Research articles for the 2019-03-01

A Study of the Regulatory Input Parameters in the Granularity Adjustment of the Gordy-Lütkebohmert Model and a New Method to Calibrate Them to Rating Grades
Posthaus, Dr. Achim
The Gordy-Lütkebohmert model marks the golden standard for determining the granularity adjustment in regulatory capital assessments. The granularity adjustment is necessary for an approximation of the effect of undiversified idiosyncratic risk in not infinite fine grained portfolios. Internal ratings-based (IRB) risk weights of Basel II and III assume that idiosyncratic risk is diversified away on portfolio level, therefore implicitly assuming that the number of individual exposures in the portfolio trends towards ∞. The Gordy-Lütkebohmert model is used in practise by many regulatory driven approaches as it develops a parsimonious, analytical traceable and easy to implement formula for determining the granularity adjustment. It requires certain input parameters, which are:a) dependent from underlying exposures of the portfolio (bank inputs)b) and a set of external (regulatory) parameters.This paper examines the regulatory input parameters and describes a new parsimonious method to calibrate and map them to rating grades.

Background Noise? TV Advertising Affects Real Time Investor Behavior
Liaukonyte, Jura,Zaldokas, Alminas
Using minute-by-minute television advertising data covering approximately 326,000 ads, 301 firms, and $20 billion in ad spending, we study the real-time effects of TV advertising on investor search for online financial information and subsequent trading activity. Our identification strategy exploits the fact that viewers in different U.S. time zones are exposed to the same programming and national advertising at different times, allowing us to control for contemporaneous confounding events. We find that an average TV ad leads to a 3% increase in SEC EDGAR queries and an 8% increase in Google searches for financial information within 15 minutes of the airing of that ad. Such advertising effects spill over through horizontal and vertical product market links to financial information searches on closest rivals and suppliers. The ad-induced queries on the advertiser and its key rival lead to higher trading volumes of their respective stocks. For large advertisers, around 0.8% of daily trading volume can directly be attributed to advertising. This suggests that advertising, originally intended for consumers, has a sizable effect on financial markets.

Board Centrality and Firm Performance: Evidence from Private Firms
Afzali, Sayed Mansoor,Kettunen, Jukka
Board centrality, measured by directorship interlocks, positively influences future firm performance in private firms. The centrality-performance relationship is stronger for private firms, where channels of information are scarce and hence the marginal effects of networks are reflected in increases in profitability and growth. Private firms with central boards also invest more, have better employee productivity, and hoard less cash. Sub-sample analyses further reveal that networks are crucial for both distressed and young firms. This is consistent with better-connected directors providing firms with informational resources when they need them the most. Alternative explanations are discussed and some causal evidence is provided on the impact of board centrality on performance. Overall, the findings suggest that boardroom interlocks are positively associated with immediate economic benefits in private firms.

Cognitive Biases and Asset Prices: Evidence from Exchange Repo Market in China
Fang, Xuyun,Jiang, Zhiqian,Liu, Baixiao,McConnell, John J.,Zhou, Mingshan
We provide empirical evidence of a strong causal relation between investors’ cognitive biases and asset prices using an exogenous regulatory shock to the exchange repurchase agreements (repo) market in China. We find that average annualized daily repo returns are negatively correlated with the actual days of the outstanding funds. The negative correlation disappears immediately after the exchanges implementing new repo price quotation rules on May 22, 2017, which simplify but do not materially alter, the calculation of repo rates offered. We attribute this phenomenon to investors’ cognitive biases that hinder them from fully adjusting for the deviation of the actual days of the outstanding funds from the nominal days of the repo term when they offer repo rates in their trading.

