Research articles for the 2019-10-04
A Climate Risk Assessment of Sovereign Bonds’ Portfolio
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Aligning finance to sustainability requires methodologies to price climate risks and opportunities in financial contracts and investors’ portfolios. Traditional approaches to financial pricing cannot incorporate deep uncertainty of climate change, asymmetric information on investors’ exposures to climate risks, and the endogeneity between climate policies and investment decision. We develop a climate-financial risk assessment methodology under uncertainty that contributes to fill this gap. We consider a disorderly policy transition to 2C-aligned climate mitigation scenarios that leads to unanticipated shocks in economic trajectories of fossil fuel and renewable energy sectors, estimated using Integrated Assessment Models. Then, we model the shock transmission from firms’ profitability to sectors’ Gross Value Added and to sovereign fiscal revenues. We then estimate the new price of the sovereign bond subject to the climate policy shock, using historical data for OECD countries, and in the financial risk associated to that, by introducing the climate spread. Finally, we assess the largest losses/gains on the Austrian National Bank’s portfolio. We find that investments’ alignment to a credible climate trajectory can strengthen the sovereign fiscal and financial position by decreasing the climate spread. In contrast, misalignment can negatively affect countries economic and financial stability, and thus investors performance. Our analysis supports investors and financial supervisors in the pricing of climate-related financial risks, and in the identification of risk mitigation measures.
SSRN
Aligning finance to sustainability requires methodologies to price climate risks and opportunities in financial contracts and investors’ portfolios. Traditional approaches to financial pricing cannot incorporate deep uncertainty of climate change, asymmetric information on investors’ exposures to climate risks, and the endogeneity between climate policies and investment decision. We develop a climate-financial risk assessment methodology under uncertainty that contributes to fill this gap. We consider a disorderly policy transition to 2C-aligned climate mitigation scenarios that leads to unanticipated shocks in economic trajectories of fossil fuel and renewable energy sectors, estimated using Integrated Assessment Models. Then, we model the shock transmission from firms’ profitability to sectors’ Gross Value Added and to sovereign fiscal revenues. We then estimate the new price of the sovereign bond subject to the climate policy shock, using historical data for OECD countries, and in the financial risk associated to that, by introducing the climate spread. Finally, we assess the largest losses/gains on the Austrian National Bank’s portfolio. We find that investments’ alignment to a credible climate trajectory can strengthen the sovereign fiscal and financial position by decreasing the climate spread. In contrast, misalignment can negatively affect countries economic and financial stability, and thus investors performance. Our analysis supports investors and financial supervisors in the pricing of climate-related financial risks, and in the identification of risk mitigation measures.
Bank Runs, Fast and Slow: From Behaviors to Dynamics
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This paper studies the dynamic occurrence of bank runs. Existing models mainly consider bank run as mis-coordination that occurs instantly in simultaneous games. In this model, bank run arises as continuous cascade of withdrawals. Depositors make decisions based on (i) their types, (ii) their information on total withdrawal and (iii) the observed actions of others within a network. By both analytical and numerical methods, the paper explores two novel aspects of bank runs and panics. First, the model is able to characterize the speed and abruptness of runs. Particularly, there are two distinct patterns of dynamics: slow runs that build up progressively vs. sudden runs that occur abruptly “out of nowhereâ€. Second, regarding the behavioral aspect, increase herding generates a trade-off between activation and speed of runs, bank runs are more frequent but slower to build up. By contrast, increase heterogeneity amplifies both activation and speed of runs, strictly increase bank failures.
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This paper studies the dynamic occurrence of bank runs. Existing models mainly consider bank run as mis-coordination that occurs instantly in simultaneous games. In this model, bank run arises as continuous cascade of withdrawals. Depositors make decisions based on (i) their types, (ii) their information on total withdrawal and (iii) the observed actions of others within a network. By both analytical and numerical methods, the paper explores two novel aspects of bank runs and panics. First, the model is able to characterize the speed and abruptness of runs. Particularly, there are two distinct patterns of dynamics: slow runs that build up progressively vs. sudden runs that occur abruptly “out of nowhereâ€. Second, regarding the behavioral aspect, increase herding generates a trade-off between activation and speed of runs, bank runs are more frequent but slower to build up. By contrast, increase heterogeneity amplifies both activation and speed of runs, strictly increase bank failures.
