Market-Based Corrective Actions

This post comes to us from Itay Goldstein of the Wharton School at the University of Pennsylvania.

In my paper Market-Based Corrective Actions (co-written with Philip Bond and Edward Simpson Prescott), which I recently presented at the Law, Economics and Organizations seminar, my co-authors and I derive a model that examines the idea that financial-market prices provide useful and important information about firms’ fundamentals.

Many economic agents take corrective actions based on information inferred from the market prices of firms’ securities. In corporate governance, it is widely believed that low market valuations trigger the replacement of CEOs by the board of directors or attract various actions by shareholder activists. In bank supervision, regulators are frequently encouraged to learn from market prices of bank securities before making an intervention decision. Even corporate managers are believed to be influenced by market prices of their firms’ securities when making a decision to invest or acquire another firm.

We provide an equilibrium analysis of such situations in light of a key problem: if the agent uses market prices when deciding on a corrective action, prices adjust to reflect this use and potentially become less revealing. For example, if the board knows that the CEO is of low quality they will replace him. This corrective action will benefit the shareholders of the firm and thus increase the price of its shares. So inferring information from the price about the quality of the CEO is a challenge: a moderate price may indicate either that the CEO is bad and that the board is expected to intervene and replace him, or that the CEO is not bad enough to justify intervention. We show that there is a strong complementarity between market information and the agent’s information, so that a market-based corrective action leads to the agent’s preferred outcome only when the information gap is not too large. We demonstrate that the type of security being traded matters, and discuss other measures that can increase the efficiency of learning from the market.

The full paper is available for download here.

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