Consumer Protection After the Global Financial Crisis
Balleisen, Edward,Jacoby, Melissa B.
Like other major events, the Global Financial Crisis generated a large and diffuse body of academic analysis. As part of a broader call for operationalizing the study of crises as policy shocks and resulting responses, which inevitably derail from elegant theories, we examine how regulatory protagonists approached consumer protection after the GFC, guided by six elements that should be considered in any policy shock context. After reviewing the introduction and philosophy of the Bureau of Consumer Financial Protection, created as part of the Dodd-Frank Act of 2010, we consider four examples of how consumer protection unfolded in the crises’ aftermath that have received less attention. Our case studies investigate a common set of queries. We sought to identify the parties who cared sufficiently about a given issue to engage with it and try to shape policy, as well as the evolving nature of the relevant policy agenda. We also looked for key changes in policy, which could be reflected in various formsâ€"whether establishing an entirely new regulatory agency, formulating novel enforcement strategies, or deflecting policy reforms.The first of our case studies focuses on operations of the Federal Trade Commission in the GFC’s aftermath. Although the Dodd-Frank Act shifted some obligations toward the CFPB, we find that the FTC continued to worry about and seek to address fraud against consumers. But it tended to focus on shady practices that arose in response to the GFC rather than those that facilitated it. Our second case study examines the Congressional adoption of a carveout from CFPB authority for auto dealers, which resulted from strong lobbying by car companies worried about a cratering sales environment, and the aftermath of the policy. Here, we observe that this carveout allowed a significant amount of troubling auto lending activity to continue and expand, with potentially systemic consequences. Loan servicer misbehavior, particularly in the form of robosigning, is the focus of our third case study. Although Dodd-Frank did not explicitly address robosigning, the new agency it created, the CFPB, was able to draw on its broad authority to address this newly arising problem. And, because the CFPB had authority over student loan servicers, the agency could pivot relatively quickly from the mortgage context to the student loan context. Our fourth and final case study is the rise and fall of Operation Choke Point, an understandably controversial interagency program, convened by the U.S. Department of Justice, which, with the GFC fresh in mind, attempted to curtail fraudulent activities by cutting off access to online payment mechanisms. Here, we see an anti-fraud effort that was particularly vulnerable to a change in presidential administration and political climate because its designers had invested little effort in building public awareness and support for the program.The Article concludes with an overall assessment and suggestions for other focal points for which our approach would be useful. The examples span a range of other domestic and global policy contexts.

Estimating the Anomaly Baserate
Chinco, Alexander,Neuhierl, Andreas,Weber, Michael
The academic literature contains literally hundreds of variables that seem to predict the cross-section of expected returns. This so-called ‘anomaly zoo’ has caused many to question whether researchers are using the right tests for statistical significance. But, here’s the thing: even if a researcher is using the right tests, he will still be drawing the wrong conclusions from his analysis if he is starting out with the wrong priorsâ€"i.e., if he is starting out with incorrect beliefs about the ex ante probability of discovering a tradable anomaly prior to seeing any test results.So, what are the right priors to start out with? What is the correct anomaly baserate?We propose a new statistical approach to answer this question. The key insight is that, under certain conditions, there’s a one-to-one mapping between the ex ante probability of discovering a tradable anomaly and the best-fit tuning parameter in a penalized regression. When we apply our new statistical approach to the cross-section of monthly returns, we find that the anomaly baserate has fluctuated substantially since the start of our sample in May 1973. The ex ante probability of discovering a tradable anomaly was much higher in 2003 than in 1990. As a proof of concept, we construct a trading strategy that invests in previously discovered predictors and show that adjusting this strategy to account for the prevailing anomaly baserate boosts its performance.

Estimation of a Nonparametric model for Bond Prices from Cross-section and Time series Information
Koo, Bonsoo,La Vecchia, Davide,Linton, Oliver B.
We develop estimation methodology for an additive nonparametric panel model that is suitable for capturing the pricing of coupon-paying government bonds followed over many time periods. We use our model to estimate the discount function and yield curve of nominally riskless government bonds. The novelty of our approach is the combination of two different techniques: cross-sectional nonparametric methods and kernel estimation for time varying dynamics in the time series context. The resulting estimator is used for predicting individual bond prices given the full schedule of their future payments. In addition, it is able to capture the yield curve shapes and dynamics commonly observed in the fixed income markets. We establish the consistency, the rate of convergence, and the asymptotic normality of the proposed estimator. A Monte Carlo exercise illustrates the good performance of the method under different scenarios. We apply our methodology to the daily CRSP bond market dataset, and compare ours with the popular Diebold and Li (2006) method.

