell. 2011. How Big Banks Fail, and What to Do About It.
Princeton, N. J.: Princeton University Press.
Edwards, Franklin R., and Edward R. Morrison. 2005. “Derivatives and the
Bankruptcy Code: Why the Special Treatment?” Yale Journal on
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Government Accountability Office. 2011. “Bankruptcy: Complex Financial
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Gruenberg, Martin J. 2012. Remarks to the Federal Reserve Bank of
Chicago Bank Structure Conference, Chicago, May 10. Available at
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Herring, Richard J. 2011. The Meeting of the Systemic Resolution Advisory
Committee of the Federal Deposit Insurance Corporation, Washington,
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Jessup, Clifton R., Jr. 1995. “Should the Automatic Stay Be Abolished?” The
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archives/1999/sp25mar99b.html.
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Scott, Kenneth. 2011. “A Guide to the Resolution of Failed Financial
Institutions: Dodd-Frank Title II and Proposed Chapter 14.” Stanford
Law School. Available at http://media.hoover.org/sites/default/files/
documents/ken-scott-guide-to-resolution-project.pdf (May).
Skadden. 2010. “The Dodd-Frank Act: Commentary and Insights.” Available
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Special Edition Dodd-Frank Act1 6.pdf.
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Authority II.” In The New Financial Deal: Understanding the
Dodd-Frank Act and its (Unintended) Consequences. Hoboken, N. J.:
John Wiley & Sons, Inc., 129–52.
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Summe, Kimberly. 2011. “An Examination of Lehman Brothers’ Derivatives
Portfolio Post-Bankruptcy and Whether Dodd-Frank Would Have Made
Any Difference.” Available at http://media.hoover.org/sites/default/files/
documents/Kimberly-Summe-Dodd-Frank-20110421.pdf.
Taylor, John B. 2010. “Defining Systemic Risk Operationally.” In Ending
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Committee Forum on Derivatives And Proposed Financial Contract
Netting Legislation, March 24.

Economic Quarterly—Volume 98, Number 1—First Quarter 2012—Pages 33–50

Contingent Capital: The
Trigger Problem
Edward Simpson Prescott

C

ontingent capital is long-term debt that automatically converts to
equity when a trigger is breached. It is a new and innovative security that many people are proposing as part of a reform in bank
capital regulations.1 The security is most associated with Flannery (2005),
but with the recent financial crisis many others, including Flannery (2009);
Huertas (2009); Albul, Jaffee, and Tchistyi (2010); Plosser (2010); Squam
Lake Group (2010); Calomiris and Herring (2011); McDonald (2011);
Pennacchi (2011); and Pennacchi, Vermaelen, and Wolff (2011), have also
advocated its adoption.2 Furthermore, the Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010 mandated a study of contingent capital,
while the Independent Commission on Banking’s report (2011) on banking in
the United Kingdom recommended that bank capital structure include lossabsorbing debt like contingent capital.
Contingent capital has four appealing properties. First, it increases a
bank’s capital when a bank is weak, which is precisely when it is hardest
for a bank to issue new equity. In doing so, contingent capital reduces the
“debt overhang” problem, which is the inability of a bank to raise funds to finance new loans because their return partially accrues to existing debtholders.
During the recent financial crisis, many U.S. banks were forced to raise new
equity. If they had had contingent capital securities, this process would have
been much easier. Second, contingent capital automatically restructures part
The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System. E-mail: edward.prescott@rich.frb.org.
1 There are already several changes to bank capital requirements, like increasing capital levels
and making them more procyclical, that have already been implemented or are in the process of
being implemented.
2 See Calomiris and Herring (2011) for a more detailed list of the various contingent capital
proposals. An early analysis is contained in Raviv (2004). Finally, there are also related proposals
like Hart and Zingales (2011) that require banks to raise more equity when price triggers are
breached.

34

Federal Reserve Bank of Richmond Economic Quarterly

of a bank’s capital structure, reducing the chance it fails and is put in resolution or bankruptcy.3 Many people think that the abrupt nature of Lehman’s
bankruptcy was very disruptive to financial markets, so a pre-bankruptcy reorganization of a financial firm may be valuable. Third, it is a way to force
regulators to act, at least when the trigger is tied to an observable variable, like
the price of a bank’s equity. Fourth, it “punishes” equityholders by diluting
existing equityholders. Some proposals argue that the threat of this dilution
will give a bank an incentive to take less risk (e.g., Calomiris and Herring
2011).
All four of these properties have varying degrees of merit, but the purpose
of this article is not to analyze these benefits.4 Instead, it is to discuss a cost
of implementing contingent capital. All contingent capital proposals rely on
a trigger to implement conversion. Many of the proposals advocate the use of
a market-price trigger (e.g., Flannery 2005, 2009), but some of them rely on
accounting numbers (e.g., Huertas 2009), and others also include a role for
regulators. For example, Squam Lake Group (2010) advocates as a trigger the
use of accounting numbers at the firm level plus a regulatory declaration that
there is a systemic crisis.
This article argues that the trigger is the weak point of contingent capital
and, more specifically, a trigger based on a market price, be it a fixed trigger
or a signal for a regulator to act, suffers from an inability to price contingent
capital. This inability will be more precisely defined later, but the problem
arises because asset prices incorporate the possibility of conversion and the
way in which contingent capital conversion is triggered makes this feedback
problematic. In practice, this will mean conversion could occur when it is not
desired. Unless the price trigger can be designed in a way to overcome this
problem, contingent capital with a price trigger will not work.
An alternative to a price-based trigger is an accounting-based one. This
article does not focus on this type of trigger except to note that accounting
measures of a bank’s quality seem to lag its actual condition. For example, the
prompt corrective action provision (PCA) of the Federal Deposit Insurance
Corporation (FDIC) Improvement Act of 1991 is an accounting-based regulatory trigger system. It does not convert debt to equity like with contingent
capital, but it requires regulators to restrict the activities of a bank and even
shut the bank down if regulatory capital drops below certain thresholds. The
motivation behind PCA was to force regulators to act before a bank’s losses
got too big. In the recent crisis, losses to the deposit insurance fund have been
very high despite the existence of PCA (Government Accountability Office
3 It is worth noting that even though converting debt to equity raises the book value of equity,
it does not bring new cash into a firm (other than indirectly by eliminating interest payments on
the converted debt) like a new issuance of equity would.
4 This is not entirely true. The Appendix contains a discussion of why the incentive effects
of contingent capital are not the major benefit of contingent capital.

E. S. Prescott: Contingent Capital: The Trigger Problem

35

2011). For example, FDIC losses on banks and thrifts (excluding Washington
Mutual) that failed over the period 2007–2010 have been 24.62 percent of the
assets of these failed institutions.5 Based on this experience, caution about
the timeliness of accounting measures seems warranted.
Underlying the use of price triggers in contingent capital is the fundamental idea that prices aggregate information, so regulation should be able to
use them to make decisions. Indeed, one of the most robust findings in financial economics is that prices are efficient in the sense that prices incorporate
all available information (Fama 1970). A striking example is found in Roll
(1984), who documents that the price of orange juice futures better predicts
variations in Florida weather than National Weather Service forecasts. Indeed,
the empirical banking literature surveyed in Flannery (1998) documents that
bank security prices can predict changes in supervisory ratings.6
This article uses a simple model to illustrate how the usual theoretical
and empirical properties of financial prices break down for contingent capital
with a price trigger. The model is based on a small theoretical literature that
has found that the discrete jump in security prices resulting from conversion
interferes with the ability of prices to aggregate information.7 This problem
with contingent capital was discovered by Sundaresan and Wang (2011), who
found that contingent capital with a trigger based on an equity price could
not be priced because there did not necessarily exist a unique set of prices.
When conversion heavily diluted equity, they found that there were multiple
equilibria. When conversion raised the value of equity, they found that there
were no equilibria.
Birchler and Facchinetti (2007) and Bond, Goldstein, and Prescott (2010)
studied the related problem of a regulator who could intervene in the operations
of a bank and thus affect the value of the bank. In both articles, the regulator
did not know the fundamental value of the bank, but instead had to infer it
from the prices of the traded bank securities. Instead of using a price-trigger
rule, the regulator had trigger-like preferences in that he wanted to intervene
only when the fundamental quality of the bank was below some threshold. The
5 Washington Mutual is excluded for two reasons. First, including it skews the average because it had about $300 billion in assets and the FDIC took no loss on it when they arranged
a sale through receivership to J.P. Morgan Chase. The high average on the rest of the failed
banks illustrates that there were a lot of banks for which the accounting numbers substantially
lagged their actual condition, otherwise losses would have been much smaller. Second, Washington
Mutual was not shut down because of a violation of PCA triggers, but rather because of liquidity
problems. Indeed, it was well capitalized by PCA standards as of September 25, 2008 (Offices of
Inspector General 2010), so it is further evidence that accounting numbers can lag actual condition.
6 Motivated by this logic, there is an older set of proposals (e.g., Stern 2001) that advocate
that bank supervisors use market prices to supplement their surveillance of banks.
7 One concern raised about the use of market price triggers is that traders will manipulate
prices to generate conversion when it would be advantagous to them. While this is a legitimate
concern, the analysis in this article shows that there are problems with using market prices as a
trigger even in the absence of these concerns.

36

Federal Reserve Bank of Richmond Economic Quarterly

effect of the intervention decision is mathematically similar to the effect from a
price trigger—there is nonexistence of equilibrium when the regulator cannot
commit to an intervention rule, though in the simplest environments there is
a unique equilibrium when there is heavy dilution. Indeed, the implication of
their work is that when prices are used as a trigger, prices need not aggregate
all available information.
Almost all the analysis of contingent capital is theoretical because there
is no financial market evidence. Sundaresan and Wang (2011) report only
four issuances of contingent capital, all of which were within the last few
years. Furthermore, none of these issuances purely rely on market prices. For
example, Credit Suisse (2011) issued a contingent-capital security in 2011 that
used as its trigger the equity capital ratio and allowed the regulator to trigger
conversion if it was determined that customary measures to improve capital
adequacy were inadequate to keep Credit Suisse viable.
To overcome this lack of data, Davis, Korenok, and Prescott (2011) ran
market experiments to study the effect of using a market price as a contingent
capital trigger. Market experiments are small scale economies run in laboratories with human subjects who trade in a market. They found that conversion
increased the volatility of prices, reduced the efficiency of allocations, and
led to conversion errors with some frequency. A summary of their findings is
provided.
Section 1 illustrates the pricing problem with a simple theoretical model.
Section 2 discusses possible ways around the pricing problem. Section 3
briefly discusses the experimental results. Section 4 concludes, and the
Appendix contains an argument for why contingent capital will only partially
reduce risk-taking incentives.

1. THE MODEL
There is a bank that is financed by one unit of equity and one unit of debt.
Debt is scheduled to pay one and there is one share of equity. The value of
the bank, that is, the amount of cash it has to distribute, is θ > 0.
The bank’s equity is traded in a market by risk-neutral traders. These
traders know the value of θ and use that information plus their expectation
of whether debt will be converted to equity to trade the equity. The price of
equity depends on θ and is written p(θ ).
For simplicity, this article only considers conversion rules in which all the
debt is converted to equity. This assumption is not important for the results.
The conversion rule is α(p), which at price p converts the single unit of debt
into α shares of equity. As with the trigger rule proposals, the conversion
depends on the price of equity. There are a lot of possible conversion rules,
but the most common ones are to convert the debt to a fixed number of shares.