Beyond Numbers and Financials: Accounting and Corporate Sustainability
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With the evolution of industrialization and the expansion of corporations, there has been much concern about the protection of “others†interest when taking business decisions. Others include the environment, different stakeholders, future generations and the corporation itself as an abstract entity. Consequently, the powerful impact of this evolution has made the Corporate Sustainability (CS) an issue that should be considered either instrumentally to achieve the objectives of owners or normatively as a part of the organization’s goals. In this paper, we summarize the key aspects of sustainability that are embedded in the accounting research and practice. We firstly look at the Corporate Social Responsibility (CSR), including Environmental Accounting (EA), as a vital starting point for the CS research in Accounting. Then, we illustrate the contribution of Accounting to CS through the enhancement of governance systems, the encouragement of a long-term outlook, ensuring the reliability of financial reports and promoting the ethical and professional behavior aspects of accounting practitioners. We conclude the paper with some recommendations for future research and accounting education which may emphasize the understanding of accounting in the context of CS.
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With the evolution of industrialization and the expansion of corporations, there has been much concern about the protection of “others†interest when taking business decisions. Others include the environment, different stakeholders, future generations and the corporation itself as an abstract entity. Consequently, the powerful impact of this evolution has made the Corporate Sustainability (CS) an issue that should be considered either instrumentally to achieve the objectives of owners or normatively as a part of the organization’s goals. In this paper, we summarize the key aspects of sustainability that are embedded in the accounting research and practice. We firstly look at the Corporate Social Responsibility (CSR), including Environmental Accounting (EA), as a vital starting point for the CS research in Accounting. Then, we illustrate the contribution of Accounting to CS through the enhancement of governance systems, the encouragement of a long-term outlook, ensuring the reliability of financial reports and promoting the ethical and professional behavior aspects of accounting practitioners. We conclude the paper with some recommendations for future research and accounting education which may emphasize the understanding of accounting in the context of CS.
Defined Benefit Pension De-Risking and Corporate Investment Policy
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U.S. corporate sponsors of defined benefit pension plans in recent years have been de-risking by paying premiums to transfer their pension plan assets and liabilities to the balance sheets of third party insurers. The passage of the Moving Ahead for Progress in the 21st Century Act (MAP-21) in 2012 provided the pension funding relief necessary to make de-risking a mainstream corporate activity. This study provides the first empirical analysis of plan and firm factors that cause a firm to de-risk its defined benefit pension plan. Results show that firms are paying premiums to de-risk when their plans are both better funded and large relative to the size of the firm. This study also finds evidence that firms will de-risk their defined benefit pension plans and increase aggregate corporate risk taking with changes in corporate investment policy. This reallocation of firm risk is reflected in greater volatility of future earnings and suggests that firms remove pension risk from their balance sheets in order to take advantage of future investment opportunities. Overall, the reallocation of risk to corporate investment policy leads to positive excess stock returns.
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U.S. corporate sponsors of defined benefit pension plans in recent years have been de-risking by paying premiums to transfer their pension plan assets and liabilities to the balance sheets of third party insurers. The passage of the Moving Ahead for Progress in the 21st Century Act (MAP-21) in 2012 provided the pension funding relief necessary to make de-risking a mainstream corporate activity. This study provides the first empirical analysis of plan and firm factors that cause a firm to de-risk its defined benefit pension plan. Results show that firms are paying premiums to de-risk when their plans are both better funded and large relative to the size of the firm. This study also finds evidence that firms will de-risk their defined benefit pension plans and increase aggregate corporate risk taking with changes in corporate investment policy. This reallocation of firm risk is reflected in greater volatility of future earnings and suggests that firms remove pension risk from their balance sheets in order to take advantage of future investment opportunities. Overall, the reallocation of risk to corporate investment policy leads to positive excess stock returns.
Does the leverage effect affect the return distribution?