Expected Loan Loss Provisioning: An Empirical Model
Lu, Yao,Nikolaev , Valeri V.
Recently introduced accounting standards require that financial institutions provision for expected losses on their loan portfolios. Understanding the economic consequences of provisioning for expected losses is of significant interest to academics and regulators. We develop an empirical model of expected loan loss provisioning and use it to construct a bank-year measure of under-provisioning for expected losses. The model relies on forward-looking bank- and macro-economic indicators of future losses. The estimated expected losses are substantially more informative in explaining realized losses as compared to the reported numbers. Unlike the reported provisions, the estimated provisions for expected losses behave in a counter-cyclical fashion. Using our measure of under-provisioning, we find evidence consistent with under-provisioning for expected losses distorting banks’ lending, financing, and dividend decisions. While in practice banks need not provision in the way predicted by the model, we provide a useful benchmark to evaluate provisioning under the new accounting rules.

Is there Momentum in Factor Premia? Evidence from International Equity Markets
Zaremba, Adam,Shemer, Koby
This study examines the momentum effect in the returns of factor premia representing a broad set of stock market strategies. Using cross-sectional and time-series tests, we investigate the performance persistence of market, value, size, momentum, low-risk, and quality premia within a sample of 24 international equity markets for the years 1990â€"2016. We provide strong evidence that the top performing factors continue to outperform the worst performing factors both in individual equity markets and in the cross-country framework. The momentum in factor premia is largely explained by the classic stock-level momentum effect.

Long-Term Bias
Barzuza, Michal,Talley, Eric L.
An emerging consensus in certain legal, business, and scholarly communities maintains that corporate managers are pressured unduly into chasing short-term gains at the expense of superior long-term prospects. The forces inducing managerial myopia are easy to spot, typically embodied by activist hedge funds and Wall Street gadflies with outsized appetites for next quarter’s earnings. Warnings about the dangers of “short termism” have become so well established, in fact, that they are now driving changes to mainstream practice, as courts, regulators and practitioners fashion legal and transactional constraints designed to insulate firms and managers from the influence of investor short-termism. This Article draws on academic research and a series of case studies to advance the thesis that the emergent folk wisdom about short-termism is incomplete. A growing literature in behavioral finance and psychology now provides sound reasons to conclude that corporate managers often fall prey to long-term biasâ€"excessive optimism about their own long-term projects. We illustrate several plausible instantiations of such biases using case studies from three prominent companies where managers have arguably succumbed to a form of “long-termism” in their own corporate stewardship. Unchecked, long-termism can impose substantial costs on investors that are every bit as damaging as short-termism. Moreover, we argue that long-term managerial bias sheds considerable light on the paradox of why short-termism evidently persists among supposedly sophisticated financial market participants: Shareholder activismâ€"even if unambiguously myopicâ€"can provide a symbiotic counter-ballast against managerial long-termism. Without a more definitive understanding of the interaction between short- and long-term biases, then, policymakers should be cautious about embracing reforms that focus solely on half of the problem.

Optimal Disclosure to a Confirmation-Biased Market
Martel, Jordan,Schneemeier, Jan
We analyze a manager's optimal disclosure policy in a market in which some traders are confirmation-biased and ignore information inconsistent with their priors. The disclosed signal informs traders about the manager's unknown ability. By exerting costly effort, the manager can increase the precision of the disclosed signal and reveal more information to the market. The manager faces career concerns and maximizes the market's assessment of his ability. We find that more bias in the market leads to a more informative disclosure policy when traders overweight positive signals. Though some traders discard negative information, the overall market assessment can become more precise. Surprisingly, confirmation bias can reduce entrenchment and increase price efficiency and the expected firm value.