E. S. Prescott: Contingent Capital: The Trigger Problem

37

In particular, they take the form
α(p) =

α>0
0

if p ≤ p
ˆ
,
if p > p
ˆ

where p is some fixed trigger. The idea is that as a bank gets closer to inˆ
solvency, its share price will drop and that is when it is best to automatically
convert debt to equity.
Definition 1 Given a trigger rule, α (p), an equilibrium is a price of equity,
p (θ), such that ∀θ
p (θ) =

θ
1+α(p(θ))

if α (p (θ )) > 0
.
if α (p (θ )) = 0

θ −1

(1)

Equilibrium requires that prices, p(θ ), be consistent with the conversion
rule. As we will see, for some conversion rules no p(θ ) will satisfy (1) and
for others multiple p(θ) will.
No Conversion Benchmark
As a benchmark, consider the case of no conversion of debt. In this case, the
price of equity is
0
if θ ≤ 1
.
θ − 1 if θ > 1
When θ ≤ 1, all the firm’s payments go to the debtholders and there is nothing
left for equityholders. When θ > 1, the debtholders get the full payment of
one and the equityholders get what is left.
p(θ) =

Decreased Value of Equity
Most contingent capital proposals advocate setting conversion so as to heavily
dilute equity in order to “punish” the owners of the bank.8 The problem with
a trigger rule that heavily dilutes equity is that there are multiple equilibria.
To illustrate the problem, consider the trigger rule that if the price of equity is
less than or equal to 1.5 then the debt is converted to one share of equity, so
there are two shares of equity total. Formally,
α(p) =

1
0

if p ≤ 1.5
.
if p > 1.5

Under this trigger rule, an equilibrium exists. One of them is
p(θ) =

θ /2
θ −1

if θ ≤ 3
.
if θ > 3

8 See the Appendix for a discussion of incentives for equity owners.

(2)

38

Federal Reserve Bank of Richmond Economic Quarterly

To see this, if, at θ ≤ 3, the traders assume that there will be conversion, then
the price is less than or equal to 1.5, which is consistent with the conversion
rule. Similarly, for θ > 3, if the traders assume that there is no conversion,
then the price is θ − 1 > 1.5, which is also consistent with the conversion
rule.
A second equilibrium is
p(θ) =

θ /2
θ −1

if θ ≤ 2.5
.
if θ > 2.5

At θ ≤ 2.5, if traders assume there will be conversion, then the price will
be less than or equal to 1.25, which is consistent with the conversion rule.
Similarly, for θ > 2.5, if the traders assume that there is no conversion, then
the price is θ − 1 > 1.5, which is also consistent with the conversion rule.
As should be apparent, any price function in which traders assume that
there will be conversion for values of θ below any cutoff between 2.5 and 3.0
will be an equilibrium. But actually, the multiple equilibria problem is even
worse than this. There are lots of other price functions that are equilibria,
some of which are rather strange. For example,
⎧
if θ ≤ 2.5
⎪ θ /2
⎪
⎨
θ − 1 if 2.5 < θ ≤ 2.6
p(θ) =
if 2.6 < θ ≤ 3
⎪ θ /2
⎪
⎩
θ − 1 if θ > 3
is also an equilibrium!
Multiple equilibria is a serious problem for contingent capital because it
is unclear what its price will be. As we will see, a variety of prices occur in the
experimental evidence. In terms of the proposal this means that conversion
need not happen when it is desired or it may happen when it is undesired.

Increased Value of Equity
The proposals do not advocate conversion to increase the value of equity, but
this case still has to be studied for two reasons. First, there may very well
be states of the world where the price of equity is low, but conversion would
increase the value of equity. For example, imagine a very high probability
that θ will be less than 1, the amount owed to debtors. Equity does not have
much value in this case, but if the debt is converted to equity, then the price
of equity may very well go up even if it is heavily diluted. After all, a high
probability of a small payment can be more valuable than a low probability
of a high payment. Second, the proposals for regulators to use prices to take
regulatory actions, like replacing management or doing something similar,
could very well increase the value of the bank. This was the scenario studied
in Birchler and Facchinetti (2007) and Bond, Goldstein, and Prescott (2010).

E. S. Prescott: Contingent Capital: The Trigger Problem

39

Figure 1 Increased Value of Equity Case
2.5

2.0

1.5

p
1.0

0.5

0.0
0.0

0.5

1.0

1.5

2.0

2.5

3.0

θ

Notes: The black line shows the price of equity assuming that the debt is not converted
to equity. The gray line shows the price of equity assuming that it converts to equity
when θ ≤ 2.5. The gray line is non-monotonic, which is suggestive as to why there is
no equilibria when the price trigger is set at 1.5. For θ just below 2.5, the price drops
below 1.5 without conversion and increases above 1.5 with conversion. Neither possibility
is consistent with the trigger rule.

If the value of equity increases from a conversion then the problem is not
one of multiple equilibria, but instead that no equilibrium even exists. To see
this, consider the same price trigger level as above, but now convert debt into
0.5 shares, that is,
0.5 if p ≤ 1.5
.
(3)
0
if p > 1.5
Under this trigger rule, no equilibrium exists. To see this, consider what
the price can be if θ = 2.5. If traders assume there will be conversion, then
there is no debt and 1.5 shares of equity. The price of equity would then
have to be 2.5 , but that is greater than the 1.5 trigger, so there cannot be
1.5
conversion. Alternatively, if traders assume that there will not be conversion
then the price of equity is 1.5 without conversion, but that violates the trigger
rule of converting when the price is less than or equal to 1.5.9
Figure 1 illustrates the problem. The gray line shows what prices would be
if conversion could be tied directly to the fundamental value θ . The problem
α(p) =

9 This is not just a problem right at the trigger point. The same logic applies to a range of
fundamentals below 2.5, in this example, down to 2.25.

40

Federal Reserve Bank of Richmond Economic Quarterly

here is that a conversion rule that increases the price of equity requires a
price function that is above the trigger value for a range of θ values below
θ = 2.5. This non-monotonicity in prices around the trigger implies that the
trigger rule, as commonly proposed, cannot distinguish between values of θ
for which conversion is desirable and values for which it is not.

2.

SOLUTIONS?

The lack of existence of a unique equilibrium is a serious challenge to implementing contingent capital proposals. Certainly, triggers of the form analyzed
above would not work. There are, however, alternative ways to structure
the trigger that avoid these problems. Below, some possible solutions are
described and assessed.
Getting the Conversion Ratio Just Right
If conversion is set so that the value of equity does not change at conversion,
then there is a unique equilibrium. In the example above, a trigger rule that
works is at a price of 1.5, convert the debt to 2 a share. Under this rule, if
3
conversion occurs at θ = 2.5, then the price of equity is 1.5, just like if there
is no conversion. Figure 2 illustrates.
More generally, the conversion ratio that generates a unique equilibrium is
the one that generates a continuous monotonic price function. With a conversion rule that converts all the debt to α shares of equity (like in the examples
ˆ
above), α needs to be set so that at the desired conversion point, θ , the prices
of equity under conversion and non-conversion are the same, that is,
ˆ
θ −1=

1
ˆ
θ
1+α

or
α=

1
ˆ
θ −1

.

This means that the trigger price in turn needs to be
1
.
α
While this conversion rule is simple and works in this one-period model,
it need not work in a dynamic model with uncertainty. Sundaresan and Wang
(2011) show that, in a dynamic model, even if the conversion ratio is set so
that at maturity there is no change in the value of equity from conversion that
is no guarantee that the same conversion ratio will not change the value of
equity in earlier periods. Basically, a simple trigger rule is not robust enough
to cover the wide variety of paths of uncertainty.
p=
ˆ

E. S. Prescott: Contingent Capital: The Trigger Problem

41

Figure 2 No Change in the Value of Equity at Conversion
3.0

2.5

2.0

p 1.5

1.0

0.5

0.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

θ

Notes: The solid line shows the price of equity assuming that the debt is not converted to
equity. The dashed line shows the price of equity assuming that the debt always converts
to equity. The portions of the lines in gray show the price of equity when the conversion
ratio is set so that there is no change in the value of equity at the trigger. This price
function is the only equilibrium.

Finally, in order to prevent a jump in the value of equity, this conversion
rule actually helps the original equity owners, at least relative to no conversion.
As Figure 2 illustrates, for values of θ less than 2.5, the price of a share is more
than it would be without conversion. With this conversion rule, equity owners
are actually not punished, which is one of the motivations behind contingent
capital.

Sliding Conversion Rules
One way to “get the conversion ratio just right” without rewarding equity
owners is to use a “sliding conversion rule.” The idea is to make the amount
of dilution vary so that as θ declines, the price continuously decreases. The
monotonicity is needed for existence and the continuity is needed for uniqueness. Birchler and Facchinetti (2007) use a similar concept in their regulatory
action model to get existence when there is a value-increasing action.

42

Federal Reserve Bank of Richmond Economic Quarterly

Figure 3 Trigger Rule with Unique Equilibrium that Punishes
Equityholders
2.5

2.0

1.5

p
1.0

0.5

0.0
0.0

•

0.5

1.0

1.5

2.0

2.5

3.0

θ

Notes: The black line shows the price of equity with non-convertible debt. The gray line
shows the price of equity with debt that converts to equity using the sliding conversion
rule in the text. The price function is continuous and monotonically increasing. Relative
to non-convertible debt, it hurts original equity owners for medium values of θ, but helps
them for low values of θ .

For this example, assume that the lower bound on θ is 0.5. A conversion
function that generates a unique price function is
⎧
if 0.10 ≤ p ≤ 0.25
⎨ (9p − 0.5)/p
(4.75 − 1.5p)/2.5p if 0.25 < p ≤ 1.5 .
α(p) =
⎩
0
if p > 1.5
Figure 3 shows the price function that results from this conversion rule. It
is the piecewise linear gray line, and it is straightforward to show that it is the
unique price function. There are three things to note about this function. First,
the continuity prevents the multiple equilibria that arose in the heavy dilution
example. Second, the monotonicity prevents the discrete drop in price at and
above a trigger point, which was the source of nonexistence in the increased
value example. Third, the price schedule punishes equity owners for a range
of values of θ below the trigger. For the lowest values of θ , equityholders
are actually made better off by conversion, but this feature is only there to
keep the price of equity above zero. With a trigger and a conversion rule that

E. S. Prescott: Contingent Capital: The Trigger Problem

43

wipes out old equity—bankruptcy can be thought of a conversion rule with
α = ∞—the price of equity is zero under conversion, so there is a really severe
form of multiple equilibria, namely, for any value of θ there is an equilibrium
where the price of equity is zero! Keeping the price of equity positive under
conversion prevents this perverse problem.