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The leverage effect refers to the generally negative correlation between the return of an asset and the changes in its volatility. There is broad agreement in the literature that the effect should be present for theoretical reasons, and it has been consistently found in empirical work. However, a few papers have pointed out a puzzle: the return distributions of many assets do not appear to be affected by the leverage effect. We analyze the determinants of the return distribution and find that the impact of the leverage effect comes primarily from an interaction between the leverage effect and the mean-reversion effect. When the leverage effect is large and the mean-reversion effect is small, then the interaction exerts a strong effect on the return distribution. However, if the mean-reversion effect is large, even a large leverage effect has little effect on the return distribution. To better understand the impact of the interaction effect, we propose an indirect method to measure it. We apply our methodology to empirical data and find that the S&P 500 data exhibits a weak interaction effect, and consequently its returns distribution is little impacted by the leverage effect. Furthermore, the interaction effect is closely related to the size factor: small firms tend to have a strong interaction effect and large firms tend to have a weak interaction effect.
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The leverage effect refers to the generally negative correlation between the return of an asset and the changes in its volatility. There is broad agreement in the literature that the effect should be present for theoretical reasons, and it has been consistently found in empirical work. However, a few papers have pointed out a puzzle: the return distributions of many assets do not appear to be affected by the leverage effect. We analyze the determinants of the return distribution and find that the impact of the leverage effect comes primarily from an interaction between the leverage effect and the mean-reversion effect. When the leverage effect is large and the mean-reversion effect is small, then the interaction exerts a strong effect on the return distribution. However, if the mean-reversion effect is large, even a large leverage effect has little effect on the return distribution. To better understand the impact of the interaction effect, we propose an indirect method to measure it. We apply our methodology to empirical data and find that the S&P 500 data exhibits a weak interaction effect, and consequently its returns distribution is little impacted by the leverage effect. Furthermore, the interaction effect is closely related to the size factor: small firms tend to have a strong interaction effect and large firms tend to have a weak interaction effect.
Easy Way to Merge Return Forecasts across Securities and Horizons
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This is a way to merge the collective information of a set of return forecasts on securities and portfolios of different horizons into forecasts on security-horizon pairs, a form that can be used for investment decisions. Similar to Black-Litterman, the method unifies predictions via Kalman filter and yields the posterior mean and covariance of returns given the information. The inputs required are minimal: a vector of forecasts, vector of horizons, matrix of linear combinations (portfolios) being forecasted, covariance of noise in the forecasts, and mean and covariance of one period returns.
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This is a way to merge the collective information of a set of return forecasts on securities and portfolios of different horizons into forecasts on security-horizon pairs, a form that can be used for investment decisions. Similar to Black-Litterman, the method unifies predictions via Kalman filter and yields the posterior mean and covariance of returns given the information. The inputs required are minimal: a vector of forecasts, vector of horizons, matrix of linear combinations (portfolios) being forecasted, covariance of noise in the forecasts, and mean and covariance of one period returns.
Intraday Jump Dynamics: What Predicts Price Jumps?
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This paper examines the relationship between liquidity fragmentation and jumps. Unexpected changes in intraday liquidity fragmentation predict jumps and jump direction. A shock to buy (sell) side liquidity fragmentation increases the probability of positive (negative) jumps by 35\%. Decomposing jumps into information and noise components we show that fragmented jumps are noisier. Our work suggests that liquidity suppliers predict jumps and actively manage their exposure to jumps by fragmenting markets before the arrival of information and large order imbalances. This makes jumps predictable as their information is reflected in liquidity fragmentation, minutes before the arrival of a jump.
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This paper examines the relationship between liquidity fragmentation and jumps. Unexpected changes in intraday liquidity fragmentation predict jumps and jump direction. A shock to buy (sell) side liquidity fragmentation increases the probability of positive (negative) jumps by 35\%. Decomposing jumps into information and noise components we show that fragmented jumps are noisier. Our work suggests that liquidity suppliers predict jumps and actively manage their exposure to jumps by fragmenting markets before the arrival of information and large order imbalances. This makes jumps predictable as their information is reflected in liquidity fragmentation, minutes before the arrival of a jump.