Platforms, American Express, and the Problem of Complexity in Antitrust
Sagers, Chris
Something old and important is lost sight of in a case like Ohio v. American Express, the Supreme Court's recent adoption of "platform" or "two-sided market" theory in American antitrust, and in theoretical efforts like the one on which it is based. A rarely discussed idea built in to American antitrust is that, as far as the law is concerned, markets are all pretty much the same. I explain why that seemingly prosaic fundamentalism in fact serves key instrumental goals, and why neglect of them is largely responsible for the failure of modern antitrust. I show the serious consequences of that mistake by asking whether anything was preserved by the "anti-steering" rules protected in the Amex case that justify making them so hard to challenge. I further ask what the broader consequences may be of letting the cat of out-of-network effects out of the bag of static, partial equilibria.

Should the Introduction of Futures Be Responsible for the Crash of Bitcoin?
Liu, Ruozhou,Wan, Shanfeng
One benefit of futures are their easy access to short underlying asset. Sometimes they are blamed for the downside movement of the asset. The price of Bitcoin reaches its peak merely a few days after the introduction of Bitcoin futures and suffers from an 80% loss in the following year. Naturally, one might link these two events together. In this paper, we find a significant and negative relationship between the introduction of Bitcoin futures and Bitcoin’s return, while for other major crypto-currencies, the relationship is either insignificant or positive. During the post-futures period, Bitcoin crashes the most. Based on these findings, we presume that the introduction of Bitcoin futures should, at least to some extent, be responsible for the crash of Bitcoin in 2018.

Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets
Zaremba, Adam,Umutlu, Mehmet
Is the value spread useful for forecasting returns on quantitative equity strategies for country selection? To test this, we examine a sample of 120 country-level equity strategies replicated within 72 stock markets for the years 1996â€"2017. The value spread is a powerful and robust predictor of strategy returns in the cross-section, subsuming other methods based on momentum, reversal, or seasonality. Going long (short) the strategies with the broadest (narrowest) value spread produces significant four-factor model alphas, markedly outperforming an equal-weighted benchmark of all of the strategies. The results are robust to many considerations.

The Cross-Section of Monetary Policy Announcement Premium
Ai, Hengjie,Han, Leyla Jianyu,Pan, Xuhui (Nick),Xu, Lai
We show that monetary policy announcements require a significant risk compensation in the cross-section of equity returns. Empirically, we use the expected reduction in implied volatility after FOMC announcements to measure the sensitivity of stock returns with respect to monetary policy announcements and find a significant monetary policy announcement premium. We develop a model of macroeconomic announcements to account for the cross-section of the monetary policy announcement premium in equity returns.

The Sources of Momentum in International Government Bond Returns
Zaremba, Adam,Kambouris, George D.
This study aims to offer a new explanation for the momentum effect in international government bonds. Using cross-sectional and time-series tests, we examine a sample of bonds from 22 countries for the years 1980 through 2018. We document significant momentum profits that are not attributable to bond-specific risk factors, such as volatility or credit risk. The global bond momentum is driven by the returns on underlying foreign exchange rates. Controlling for currency movements fully explains the abnormal returns on momentum strategies in international government bonds. The results are robust to many considerations including alternative sorting periods, portfolio construction methods, as well as subperiod and subsample analysis.

U.S. Evidence from D&O Insurance on Agency Costs: Implications for Country-Specific Studies
Donelson, Dain C.,Monsen, Brian,Yust, Christopher G.
Many academic studies use country-specific evidence to investigate research questions of broad interest due to unique research advantages of a given country, such as data availability or to exploit an exogenous event that allows identification. One such research stream examines Canadian directors’ and officers’ (D&O) insurance and generally finds that policy limits are positively associated with firm agency cost measures. However, the U.S. and Canada differ on key legal issues relevant to securities litigation and institutional features of the D&O insurance market. Accordingly, we predict and find that premiums, rather than limits, provide useful information about U.S. agency cost measures. Thus, while researchers argue for disclosure of U.S. D&O insurance information, the usefulness of such disclosures would be limited. We conclude that calls for the disclosure of U.S. D&O insurance information are premature. Our findings provide a cautionary note for the generalizability of country-specific studies.