Use Other Information
Another possible solution is to make the conversion depend on the total value
of the firm (e.g., Raviv [2004] and Pennacchi [2011]). In the example, the
total value of the firm is simply the value of equity plus the value of contingent
capital. If the trigger were set so that the total value of the firm is less than
or equal to 2.5, then a unique equilibrium would exist. The reason is that the
value of equity plus debt is simply the value of the firm, that is, the cash flow
θ , and that does not change with conversion.
The obvious concern with this solution is that markets for bank debt (not
to mention bank deposits) are far less liquid than those for equity, so good
measures of the value of the firm will not be readily available. But even if
this issue could be overcome, the deeper issue is whether conversion affects
the value of a firm. The firm-value trigger works in this example because the
model is a Modigliani-Miller environment in that the capital structure does not
affect the value of the firm. However, implicit in many of the arguments for
contingent capital is that a debt-to-equity conversion will improve the value of
the firm by reducing debt overhang. But if there is a debt overhang problem
then the environment is not a Modigliani-Miller one, so a change in the capital
structure would create a discrete change in the value of the firm and there would
be the same problems with equilibrium that we analyzed above.10

Price Restrictions
A simple way to deal with the multiple equilibria is to forbid exchanges of
equity at certain prices. In the decreased value of equity example above,
if equity were forbidden to trade over the range (1.25, 1.5] then the only
equilibrium would be the one where conversion occurs for θ ≤ 2.5. The other
equilibria discussed above simply cannot occur.
Even if it were feasible to prohibit trading at certain prices, this solution
would still require a lot of information to set up. The amount of the drop in the
price of equity will depend on the aggregate state (something that was not in
10 The Birchler and Facchinetti (2007) and Bond, Goldstein, and Prescott (2010) studies were

precisely worried about regulatory interventions that changed, and more specifically improved, the
value of the bank.

44

Federal Reserve Bank of Richmond Economic Quarterly

the model above). That requires a lot of information on the part of regulators
to set up.
Prediction Markets
Another possible solution is to introduce prediction markets in whether or
not there is conversion and use that information as part of the trigger. Bond,
Goldstein, and Prescott (2010) show that in the regulatory action with an
increased value of equity case, when prediction markets are added, a unique
equilibrium exists. Here, we show that with a price trigger rule that also
depends on the price of the prediction security, a unique equilibrium exists for
both the decreased and increased value examples.
The prediction market is a market in a security that pays one if there is
conversion and zero otherwise. The same traders who trade equity also trade
the prediction security. The price of the prediction security is q(θ ) and the
trigger rule now depends on both prices, that is, α(p, q). A price of one means
that traders expect conversion and a price of zero means they do not.
Definition 2 Given a trigger rule, α (p, q), an equilibrium is a price of equity,
p(θ), and a price of the prediction security, q(θ ), such that ∀θ
θ
1+α(p(θ),q(θ))

p(θ) =

if α (p (θ ) , q (θ)) > 0
if α (p (θ ) , q (θ )) = 0

θ −1
0
1

q(θ) =

if α (p (θ ) , q (θ )) = 0
.
if α (p (θ ) , q (θ )) > 0

For the example studied earlier, where the value of equity declines with
conversion, consider the following modification to the trigger rule (2):
⎧
⎪ 1 if p ≤ 1.25
⎪
⎨
1 if 1.25 < p ≤ 1.5 and q = 0
.
α(p, q) =
⎪ 0 if 1.25 < p ≤ 1.5 and q = 1
⎪
⎩
0 if p > 1.5
The price function
p(θ) =

θ /2
θ −1

q(θ) =

1
0

if θ ≤ 2.5
if θ > 2.5

if θ ≤ 2.5
if θ > 2.5

is an equilibrium. For θ ≤ 2.25, conversion has to happen, while for θ > 3,
conversion cannot happen. Where the prediction security gets used is for
the range of θ where multiple equilibria were an issue without the prediction
security. First, consider the range 2.25 < θ ≤ 2.5. If traders assume that there
will be no conversion, then 1.25 < p ≤ 1.5 and q = 0, but by the trigger

E. S. Prescott: Contingent Capital: The Trigger Problem

45

rule there will be conversion. If traders assume there will be conversion, then
p ≤ 1.25, and there is conversion (and q = 1), which is consistent with the
trigger rule. Second, consider the range 2.5 < θ ≤ 3. If traders assume that
there will be conversion, then 1.25 < p ≤ 1.5 and q = 1, but by the trigger
rule there will not be conversion. In contrast, if traders assume there will not
be conversion, then p > 1.5, and there is no conversion (and q = 0), which
is consistent with the trigger rule. This trigger rule eliminates the multiple
equilibria by making it impossible for prices to fall in the range between 1.25
and 1.5, which prevents conversion at values of θ > 2.5. Essentially, this
solution uses the trigger rule to restrict the prices in the same way that the
analysis of the price-restriction solution did earlier.
In the case where the value of equity increases, where existence of equilibrium was the problem earlier, the prediction market gives the trigger rule
enough extra information to recover existence. Consider the modification to
the earlier trigger rule (3):
⎧
⎪ 0.5
⎪
⎨
0.5
α(p, q) =
⎪ 0
⎪
⎩
0

if p ≤ 1.5
if 1.5 < p ≤ 1 2 and q = 1
3
.
if 1.5 < p ≤ 1 2 and q = 0
3
if p > 1 2
3

The price function
p(θ) =
q(θ) =

2
θ
3

θ −1
1
0

if θ ≤ 2.5
if θ > 2.5

if θ ≤ 2.5
if θ > 2.5

is a unique equilibrium. To see this, first consider θ ≤ 2.5. If traders assume
conversion, then p ≤ 1 2 and q = 1, which is consistent with the trigger rule.
3
If traders assume no conversion then p ≤ 1.5, but that requires conversion
according to the trigger rule, so that is not a possibility. Now consider θ > 2.5.
If traders assume that there is no conversion, then p > 1.5 and q = 0, which
is consistent with the trigger rule. However, if traders assume conversion,
then p > 1 2 , which by the trigger rule requires no conversion, so that is not
3
a possibility.
A prediction market security of the form discussed above does not exist
right now. Nevertheless, credit default swaps are very close in that they are
essentially insurance contracts that pay out in the event of a default. If a credit
default swap was designed so that conversion was the triggering “default”
event, then the swap could be used as the prediction security. Of course, the
usual concerns about liquidity and market manipulation would apply.

46
3.

Federal Reserve Bank of Richmond Economic Quarterly

EVIDENCE

As was discussed earlier, there is very little empirical evidence on the effectiveness of contingent capital. The only source of evidence that I am aware of
is from the laboratory experiments reported in Davis, Korenok, and Prescott
(2011). Laboratory experiments are games played by subjects (typically college students) for real stakes. The experiments can be used to study individual
decisionmaking or more complex group interactions.
Davis, Korenok, and Prescott (2011) ran experiments where the subjects
used a standard open book double auction to trade an asset that could change
in value if a price trigger were breached. The price trigger worked just like
the examples above. If breached, the underlying value of the asset jumped up
in some of the experiments and dropped in others.
As predicted by theory, they found that the fixed-price trigger created informational inefficiencies in the sense that prices deviated from fundamentals
and were more volatile. This was true in experiments where the value of equity
was increased and those where it was decreased. The problems were worse,
however, in the case where the value increased.11
Compared with a no-conversion baseline, they also found that conversion made the allocation less efficient in the sense that assets ended up less
frequently in possession of the traders who valued them the most. Finally,
they also found the trigger was frequently breached when the fundamentals
did not warrant conversion and it was sometimes not breached when fundamentals warranted conversion. For some ranges of fundamentals, these errors
occurred most of the time. There were some caveats to their findings. In
particular, conversion errors in the decreased-value experiments were concentrated in the range of fundamentals just above the trigger, which may be
tolerable from a cost-benefit perspective, but for increased-value experiments
conversion errors were dispersed over a wider range of fundamentals.
They also ran experiments where, instead, a regulator made the decision
of whether or not to convert. The regulator was given a reward structure that
rewarded him if he converted when the fundamental was below the trigger or
if he did not convert when it was above the trigger. Compared with the fixedprice trigger, performance by a regulator tended to be worse. In particular, it
seemed that the additional source of uncertainty for traders, namely, guessing how the regulator would interpret the price, made prices more volatile.
Furthermore, the regulator made conversion errors over a wider range of fundamentals than in the fixed-trigger experiments. They also ran experiments
with a prediction market in whether the regulator would convert. The additional information from the prediction market improved the efficiency of
11 This was the case where an equilibrium did not exist in the model.

E. S. Prescott: Contingent Capital: The Trigger Problem

47

prices and allocations as well as the performance of the regulator, but substantial inefficiencies remained.12
For more details see the article, but overall they concluded that the inefficiencies and frequency of conversion errors are a significant cost to using
contingent capital with a price trigger.

4.

CONCLUSION

This article illustrates the potential pitfalls of using a market-price trigger in
contingent capital. The multiple equilibria and nonexistence results are problematic for these proposals. Indeed, in the closest thing we have to empirical
evidence—the market experiment data—the use of a trigger made prices and
allocations less efficient, increased volatility, and led to numerous conversion
errors.
In my view, any contingent capital proposal that uses market-based prices
needs to confront these problems. A viable proposal needs to find a trigger
that is not subject to multiple equilibria and nonexistence or, alternatively, one
that leads to few conversion errors, minor inefficiencies, and reasonable levels
of price volatility.

APPENDIX:

A DIGRESSION ON INCENTIVES

Many of the proposals advocating contingent capital emphasize the value of
“punishing” the equity owners by diluting equity (e.g., Calomiris and Herring
2011) in order to improve equity owners’ ex ante incentives. Structuring bank
capital to improve incentives is an idea with a long tradition in the banking
literature. The banking literature that came out of the savings and loan crisis
emphasized the risk-shifting incentives that bank equity owners have under a
legal and regulatory system that includes limited liability and deposit insurance
(e.g., White 1991).
This perspective is one that I am sympathetic with, but if incentives are
the motivation behind contingent capital, then the analysis is better served by
directly using an incentive model with an explicit treatment of moral hazard.
The standard approach to analyzing incentives is to use a moral hazard model
where bank equity owners have limited liability and can choose the amount
12 They did not run experiments where a prediction market was combined with a fixed-price

trigger.

48

Federal Reserve Bank of Richmond Economic Quarterly

of risk the bank takes.13 Interestingly, in this class of models, Marshall and
Prescott (2001, 2006) found that the most effective way to discourage a bank
from taking excessive risk was to, counterintuitively, “punish” the bank when it
did well! (In their context, punishment meant requiring that the bank’s capital
structure include warrants with a high strike price that essentially reduced
the upside gain to the bank. For a summary of their argument, see Prescott
[2001].) The reason for their surprising result was that very high returns were
more likely when a bank took an excessive amount of risk than an appropriate
amount, so reducing equityholders’ payoffs in these states was desirable. In
their model, it was also desirable to “punish” the equityholders when the bank
did poorly, but limited liability reduced the amount of punishment that could
be provided in this case.
The point of this digression is to argue that bank incentives need to be
viewed from a broad perspective that may well put little emphasis on “punishing” equityholders when a bank does poorly, or more accurately, that the
incentive implications of a heavy dilution are only a part, and possibly a small
part, of the total incentives created by a bank’s capital structure. For this reason, I think recapitalization effects rather than any incentive effects are what
is potentially most valuable about contingent capital.

REFERENCES
Albul, Boris, Dwight M. Jaffee, and Alexei Tchistyi. 2010. “Contingent
Convertible Bonds and Capital Structure Decisions.” Manuscript,
University of California at Berkeley.
Birchler, Urs, and Matteo Facchinetti. 2007. “Self-Destroying Prophecies?
The Endogeneity Pitfall in Using Market Signals as Triggers for Prompt
Corrective Action.” Manuscript, University of Zurich.
Bond, Philip, Itay Goldstein, and Edward Simpson Prescott. 2010.
“Market-Based Corrective Actions.” The Review of Financial Studies 23
(February): 781–820.
Calomiris, Charles W., and Richard J. Herring. 2011. “Why and How to
Design a Contingent Convertible Debt Requirement.” Wharton Financial
Institutions Center Working Paper 11-41 (April).
13 Implicitly, these models assume that bank managers act in the best interest of equity owners. That assumption is, of course, debatable.

E. S. Prescott: Contingent Capital: The Trigger Problem

49

Credit Suisse Group. 2011. “Buffer Capital Notes Information
Memorandum.” Available at www.credit-suisse.com/investors/doc/
buffer capital notes information memorandum.pdf.
Davis, Douglas, Oleg Korenok, and Edward Simpson Prescott. 2011. “An
Experimental Analysis of Contingent Capital Triggering Mechanisms.”
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Flannery, Mark J. 2009. “Stabilizing Large Financial Institutions with
Contingent Capital Certificates.” Manuscript, University of Florida.
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2010/07/ICB-Final-Report.pdf.
Marshall, David A., and Edward Simpson Prescott. 2001. “Bank Capital
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McDonald, Robert L. 2011. “Contingent Capital with a Dual Price Trigger.”
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Economic Quarterly—Volume 98, Number 1—First Quarter 2012—Pages 51–76

Exchange Rate Volatility in
a Simple Model of Firm
Entry and FDI
Thomas A. Lubik and Katheryn N. Russ

In recent years, the field of international trade has experienced a renaissance in theory and measurement, much of which is rooted in the seminal
contribution by Melitz (2003). Melitz’s theory of heterogeneous firms and
entry has changed not only how the field understands trade flows, but also
how it views multinational production. It enables more realistic modeling of
multinational firm behavior by capturing the fact that only the largest and most
efficient manufacturing firms invest abroad and, most importantly, that they
earn positive profits.
In this article, we present and analyze a simple model of firm exit and entry
in a Melitz-type environment. We apply the notion of endogenous variation
in the entry margin to location decisions by domestic and foreign firms. If
a firm wants to supply markets abroad, it has to locate production facilities
in the foreign country. We interpret the outcome of this decision as foreign
direct investment (FDI). Modeling this location decision thus links the theory
of FDI with models of multinational enterprises (MNEs). Moreover, this has
implications for the determination of international prices and quantities and
related macroeconomic issues.
We want to accomplish two things with this article. First, we derive
and explain a full set of analytical solutions for all variables of interest in
our theoretical model. This comes at the price of some arguably restrictive assumptions. However, by doing so we can cleanly isolate the entry
Lubik is a senior economist and research advisor at the Richmond Fed. Russ is an assistant
professor at the University of California, Davis. The authors are grateful to John Muth, Pierre
Sarte, and Felipe Schwartzman, whose comments greatly improved the exposition of this article. The views expressed in this paper are those of the authors and do not necessarily reflect
those of the Federal Reserve Bank of Richmond or the Federal Reserve System. E-mails:
thomas.lubik@rich.frb.org; knruss@ucdavis.edu.

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Federal Reserve Bank of Richmond Economic Quarterly

mechanism that is at the core of the model and carries over to the variables
in the model. Our contribution thus lies in making this mechanism more
transparent compared to richer modeling environments that have to rely on
numerical solutions. We therefore see this article as an introductory guide to
the mechanics of Melitz-style models of multinational firms.
Second, we use the model to take a look at a perennial issue in international
finance, namely the determinants of exchange rate volatility and the apparent
disconnect with economic fundamentals. Recent discussions of exchange
rate determination have increasingly emphasized the possible role of payments
earned on FDI and other assets held abroad. Yet, there are few existing models
of MNEs and endogenous exchange rates. This article demonstrates that the
entry decisions of MNEs influence the volatility of the real exchange rate in
countries where there are significant costs involved in maintaining production
facilities, even when prices are perfectly flexible. We show that for plausible
parameterizations, MNE activity can make the exchange rate more volatile
than relative consumption.
The key element of this framework is that a firm’s technology depends
both on aggregate and idiosyncratic labor productivity. Given fixed costs of
entry, this determines a firm-specific threshold productivity level, below which
firms do not operate. This threshold moves around with aggregate economic
conditions. Moreover, the model implies an endogenous distribution of firmlevel productivities that has strong empirical support (e.g., Helpman, Melitz,
and Yeaple 2004). In our model, the threshold or entry margin influences the
relative volatility of exchange rates, the aggregate price level, and consumption arising in response to productivity shocks. A positive country-specific
productivity shock allows both native and foreign-owned firms with lower
firm-specific levels of productivity to become profitable. Lower idiosyncratic
labor productivity in these new entrants dampens the impact of the countryspecific shock on total aggregate productivity. Thus, a positive productivity
shock can impact the real exchange rate at the same time entry by progressively less productive firms dampens the effect of the productivity shock on
the aggregate price level and consumption.
In order to highlight the entry channel for exchange rate determination
and to derive closed-form solutions, we make two simplifying assumptions.
First, we segment markets by allowing no cross-border transfers of wealth
via portfolio investment and we shut down any real trade linkages, except for
those involving the production and remittance activities of multinational firms.
These assumptions leave the nominal exchange rate completely determined
by flows of currency used for paying local costs of production incurred by
overseas branches of MNEs and for repatriating their profits earned abroad.
We show that FDI, even in this model without sunk costs of physical capital,
can act as the key driver of real and nominal exchange rate movements.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

53

The second assumption is standard in the Melitz-type literature, namely
that participation in any market is a period-by-period decision. This simplifies the model’s solution considerably since it eliminates the presence of
endogenous state variables in the solution. In addition, it yields testable empirical implications linking a country’s industrial structure to the volatility of
its exchange rate. We find that the behavior of multinationals is most likely to
generate excess volatility when FDI is plentiful in sectors with higher industry
concentration, higher value-added, and higher barriers to foreign participation
relative to domestic production, so that foreign firms tend to be big relative to
domestic firms.
The rest of the article considers the role that MNEs can play in explaining the determinants of exchange rates. We begin by placing our analysis
within the broader context of the recent literature. We then introduce a simple, stylized model of multinational production. We emphasize the role of
entry in determining the aggregate productivity level and the number of different goods available in the economy. Section 3 contains the main analysis
of the model. We discuss intuitively the role that market entry plays in the
response to shocks to technology for both nominal and real exchange rates,
as well as for consumption and other real quantities. We show analytically
how this can be decomposed into direct and indirect effects. We then discuss
the implication of our model for the exchange rate disconnect puzzle and the
volatility puzzle. The last section concludes.

1.

RELATION TO THE LITERATURE

It is well known that the volatility of the exchange rate is much higher than
that of other macroeconomic variables, such as the aggregate price level and
consumption. This produces a fundamental challenge for optimization-based
open economy models that link marginal rates of substitution to international
goods prices. For instance, Baxter and Stockman (1989) and Flood and Rose
(1995) point out that nominal and real exchange rate volatility is typically 10
times higher than the volatility of relative prices and several times greater than
the volatility of output or consumption. As demonstrated by Backus, Kehoe,
and Kydland (1992), standard open economy business cycle models have difficulty replicating these stylized facts unless implausible substitution elasticities
are assumed. The reason is the tight link between marginal rates of substitution and international relative prices that are at the heart of optimization-based
frameworks.
This exchange rate volatility puzzle is related to, in the nomenclature
of Rogoff (1996), the exchange rate disconnect puzzle. It stipulates that,
empirically, exchange rates appear to behave virtually independently of underlying economic fundamentals. Consequently, the ability of modern open
economy macroeconomics to explain exchange rate movements has not been

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Federal Reserve Bank of Richmond Economic Quarterly

an unqualified success.1 In this article, we approach this issue not from the
goods side, but rather from a perspective of financial flows generated by the
operations of MNEs. This removes the burden of having relative quantities
match the volatility of relative prices.2 In order to capture in the model the
disconnect between relative consumption and international prices, we turn
to the literature on MNEs and FDI, which de-emphasizes the role of final
consumption in favor of production decisions.
Our model draws its motivation from this growing body of work that
stresses the potential role of MNEs as one factor driving exchange rate fluctuations. We add the additional consideration that entry by heterogeneous
firms affects fluctuations in prices and consumption, and thus exchange rate
volatility. Quantitatively, there are several studies that highlight a causal relationship between FDI and the exchange rate. Kosteletou and Liargovas (2000)
provide empirical evidence that inflows of FDI Granger-cause fluctuations in
the real exchange rate for some European countries. Whether FDI generates
appreciating or depreciating tendencies varies by country, a disparity that the
authors explain as emerging from each country’s use of the inflows to finance
either consumption or capital accumulation. Shrikhande (2002) builds a theoretical model that allows for cross-border acquisitions of physical capital.
He is able to replicate the observed persistence and time-varying volatility in
the real exchange rate using fixed investment costs, similar to the fixed cost
of entry in our model. Gourinchas and Rey (2007) find empirical evidence of
a recursive relationship between exchange rates and the return on net foreign
asset holdings, including FDI, such as we model here.
Whereas the reduced-form correlation between FDI and exchange rate
volatility is well established, the direction of causality is widely debated.
Specifically, the literature seeking to measure the effect of exchange rate
volatility on FDI is vast and conflicted, which further supports the analysis in this article linking them both as endogenous variables. Phillips and
Ahmadi-Esfahani (2008) provide an exhaustive survey of these varied empirical and theoretical results. Several articles have recently analyzed entry and
production behavior of heterogeneous multinational firms. Russ (2007, 2011)
shows that accounting for the source of exchange rate volatility can determine
whether the relationship between volatility and FDI is positive or negative.
Fillat and Garetto (2010) find evidence that increased uncertainty of any type
in the host country can increase the likelihood that firms will export rather
than invest abroad. Ramondo, Rappoport, and Ruhl (2010) obtain the result
1 The seminal article in this literature is Meese and Rogoff (1983). Different perspectives
on this issue are given by Clarida and Gal´ (1994) in a value-at-risk framework, and Lubik and
ı
Schorfheide (2005) in an estimated dynamic stochastic general equilibrium model.
2 We should point out, however, that we do not speak to the other part of the disconnect
puzzle, namely that exchange rates are essentially unpredictable. This issue is left for a much
more empirical treatment than the scope of this article allows.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

55

that real exchange rate volatility can be correlated with lower multinational
production relative to arms-length exports when real wages and employment
are fixed.
There are important conceptual, empirical, and purely practical reasons
for modeling multinational firms characterized by heterogeneous productivity
levels. First, it is difficult to explain why some firms, but not all, establish
branches abroad, unless there exists some differential in their potential to
make a profit, as would occur when firms have differing labor productivity.
Second, there are several stylized facts regarding the behavior of MNEs that
conflict with the representative firm assumption. Using an extensive data set
that joins observations on firm size and employment with intra- and interfirm trade data, Bernard, Jensen, and Schott (2009) show that multinational
firms are larger in size and have greater revenues per worker than firms that
do not show evidence of having overseas affiliates. Modeling firm-specific
labor productivity as Pareto-distributed generates a pattern of firm sizes that
is also Pareto, which conforms to empirical findings by Helpman, Melitz,
and Yeaple (2004) and di Giovanni, Levchenko, and Ranci` re (2011), among
e
others. These stylized facts of firm size and distribution are captured by the
heterogeneous firm framework.
Finally, introducing heterogeneity in the tradition of Melitz (2003) causes
the entire solution of the model to rest only on the lowest productivity level
among firms producing in a particular period and a set of exogenous parameters. Pinpointing this threshold productivity level using a zero-profit cutoff
condition allows the entire model to be solved numerically without linearization and yields analytical results depicting the influence of shocks to a country’s
general technological state on the nominal and real exchange rate.
The mechanism we identify, namely that aggregate consumption and
prices appear to be much less volatile than the exchange rate because their
movement in response to a positive country-specific productivity shock can
be dampened by the entry of less productive domestic firms, is akin to a new
vein of literature on the exchange rate disconnect puzzle emphasizing the role
of transaction costs in trade. Fitzgerald (2008) shows both theoretically and
empirically that trade costs based on the geographic distance between countries can explain why relative price levels are much less volatile than the real
exchange rate, even when prices are perfectly flexible. Our article abstracts
from trade in goods, all local consumption being produced by either domestic
firms or resident branches of MNEs. It nonetheless approaches the disconnect
puzzle in a similar spirit, asking not why nominal and real exchange rates
are so volatile, but why they appear so volatile relative to consumption and
relative price levels.
The model closest to ours is Cavallari (2007), which demonstrates that in
a framework with heterogeneous firms, exchange rate overshooting may be
generated by repatriated profits from multinational firms exploiting a positive

56

Federal Reserve Bank of Richmond Economic Quarterly

productivity shock overseas. Cavallari relies on sticky prices to drive the
result. We show, on the other hand, that entry behavior alone can create
exchange rate volatility exceeding that of fundamentals, even with flexible
prices. As opposed to the model in Ghironi and Melitz (2005), our framework
does not involve the sunk costs or incomplete asset markets that generate,
respectively, endogenous persistence in exchange rate behavior and a role for
active monetary policy in a study of heterogeneous exporters and exchange
rates. However, it is rich enough to demonstrate that production decisions
by multinational firms can explain part of the differential in the variance of
exchange rates and other macroeconomic variables without nominal rigidities.

2. A SIMPLE MODEL OF ENTRY AND FDI
Our model economy consists of two countries, Home and Foreign, that are
identical in every respect. Each country is composed of a representative consumer and a continuum of firms. The consumer enjoys the consumption of
goods supplied by both Home and Foreign firms, but derives disutility from
supplying labor to firms operating in his home country. Home and Foreign
firms are distributed along separate unit intervals. What classifies a firm as
Foreign is that it pays a fixed overhead cost denominated in the currency of
its host country and repatriates (nominal) profits earned at the end of each
production period. This creates a necessity for foreign exchange since the
firm’s owners can only buy goods using their own home currency.
Furthermore, we assume that there is no trade in goods. Foreign firms
can supply the domestic market only by opening production facilities there.
Consequently, there is no trade balance, only a capital account in the balance
of payments. We also abstract from international borrowing and lending.
However, consumers can hold financial wealth in the form of currency that is
issued by each country’s monetary authority. The relative supply of the two
currencies is one of the determinants of the nominal exchange rate.

The Consumer’s Problem
The representative consumer in the Home country maximizes lifetime utility
∞

max

{Ct ,Lt ,Mt+1 }∞
t=0

β t U (Ct , Lt ) ,

E0

(1)

t=0

subject to the budget constraint
Pt Ct + Mt+1 ≤ Wt Lt + Mt +

t

+ Tt ,

(2)

and the cash-in-advance constraint
Pt Ct ≤ Mt .

(3)

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

57

Ct is aggregate consumption, Lt is labor input, Mt is the money stock, Wt
is the nominal wage, t are firm profits accruing to the household, and Tt
are transfer payments from the government; Pt is the aggregate price index,
which we define below. The household discounts future utility streams with
0 < β < 1.
We assume that the period utility function is additively separable,
C

1−ρ

−1

U (Ct , Lt ) = t1−ρ − χ Lt , where ρ > 0, χ > 0. Furthermore, we define the consumption aggregator as
θ
⎡
⎤ θ −1
1+nf,t

nh,t

⎢
Ct = ⎣

ch,t (i)

θ −1
θ

0

di +

cf,t (i)

θ −1
θ

⎥
di ⎦

,

(4)

1

with θ > 1. The interval [0, nh,t ) represents the continuum of all goods
ch,t (i) that can possibly be produced by Home-owned firms for the Home
market, while the interval [1, 1 + nf,t ] represents the continuum of all goods
that can be produced by Foreign-owned firms, cf,t (i), for the Home market
(nh,t , nf,t ≤ 1). The specification of the sub-utility function Ct encapsulates a
preference for variety in that it is increasing in the number of firms nh,t + nf,t
supplying the market. Variations in this extensive margin through entry will
therefore be another determinant of the exchange rate.
In solving our model, we assume that the cash-in-advance constraint always binds. This determines aggregate consumption as a function of real
money balances, Ct = Mtt . From the consumption aggregator, we can deP
rive demand equations for individual goods produced by Home and Foreign
firms that are downward sloping in relative prices. Homothetic preferences
imply that the demand for each good is a constant proportion of aggregate
consumption:
ch,t (i) =

ph,t (i)
Pt

−θ

Ct ,

pf,t (i) −θ
Ct .
(5)
Pt
Finally, the optimality condition for total labor input yields a wage equation:
cf,t (i) =

Wt = χ Pt Ctρ .

(6)

The Firm’s Problem
In each country, there is a continuum of firms with plans to put their particular invention into production. We denote firms owned by residents of the
Home country with the label h, while firms owned by residents of the Foreign country carry f . The location of production is identified by a “∗” for
Foreign, and no label for Home. Every firm that decides to enter the market

58

Federal Reserve Bank of Richmond Economic Quarterly

during period t produces a unique good and operates under a unique, firmspecific productivity level, ϕ (i). We assume that idiosyncratic productivity
has a continuous distribution g(ϕ), with support over the interval (0, ∞). Any
difference among the pricing rules and production decisions of firms operating
in the Home country is due only to differences in ϕ. Thus, ϕ is used to index
each good and the firm that produces it, instead of the general subscript i.
This idiosyncratic component is distinct from an aggregate time-varying
disturbance At , which denotes the country-specific state of technology available to all firms operating in the Home country. Technology is thus characterized by
yh,t (i) = At ϕ(i)lh,t (i),

(7)

where lh,t (i) is the amount of labor used by Home firm i for production in
the Home country. The country-specific productivity parameter for the Home
country, At , is defined by
log At = φ log At−1 + ε At ,
where εAt ∼ N (0, σ 2A ).
ε
Home firms operating in the Home country maximize profits subject to
consumer demand. They also bear a fixed overhead cost of production, fh ,
denominated in units of aggregate output. The profit maximization problem
is thus
ch,t (ϕ)
max π h,t (ϕ) = ph,t (ϕ)ch,t (ϕ) − Wt
− P t fh
ph,t (ϕ)
ϕAt
s.t.

ch,t (ϕ) ≤

ph,t (ϕ)
Pt

−θ

Ct ,

(8)

where we have used the market clearing condition ch,t (ϕ) = yh,t (ϕ), and
substituted out labor input lh,t (ϕ) with the production function. Assuming an
interior solution, that is, where the firm has already entered and operates in
the Home market, the first-order condition for profit maximization is then
∂π h,t (ϕ)
∂ch,t (ϕ)
∂ch,t (ϕ) Wt
: ch,t (ϕ) +
ph,t (ϕ) −
= 0.
∂ph,t (ϕ)
∂ph,t (ϕ)
∂ph,t (ϕ) ϕAt

(9)

We can now derive the optimal price-setting condition by substituting the
derivative of the demand equation into the firm’s first-order condition:
θ Wt
.
(10)
θ − 1 ϕAt
As is typical in models with Dixit-Stiglitz-type preferences for variety, firms
set prices as a markup over marginal costs. Moreover, for a given wage, higher
productivity firms charge a lower price since they have lower marginal costs.
The same steps can be used to derive the pricing equation for Foreignowned firms operating in the Home country. The profit maximization problem
ph,t (ϕ) =

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

59

is
max π f,t (ϕ) =

pf,t (ϕ)

1
St

pf,t (ϕ)cf,t (ϕ) − Wt

cf,t (ϕ)
− P t ff
ϕAt

pf,t (ϕ) −θ
Ct ,
(11)
Pt
where St is the nominal exchange rate at time t, measured in units of Home
currency per unit of Foreign currency. The term ff denotes the fixed cost
paid by Foreign-owned firms operating in the Home country. The fixed cost
is denominated in units of the aggregate output of the host country and paid
in units of local currency. It can be thought of as an overhead cost, or, more
abstractly, as the cost of capital with 100 percent depreciation. The pricing
rule for Foreign goods produced and sold in the Home country turns out to be
identical, since firms face the same Home-country wage and are influenced
by the same country-specific productivity shocks:
∂π f,t (ϕ)
1 ∂cf,t (ϕ)
1 ∂cf,t (ϕ) Wt
1
= 0,
:
pf,t (ϕ)−
cf,t (ϕ)+
St
St ∂pf,t (ϕ)
St ∂pf,t (ϕ) ϕAt
∂pf,t (ϕ)
(12)
from which it follows immediately that
θ Wt
pf,t (ϕ) =
.
(13)
θ − 1 ϕAt
More productive firms, that is, those having a high level of labor productivity
ϕ, will charge lower prices, sell more units, and earn higher revenues and
profits.
We now define a few more concepts that will prove useful in solving the
model. Let ηh,t (ϕ) and ηf,t (ϕ) be the distributions of firm-specific productivity
levels observed among active Home- and Foreign-owned firms. The aggregate
price level Pt , which is the price index that minimizes expenditure on a given
quantity of the aggregate consumption index in equation (4) is then given by3
1
⎡
⎤ 1−θ
∞
∞
s.t. cf,t (ϕ) ≤

Pt = ⎣nh,t

pf,t (ϕ)1−θ ηf,t (ϕ)dϕ ⎦

ph,t (ϕ)1−θ ηh,t (ϕ)dϕ + nf,t
0

.

0

(14)
Substituting the pricing rules for individual goods, the expression reduces to
1
⎤ 1−θ
⎡
∞
∞
θ
Wt ⎣
Pt =
nh,t ϕ θ−1 ηh,t (ϕ)dϕ + nf,t ϕ θ−1 ηf,t (ϕ)dϕ ⎦ .
θ − 1 At
0

0

(15)
3 See Melitz (2003) and Russ (2007) for a discussion of the computation of the aggregate
price level and average firm-specific level of labor productivity.

60

Federal Reserve Bank of Richmond Economic Quarterly
We now define the average firm-specific productivity level for firms owned
1
⎡∞
⎤ θ −1

by country j as ϕ j,t = ⎣
¯

ϕ θ−1 ηj,t (ϕ)dϕ ⎦

. It follows that the production-

0

weighted average firm-specific level of labor productivity ϕ t can be written
¯
as
nh,t θ−1 nf,t θ−1
ϕt =
¯
ϕ
¯
+
ϕ
¯
Nt h,t
Nt f,t

1
θ −1

(16)

,

where Nt = nh,t + nf,t is the composite continuum of goods available in the
Home economy, which equals the number of firms. Using these expressions
for average firm productivity together with the wage equation (6) and the cashin-advance constraint in (15), we can finally express the aggregate price level
as
1
⎛
⎞ρ
1
θ Nt1−θ ⎠
Pt = ⎝χ
Mt .
(17)
θ − 1 ϕ t At
¯
The price level is decreasing in the number of goods available since consumers
have a preference for variety, which makes for a more expensive consumption
bundle. It is decreasing in aggregate productivity and the index of average
idiosyncratic productivities.

The Zero-Profit Cutoff Condition
The production side of the economy is characterized by a continuum of
prospective Home and Foreign entrepreneurs distributed, respectively, over
[0, 1) and [1, 2], but only firms that can expect to be sufficiently productive
to recoup the overhead cost will choose to produce in a particular period.
Any firm may enter, depending on whether its total productivity, ϕAt , is high
enough to result in revenues sufficient to cover this per-period fixed cost.
We now determine the idiosyncratic productivity level that is sufficient
for a firm to generate non-negative revenue net of entry costs. We identify the
lowest productivity level, ϕ, that allows a firm to enter into production using
ˆ
the Zero-Profit Cutoff (ZPC) condition. Formally, the ZPCs for Home- and
Foreign-owned firms operating in the Home country are given by
!

π h,t (ϕ h,t ) = ph,t (ϕ h,t )ch,t (ϕ h,t ) − Wt lh,t (ϕ h,t ) − Pt fh = 0
ˆ
ˆ
ˆ
ˆ

(18)

and
ˆ
π f,t (ϕ f,t ) =

1
St

!

pf,t (ϕ f,t )cf,t (ϕ f,t ) − Wt lf,t (ϕ f,t ) − Pt ff = 0, (19)
ˆ
ˆ
ˆ

respectively. Analogous expressions apply to entry in the Foreign market.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

61

We substitute the optimal pricing equation, the goods demand function,
and the expression for real balances into the respective ZPCs. After straightforward, but tedious algebra, we arrive at the following intermediate expression
for the productivity threshold values:
θ−1−1/ρ
1
θ χ 1/ρ
, j = h, f.
(20)
ϕ t Ntθ −1
¯
θ − 1 At
The threshold values are identical for both Home and Foreign firms except for
the differences in the fixed cost of entry. Furthermore, the difference between
the thresholds depends only on the ratio of the fixed costs they pay to produce
in the Home market:

ϕ j,t = θ fj
ˆ

1

ff (θ −1)
ϕ f,t =
ˆ
ϕ h,t .
ˆ
(21)
fh
Firms with a higher entry cost need to have higher productivity to stay active.
This is a recurring theme in the FDI literature, as there is substantial empirical
evidence showing that only the highest-productivity firms engage in foreign
direct investment.
We can derive similar expressions from the ZPCs for the Foreign country:
θ−1−1/ρ
1
θ χ 1/ρ
∗ ∗ θ −1
ϕ t Nt
¯
=
, j = h, f.
(22)
θ − 1 A∗
t
The structure of the threshold condition is identical to the one for the Home
country, but we allow for potentially different entry costs. Moreover, we
assume that the fixed cost involved in production abroad is sufficiently large
that a firm producing abroad will always produce in its native country as
well (ϕ ∗ ≤ ϕ f,t ). Thus, our model does not capture issues of geographic
ˆ f,t
ˆ
preference in firm location.
There are two ceteris paribus observations we can make at this stage.
First, the threshold is decreasing in aggregate productivity. In a cyclical upswing, firms’ idiosyncratic productivity does not have to be as high to generate
enough revenue to cover the fixed cost. Second, for large enough values of
the substitution elasticity θ, the threshold is increasing in both the average
productivity ϕ t and the number of firms operating in the home country Nt .
¯
Both effects reflect the influence of competition. The marginal firm operating in the Home country needs to have higher idiosyncratic productivity, both
when average firm productivity is higher and when it is competing with a large
number of other firms. We should note, however, that these deliberations are
partial equilibrium in nature, as an exogenous rise in aggregate productivity
presumably increases the number of firms, but lowers average productivity. In
order to go much further we now need to make distributional assumptions on
the nature of the firm-specific productivity process. Once g(ϕ) is specified,
equation (20) is sufficient to pinpoint the minimum level of labor productivity
for Home and Foreign firms entering the Home market.

ϕ∗
ˆ j,t

θ fj∗

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Federal Reserve Bank of Richmond Economic Quarterly

The Number of Firms
As described in Helpman, Melitz, and Yeaple (2004) and Russ (2007), the
equilibrium distribution of firm-specific productivity levels for firms owned
by country j ∈ [h, f ] is truncated, so that firms with productivity levels
too low to earn at least zero profits do not produce in period t. These lowproductivity firms are plucked from the formulation of the aggregate price and
output levels, leaving a truncated equilibrium distribution:
0 for ϕ < ϕ j,t
ˆ
for ϕ > ϕ j,t
ˆ

ηj,t (ϕ) =

g(ϕ)
1−G(ϕ j,t )
ˆ

(23)

.

This allows us to determine the number of firms in the economy. Denote nj,t for
firms owned by residents of country j who enter the Home market (j ∈ [h, f ]).
It follows that this is simply the probability that any firm holds an idiosyncratic
productivity parameter greater than ϕ j,t . Specifically, nj,t = 1 − G(ϕ j,t ). For
ˆ
ˆ
instance, as ϕ f,t increases, the proportion of Foreign-owned firms entering the
ˆ
Home market falls. Such an increase means that a Foreign firm must have
a greater idiosyncratic level of labor productivity to expect to enter without
incurring a loss. We can thus write average productivity levels in the Homeand Foreign-owned sector as
1
⎡
⎤ θ −1
ϕ j,t
¯

⎢
=⎣

1
1 − G(ϕ j,t )
ˆ

∞

⎥
ϕ θ−1 g(ϕ)dϕ ⎦

, j = h, f.

(24)

ϕ j,t
ˆ

Using this expression and the definition of productivity index (16) we find that
1
⎡
⎤ θ −1
ϕ t Nt
¯

1
θ−1

⎢
=⎣

∞

∞

ϕ

θ−1

g(ϕ)dϕ +

ϕ h,t
ˆ

⎥
ϕ θ−1 g(ϕ)dϕ ⎦

.

(25)

ϕ f,t
ˆ

We further assume, for purposes of exposition, that idiosyncratic productivity is drawn from a Pareto distribution. The Pareto distribution is used
widely in the literature on firm entry and FDI as it describes firm size and rank
distribution well. Specifically, the probability and cumulative density functions are given by, respectively, g(ϕ) = kϕ −(k+1) and G (ϕ) = 1 − ϕ −k , with
the shape parameter k > 0.4 This specification now allows us to compute the
integrals in the above expression. After several steps, using condition (21),
we can solve for the threshold productivity level for Home firms as a function
of the exogenous aggregate productivity shock alone:
θ −1
− kρ(θ−1)+(θ−1)−k

ϕ h,t = ψ 0 At
ˆ

,

(26)

4 We normalize the location parameter of the distribution to 1, which implies a support of

[1, ∞).

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

63

where ψ 0 is a constant.5 We note that for the underlying Pareto distribution
to have bounded variance, we need k > 2. Furthermore, for the integral to
exist, we have to assume k > θ − 1. We also note that the distribution of
firm-specific productivity induces a distribution over the idiosyncratic productivities of active firms in the Home country, which is Pareto itself.
It can be easily verified that the exponent on At in equation (26) is positive
for all ranges of parameter values for ρ and θ . However, if the Pareto shape
parameter k becomes very large relative to the coefficient of relative risk
aversion, then firms become less disperse (that is, heterogeneity becomes less
important). Moreover, θ should not be too large relative to k since otherwise
consumers’ love of variety is not strong enough to keep them from buying only
the cheapest goods. We thus find that an increase in aggregate productivity
leads to a fall in the threshold level of idiosyncratic productivity that firms
need to cross in order to cover the fixed costs of operation.
We can now compute the remaining endogenous variables. The total
number of varieties equals
Nt = nh,t + nf,t =

ϕ −k
ˆ h,t

+

ϕ −k
ˆ f,t

= 1+

ff
fh

1
(θ−1)

ϕ −k .
ˆ h,t

(27)

An increase in aggregate productivity lowers the threshold for both Homeand Foreign-owned firms, which raises their numbers in the Home economy.
It can also be quickly verified that the average firm-specific productivity level
is
ϕ j,t =
¯

1
θ −1

k
k − (θ − 1)

ϕ j,t , j = h, f.
ˆ

It is proportional and increasing in the threshold level. An increase in ϕ j,t
ˆ
reflects the exit of less productive firms, and thus implies that average idiosyncratic productivity rises. Similarly, the measure of aggregate firm productivity,
ϕt = 1 +
¯

fh
ff

k−(θ −1)
(θ −1)

1
θ−1

ff
fh

1+

1
(θ−1)

1
1−θ

k
k − (θ − 1)

1
θ −1

ϕ h,t ,
ˆ

(28)
is increasing in the Home- and Foreign-owned average productivities and thus
the threshold, ϕ h,t .
ˆ
5 Specifically,

ψ0 =

⎧
⎪
⎪
⎪
⎨
⎪
⎪
⎪
⎩

⎡
(θ fh )ρ

θ −1
⎢
κ ⎣1 +
θ

fh
ff

κ−(θ−1)
(θ−1)

θ −1
⎫
⎪ kρ(θ−1)+(θ−1)−k

⎤ ρ(θ−1)−1
(θ−1)

⎥
⎦

k
k − (θ − 1)

ρ(θ−1)−1 ⎪
⎪
⎬
(θ−1)

⎪
⎪
⎪
⎭

.

64

Federal Reserve Bank of Richmond Economic Quarterly

The Balance of Payments and the
Exchange Rate
We now close the model by describing international transactions. There is
no international borrowing and lending and domestic agents are restricted to
holding only domestic currency. Moreover, there is no international trade
in goods. Instead, domestic consumers can satisfy their demand for Foreign
products from Foreign firms that have located their production facilities in the
Home country. The only exchange across borders is through the repatriation
of profits, as we assume that entry costs of Foreign firms have to be paid in
terms of the host country’s currency.
Equilibrium in the Foreign exchange market requires that the number
of units of Home currency being offered for exchange by overseas branches
of Foreign multinationals repatriating their profits equal the number of units
of Home currency demanded by overseas branches of Home multinationals
repatriating their own profits. This condition is the multinational analog to the
condition for a world with exporters described in Bacchetta and van Wincoop
(2000):6
St n∗ π ∗ (ϕ ∗ ) = nf,t π f,t (ϕ f,t ).
¯
h,t h,t ¯ h,t

(29)

Using the ZPC condition and the solution for the average firm-specific productivity level, we have
nf,t π f,t (ϕ f,t ) = nf,t pf,t (ϕ f,t )cf,t (ϕ f,t ) − Wt lf,t (ϕ f,t ) − Pt ff
¯
¯
¯
¯
k
−1 .
= nf,t Pt ff
k − (θ − 1)
Applying the same process to the left-hand side of the balance-of-payments
equation yields an expression for the nominal exchange rate:7
St =

ff nf,t Pt
.
∗
fh n∗ Pt∗
h,t

(30)

The exchange rate is determined by three factors: first, the relative size of
the entry costs; second, the number of firms operating in the respective foreign
markets. This determines the overall volume of capital account transactions.
Ceteris paribus, if the number of Foreign firms operating in the Home country
is relatively large, then their domestic currency denominated profits have to be
6 See Russ (2007) for a derivation of the aggregation of profits, which is also described in
Melitz (2003). Intuitively, we have to aggregate over all individual Foreign-owned firms operating
in the respective host countries. As it turns out, this can be expressed as the product of the profit
of the firm with average productivity π f,t (ϕ f,t ) and the number of firms nf,t . Similar reasoning
¯
applies to Home firms operating abroad.
7 The expression is considerably simplified by the assumption that both countries are identical
except for the exogenous shock processes. We regard this as a clean benchmark and a starting
point for further work.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

65

exchanged against a relatively smaller supply of foreign currency denominated
profits. Hence, their relative value and thus the price of domestic currency is
low (i.e., the exchange rate St is high). The third factor are domestic price
levels, as in any quantity-theoretic model. What differentiates our framework
from a standard exchange rate model is the presence of frictions in the form
of entry costs into foreign markets.
We now perform the final steps in deriving an analytical solution for the
model. The price level Pt in equation (17) depends on the total number of firms
Nt , aggregate firm productivity ϕ t , the money supply Mt , and the exogenous
¯
shock At . We can substitute the reduced-form expressions for the endogenous
variables in the price level equation, which yields
k−(θ−1)
ρ(θ−1)

Pt = ψ 0
where ψ 1 =

κθ
θ−1

1
ρ

1+

ff
fh

ψ1
1
(θ−1)

1
At

k(θ−1)
kρ(θ−1)+(θ−1)−k

(31)

Mt ,

1
− ρ(θ−1)

k
k−(θ−1)

1
− ρ(θ−1)

. The nominal

price level is increasing in the money stock with unit elasticity, while it is
decreasing in the productivity shock. We will make a quantitative assessment
of the productivity elasticity below. We also note that the solution for aggregate
consumption can be found from this expression, using the cash-in-advance
constraint, that is, Ct = Mtt .
P
We assume that both countries are identical with respect to their economic
structure, except that they are driven by independent shocks. We can therefore
A∗

k(θ−1)
kρ(θ−1)+(θ −1)−k

P
Mt
write the price level ratio P t∗ = Att
. These two expressions
Mt∗
t
reflect the cash-in-advance constraint for money holding, which delivers a
quantity-theoretic result, but with a twist. The relative and absolute price
level is unit-elastic in money supply, but moves inversely with (relative) productivity. We also find it useful to compute the expression for the relative con-

sumption ratios between the two countries, namely

Ct
Ct∗

=

At
A∗
t
Pt∗
St Pt

k(θ−1)
kρ(θ−1)+(θ−1)−k

.

ff nf,t
.
∗
fh n∗
h,t

=
In
We can now define the real exchange rate RERt =
order to provide a closed-form solution, we need to determine the relative
nf,t
number of Foreign firms operating in their respective host countries, n∗ . We
h,t

note that nf,t = ϕ f,t , namely the value of the productivity threshold. We can
ˆ
substitute this into the definition of the real exchange rate:
k(θ−1)

ff
At kρ(θ−1)+(θ−1)−k
.
(32)
RERt =
fh
A∗
t
The real exchange rate depends only on relative productivity levels. Since
k(θ−1)
> 0, an increase in productivity at home increases the real
kρ(θ−1)+(θ−1)−k
exchange rate and the relative price of the domestic consumption bundle falls.
This is the standard supply effect on the real exchange rate, as ceteris paribus

66

Federal Reserve Bank of Richmond Economic Quarterly

the productivity increase leads to higher output, lower prices, and thus a lower
price level, which makes Foreign-produced goods more expensive. The elasticity coefficient is the same as the one we identified before in the price level.
This shows that real exchange rate movements are driven by real factors. This
conjecture is borne out when we compute the nominal exchange rate:
St =

ff nf,t Pt
ff M t
.
∗ ∗
∗ =
fh nh,t Pt
fh Mt∗

(33)

In the absence of any nominal friction, there is no effect of the money supply
on real variables.

Closing the Model
We now discuss the remaining general equilibrium and aggregation conditions
that close the model. Expressions for all reduced-form solutions are listed in
Table 1. We first compute the solution for the labor supply. Noting that
ch,t (i) = yh,t (i), we can use the firm-specific demand function in equation (5)
and the production function in equation (7) to find labor input for firm i:
ph,t (i)
Pt

lh,t (i) =

θ −11
θ κ

=

−θ

Ct
=
At ϕ (i)

θ

Ct1−ρθ Aθ−1 ϕ (i)θ−1 .
t

(34)

The second line is derived by using the solution for firm i’s optimal price (10)
and the wage (6). This relationship applies to all firms making non-negative
profits.
We can thus aggregate over all Home firms that operate domestically:
Lh,t

nh,t

=

lh,t (i)di =

0

=

1
θ

θ −11
θ κ

θ

θ −11
θ κ

θ

Ct1−ρθ Aθ−1
t

Ct1−ρθ Aθ−1 ϕ −k(θ−1) ,
ˆ h,t
t

nh,t

ϕ (i)θ−1 di

0

(35)

where the last equality uses nh,t = ϕ −k . We can derive a virtually identical
ˆ h,t
expression for Foreign firms operating in the Home market, whereby we rely
on the assumption that they face the same demand schedules and the same
labor market. The only difference is that Foreign firms pay a higher fixed cost
for entry, which results in a higher productivity threshold.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

67

Table 1 Closed-Form Solutions
Variables
θ−1
− kρ(θ −1)+(θ−1)−k

ϕ h,t = ψ 0 At
ˆ

Productivity Threshold Home Firms

1

f
(θ−1)
ϕ f,t = ff
ˆ
ϕ h,t
ˆ
h
−k
ˆ
nh,t = ϕ h,t
ˆ f,t
nf,t = ϕ −k
Nt = nh,t + nf,t
− k−(θ−1)
ρ(θ−1)

Ct = ψ 0

Productivity Threshold Foreign Firms
Number of Home Firms
Number of Foreign Firms
Total Number of Firms at Home
k(θ−1)

ψ −1 Atkρ(θ −1)+(θ−1)−k
1

Aggregate Home Consumption

1 θ 1−ρθ Aθ−1 ϕ −k(θ−1)
1
ˆ h,t
Lh,t = θ θ−1 κ Ct
t
θ
1 θ−1 1 θ C 1−ρθ Aθ−1 ϕ −k(θ−1)
ˆ f,t
Lf,t = θ
t
t
θ κ
Lt = Lh,t + Lf,t

RERt =

ff
fh

At
A∗
t

f Mt
St = ff M ∗
h
t

Employment at Home Firms
Employment at Foreign Firms
Aggregate Home Employment

k(θ−1)
kρ(θ −1)+(θ −1)−k

Real Exchange Rate
Nominal Exchange Rate

k−(θ−1)
ρ(θ−1)

Pt = ψ 0

1
ψ1 A
t

k(θ−1)
kρ(θ −1)+(θ−1)−k

Price Level

Mt

Coefficients

ψ0 =

ψ1 =

⎧
⎪
⎨
⎪
⎩

f
(θ fh )ρ θ−1 κ 1 + f h
θ

κ−(θ−1)
(θ−1)

f

κθ
θ−1

1
ρ

ff
fh

1+

1
(θ −1)

1
− ρ(θ−1)

⎫

ρ(θ−1)−1
(θ−1)

k
k−(θ−1)

ρ(θ−1)−1 ⎪
⎬
(θ−1)

θ −1
kρ(θ−1)+(θ−1)−k

⎪
⎭

− ρ(θ1
−1)
k
k−(θ−1)

Aggregate labor supply is found by aggregating over the individual labor
supplies:
Lt

nh,t

= Lh,t + Lf,t =
0

=

1
θ

θ −11
θ κ

θ

nf,t

lh,t (i)di +

lf,t (i)di =

0

Ct1−ρθ Aθ−1 ϕ −k(θ−1) + ϕ −k(θ−1) .
ˆ f,t
ˆ h,t
t

(36)

This expression isolates the three effects working on labor input. Since consumption and leisure are substitutes, the wage increases in aggregate consump1
tion. Unless ρ < θ , which would imply that households are close to being
risk-neutral, increases in aggregate consumption, driven by productivity increases, reduce labor. A countervailing effect is coming from labor demand,

68

Federal Reserve Bank of Richmond Economic Quarterly

whereby productivity shocks directly raise employment. The third element
is the entry effect identified earlier. Productivity improvements lower the
thresholds for both Home and Foreign firms, entry occurs, and labor demand
rises.
The consumption effect is generally not strong enough to overturn the
direct productivity effect outside of sticky price models, hence the overall effect of productivity shocks on employment is positive. But this is reinforced
through the entry mechanism, which implies that in our Melitz-type framework, labor input is likely to be more volatile than in standard models. The
reduced-form expression for Lt is straightforward to compute, but lengthy.
We thus only report the elasticity of Lt with respect to aggregate productivity:
k(θ−1)
(θ − 1) + (1 − ρ) θ kρ(θ−1)+(θ−1)−k . It is composed of the direct effect from
productivity, (θ − 1); the second terms amalgamate the indirect effects from
consumption-leisure substitutability and entry. In the benchmark case of logutility, ρ = 1 and the indirect effects cancel each other out. When agents are
less risk-averse, 0 < ρ < 1, then the indirect effects amplify labor movements, and have a dampening effect otherwise. We will discuss this insight in
more detail below.
The remaining reduced-form solutions are now easy to compute. We forgo
discussion of these as they simply reiterate the main themes. The expressions
are listed in Table 1. Finally, the model is closed by specifying monetary
policy. We assume the money supply evolves according to a simple monetary
base rule subject to i.i.d. injections,
Mt+1 = Mt + ε Mt ,

(37)

Seigniorage revenue is rebated to the household:
where logε Mt ∼
Tt = Mt+1 − Mt = εMt . This completes the specification of the model.
N (0, σ 2M ).
ε

3.

DISCUSSION

The logic behind the model emerges most clearly by considering the effects
of a productivity shock. We first note that the model contains no endogenous
propagation mechanism. Any persistent effects thus stem entirely from serial
correlation in the exogenous disturbances. In other words, there are no intertemporal tradeoffs to consider. However, this allows us to cleanly isolate
the entry mechanism at play, which is something that is not easily discernible
in richer environments built around the Melitz-framework (e.g., Ghironi and
Melitz 2005).

Model Mechanics
Suppose aggregate productivity At unexpectedly increases by 1 percent. Because overall productivity, composed of aggregate and firm-specific

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

69

productivity, rises, firms can expect to generate higher revenue out of which
the fixed cost of entry can be more easily financed. The idiosyncratic productivity threshold thus falls for both Home and Foreign-owned firms and entry
occurs. If fh < ff , relatively more Home firms enter, but the overall number
of firms in the economy, Nt , increases. The elasticity of the number of firms
with respect to productivity can be found by combining equations (26) and
k(θ−1)
(27). This yields an elasticity coefficient of kρ(θ−1)+(θ−1)−k > 0. As it turns
out, this is a key coefficient for the behavior of the model. We will analyze its
determinants in more detail in the next section.
The flip side of more firms operating in the economy is that it has adverse
effects on several productivity measures. Since there are now more lower
productivity firms after the positive aggregate productivity shock, average
idiosyncratic productivity for home and foreign firms, ϕ j,t , j = h, f , and for
¯
the overall economy, ϕ t , falls. Vice versa, a decline in aggregate productivity
¯
raises average productivity since firm entry declines relative to its steady state.
The model thus captures a cleansing effect of recessions and the observed
increase in average firm productivity over the course of a downturn. In a
similar vein, this also illustrates how measured total factor productivity can
be a misleading indicator for actual firm productivity due to the composition
effect caused by entry and exit.
The effect on other real quantities is quickly established. The solution
for consumption comes directly from the cash-in-advance constraint. Its responsiveness to productivity is again given by the previous coefficient. An
increase in aggregate productivity lowers the aggregate price level in equation
(31) with the same elasticity coefficient and raises the real exchange rate. As
we pointed out before, there is no effect on the nominal exchange rate since the
real exchange rate freely adjusts to equilibrate the balance of payment flows
generated by the increased FDI from the low to the high productivity country.
More Foreign firms enter the domestic market and produce output, which increases nf,t . However, the domestic price level falls due to the supply effect,
which lowers the nominal value in domestic currency terms of the Foreignoperated firms. As the expressions for the nominal exchange rate show, see
equations (30) and (33), these two effects exactly offset each other. We also
want to point out that the model preserves monetary neutrality. Money supply
shocks only affect the nominal exchange rate, see equation (33).

Entry and Exchange Rate Volatility
We now use the analytical solutions derived above to study the relationship
between the nominal exchange rate, the real exchange rate, and the underlying fundamentals. The first issue we discuss is the relationship between the
exchange rates and the fundamental shocks, namely the money supply and
productivity processes. The background to this discussion is the so-called

70

Federal Reserve Bank of Richmond Economic Quarterly

exchange rate disconnect puzzle, which stipulates that, empirically, exchange
rates appear to behave independently of underlying economic fundamentals—
that they are virtually autonomous processes best captured by a unit root model
(see Meese and Rogoff 1983). A corollary of this puzzle is that the behavior
of real quantities is well captured by underlying shocks, whereas exchange
rates are not.
We first note that the nominal and real exchange rates are driven by different shock processes, that is, the dichotomy in this framework between the
effects of real and nominal shocks is preserved. Movements in the real exchange rate are explained by movements in relative productivity levels, see
k(θ−1)
equation (32), with an elasticity coefficient of kρ(θ−1)+(θ−1)−k . The properties
of the underlying driving processes thus carry over to the exchange rates. High
persistence in the latter would therefore have to be generated by a high degree
of persistence in productivities. One problematic issue is that the underlying
shock processes are generally not observable. Consequently, the literature
thus often uses the alternative metric of relative consumption. As the expresk(θ−1)
kρ(θ −1)+(θ −1)−k

Ct
At
sion C ∗ = A∗
shows, this is the same as for the real exchange
t
t
rate up to a scale factor. Real exchange rates thus move one-to-one with relative consumption ratios. In other words, there is no exchange rate disconnect
puzzle in this framework. As in the standard literature with trade in goods,
movements in relative consumption are closely tied to the real exchange rate.
However, we want to point out again that the only cross-country linkage here
is via the capital account in terms of repatriated profits. What proxies for the
international risk-sharing condition is thus the balance of payments condition.
We now turn to the other dominant issue in the international macro literature, namely the exchange rate volatility puzzle. There are two aspects to
this: one, the relative volatilities of nominal and real exchange rates, and two,
the relative volatilities of exchange rates and the underlying shocks. We find
it convenient to express the moments in terms of natural logarithms:

= const. + mt − m∗ ,
t
k(θ − 1)
rert = const. +
at − at∗ .
kρ(θ − 1) + (θ − 1) − k
Assuming independence amongst the exogenous shock processes, we thus find
that the volatility of the exchange rates is given by
st

σ 2 = σ 2 + σ 2 ∗,
s
m
m
2
k(θ − 1)
σ 2 + σ 2∗ .
a
a
kρ(θ − 1) + (θ − 1) − k
As we already pointed out in the discussion above, nominal and real exchange
rate movements move independently from each other. It follows that the relative volatilities of the exchange rates are essentially arbitrary in this framework
and that the model imposes no restrictions on their co-movement. This is the

σ2
rer

=

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

71

outcome of the two arguably extreme assumptions: the lack of international
trade in goods and assets (besides profit flows) and the identical nature of both
countries. Nevertheless, we regard this result as an interesting benchmark for
future literature.
What the model is not silent about, however, is the second aspect of the
exchange rate volatility puzzle, namely the degree of amplification of fundamental shocks inherent in the entry mechanism. The key for this is the
coefficient:
⎧
⎨ > 1 Amplification
k(θ − 1)
= 1 Equiproportional .
kρ(θ − 1) + (θ − 1) − k ⎩ < 1 Dampening
This translates into the following restriction on the parameters: Shocks are
θ
1
amplified (dampened) through the entry mechanism if ρ < (>) θ−1 − k . We
thus expect productivity shocks to be amplified (i) when θ is low (and the
markup high), (ii) when k is large, and (iii) when the degree of risk aversion
is low.
We can assess quantitatively whether these conditions are reasonable. Estimates for the shape parameter k of the Pareto distribution and the substitution
elasticity θ run the gamut in the literature. Estimates of the dispersion of firm
size from Helpman, Melitz, and Yeaple (2004) suggest a value of k = 11.
Furthermore, di Giovanni, Levchenko, and Ranci` re (2011) suggest that in
e
any Melitz-model k should be roughly equal to θ . θ = 11 implies a markup
of 10 percent, which is an often used value in the macroeconomics literature.
On the other hand, Broda and Weinstein (2006) and Feenstra, Obstfeld, and
Russ (2011) find values for θ between 2 and 3, which would imply markups
between 50 percent and 100 percent.
θ
1
Figure 1 depicts iso-curves for the equation θ−1 = ρ + k , at which there
is neither an amplification nor a dampening effect. We report curves for four
values of the coefficient of relative risk aversion, ρ = 0.5,1.0,1.5,2.0. Areas
above and to the right of each curve imply an amplification effect, while below
and to the left indicate a dampening effect. It is obvious that an amplification
effect generally requires a low degree of risk aversion. This stems from the
fact that, with low risk aversion, households willingly substitute into and out
of leisure, which implies high labor volatility as we discussed above. At even
moderate degrees of risk aversion, for instance, ρ = 2, an amplification effect
can be ruled out except for implausibly high markups above 100 percent. In
a baseline case with log-utility, ρ = 1, a value of the shape parameter of
k = 11, implies a markup of at least 9.1 percent, or θ < 12, for amplification
of productivity shocks on real variables; whereas for the alternative case of
θ = 3 (and a markup of 50 percent), a value of k > 2 would be required.
None of these baseline cases appear implausible. In fact, a markup of 10
percent and log-utility is quite standard in the macro literature. However,
they are predicated on a narrow range for the risk-aversion parameter. Any

72

Federal Reserve Bank of Richmond Economic Quarterly

Figure 1 Amplification Iso-Curves
200
180

ρ = 0.5
ρ = 1.0
ρ = 1.5
ρ = 2.0

160

Markup in Percent

140
120
100
80
60
40
20
0
0

5

10

15

Pareto Shape Parameter k

θ
1
Notes: The graph depicts the iso-curves θ−1 = ρ + k for various values of the coefficient of relative risk aversion ρ. Areas above and to the right of each curve imply an
amplification effect, while below and to the left indicate a dampening effect.

amplification that occurs can be sizeable, however. For instance, when ρ = 1,
k = 11, and θ = 4 (implying a markup of 33 percent), the amplification effect
is 32 percent. Given the stylized nature of the model, this appears to us as
quite large.8

Testable Implications
Given the nature of the quantitative exercise above, any potential empirical
statements would have to be heavily qualified. However, the analysis yields
several interesting testable implications regarding when amplification effects
are most likely to be important. First, Figure 1 shows that the lower is the
Pareto shape parameter k, the greater is the range of elasticities for which
8 We should point out a further caveat to our analysis. The various exchange rate puzzles are
typically discussed for high frequency data of a quarter or less. In our framework, the time period
is arguably of a much lower frequency since the FDI process of physically locating production
abroad takes place on a longer time scale.

T. A. Lubik and K. N. Russ: Exchange Rate Volatility

73

amplification effects arise. Thus, we would expect a generally positive causal
relationship between multinational firm activity and the relative volatility of
the exchange rates for countries with a large degree of multinational activity
in industries with a higher dispersion in firm size (that is, a low k) and thus
higher industry concentration.
Second, it is apparent that for countries with FDI in manufacturing sectors
focused on the production of products with high markups (that is, highly differentiated goods with a low elasticity of substitution), amplification effects
are much more likely, even with higher measures of market concentration indicative of low k. Finally, regardless of the size of these parameters, countries
and industries with higher fixed costs for multinationals relative to domestic
f
firms (high ff ) will exhibit greater amplification effects. Higher fixed costs
h
may arise due to difficulties connected with obtaining crucial information
about the host market, communicating and coordinating with headquarters, or
surmounting technological hang-ups. Thus, all else equal, we would expect
excess volatility stemming from multinational firm activity to be decreasing
in the quality of a country’s infrastructure and institutions, and increasing in
the level of technological sophistication of its main manufacturing sectors in
which FDI plays a key role.9
In short, the most promising avenue for the Melitz-type framework we
developed to make a contribution to the international trade and macro literature
is through an amplification effect of shocks and a variable entry and exit
mechanism. The quantitative importance of this mechanism rests on a narrow
(though commonly used) set of parameter values within the boundary of what
is likely empirically founded. Our quantitative analysis points to three testable
implications for researchers seeking to investigate the causal link between
multinational activity and excess volatility.

4.

CONCLUSION

We build a simple model of market entry with heterogeneous firms and multinational production. We are able to characterize the solutions for all variables
analytically, which allows us to identify the key mechanism in the model
without having to resort to numerical methods. Fluctuations in the net profits
repatriated by multinational firms can generate real and nominal exchange
rate volatility. Variability in repatriated profits, since it is entirely dependent
upon consumption in our Melitz-type framework with homothetic preferences
and constant markups, does not generate a disconnect—variability in the real
9 We note that when the Pareto shape parameter k is less than 2.5, as is the case in estimates
for all industries by di Giovanni, Levchenko, and Ranci` re (2011), the degree of risk aversion is
e
not a prime determinant of whether amplification effects arise due to multinational behavior. Thus,
the degree of risk aversion should be of second-order importance in an empirical analysis of the
causal effects of FDI on excess volatility.

74

Federal Reserve Bank of Richmond Economic Quarterly

exchange rate is driven by exactly the same factors and to the same degree as
relative consumption. However, there is a potential for disconnect between the
real and the nominal exchange rate: the first is driven by productivity shocks
and the second by monetary shocks.
In addition, we derive conditions under which the volatility of the real exchange rate can deviate from the volatility of underlying productivity shocks,
dampened or amplified by the entry and exit and profit remittances of multinational firms. A reasonable range of parameters can produce either effect.
Amplification, that is, excess volatility, emerges under the most commonly
used set of parameters, which is remarkable in that it occurs even though prices
are fully flexible and markups are constant. In particular, we find that excess
volatility in our flexible-price framework is most likely when the distribution
of firm size is more fat-tailed, when industries in which FDI is important are
highly differentiated with high levels of technical sophistication that generate
large coordination costs specific to multinationals, and in countries with low
levels of infrastructure and institutional development. In this way, we link a
macroeconomic puzzle to the microeconomics of industry structure using the
tools from the New Trade Theory.

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