Loosey-Goosey Governance: Four Misunderstood Terms in Corporate Governance
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A reliable system of corporate governance is considered to be an important requirement for the long-term success of a company. Unfortunately, after decades of research, we still do not have a clear understanding of the factors that make a governance system effective. Our understanding of governance suffers from: 1) a tendency to overgeneralize across companies and 2) a tendency to refer to central concepts without first defining them. In this Closer Look, we examine four central concepts that are widely discussed but poorly understood.We ask:• Would the caliber of discussion improve, and consensus on solutions be realized, if the debate on corporate governance were less loosey-goosey?• Why can we still not answer the question of what makes good governance?• How can our understanding of board quality improve without betraying the confidential information that a board discusses?• Why is it difficult to answer the question of how much a CEO should be paid?• Are U.S. executives really short-term oriented in managing their companies?
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A reliable system of corporate governance is considered to be an important requirement for the long-term success of a company. Unfortunately, after decades of research, we still do not have a clear understanding of the factors that make a governance system effective. Our understanding of governance suffers from: 1) a tendency to overgeneralize across companies and 2) a tendency to refer to central concepts without first defining them. In this Closer Look, we examine four central concepts that are widely discussed but poorly understood.We ask:• Would the caliber of discussion improve, and consensus on solutions be realized, if the debate on corporate governance were less loosey-goosey?• Why can we still not answer the question of what makes good governance?• How can our understanding of board quality improve without betraying the confidential information that a board discusses?• Why is it difficult to answer the question of how much a CEO should be paid?• Are U.S. executives really short-term oriented in managing their companies?
Mapping the Shadow Payment System
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Recent years have witnessed the emergence and rapid growth of a large, diverse, and constantly evolving shadow payment system. The shadow payment platforms (SPPs) that populate this system perform many of the same core payment functions as conventional deposit-taking banks: including custody, funds transfer, and liquidity. The crucial difference is that SPPs operate outside the perimeter of bank regulation, thereby depriving customers of the deposit guarantee schemes, lender of last resort facilities, special resolution regimes, and other legal protections typically enjoyed by bank depositors. This paper represents the first attempt to map the global shadow payment system and identify what mechanisms, if any, SPPs use to protect their customers. Examining the business models and customer contracts of over 100 SPPs, we find that it is often difficult to ascertain information essential to evaluating levels of customer protection and, where such information is available, that customers generally enjoy relatively limited structural, contractual, or other private legal protections. This puts enormous pressure on public regulatory frameworks to ensure a sufficient level of consumer protection. Regrettably, we also find that the applicable regulatory frameworks in several key jurisdictions often provide a level of protection that is far below that enjoyed by bank depositors. These findings suggest that, at least from a consumer protection perspective, SPPs are currently not an effective substitute for bank-based payment systems.
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Recent years have witnessed the emergence and rapid growth of a large, diverse, and constantly evolving shadow payment system. The shadow payment platforms (SPPs) that populate this system perform many of the same core payment functions as conventional deposit-taking banks: including custody, funds transfer, and liquidity. The crucial difference is that SPPs operate outside the perimeter of bank regulation, thereby depriving customers of the deposit guarantee schemes, lender of last resort facilities, special resolution regimes, and other legal protections typically enjoyed by bank depositors. This paper represents the first attempt to map the global shadow payment system and identify what mechanisms, if any, SPPs use to protect their customers. Examining the business models and customer contracts of over 100 SPPs, we find that it is often difficult to ascertain information essential to evaluating levels of customer protection and, where such information is available, that customers generally enjoy relatively limited structural, contractual, or other private legal protections. This puts enormous pressure on public regulatory frameworks to ensure a sufficient level of consumer protection. Regrettably, we also find that the applicable regulatory frameworks in several key jurisdictions often provide a level of protection that is far below that enjoyed by bank depositors. These findings suggest that, at least from a consumer protection perspective, SPPs are currently not an effective substitute for bank-based payment systems.
Shadow Governance
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Corporations have something to say about some of the most important social and economic issues of our time"and one way they say it is through shadow governance. This Article spotlights a group of influential corporate policies that it calls "shadow governance." These non-charter, non-bylaw governance documents express a corporation's commitment in and process on issues as wide-ranging as campaign finance, environmental sustainability, and sexual harassment, but are largely overlooked by scholars and practitioners alike. This Article fills the gap: it reveals how shadow governance documents influence corporate decision-making and corporate behavior. This Article makes two contributions to the literature. First, it uses original interviews with directors and general counsels to show how shadow governance documents influence corporate decision-making. Among other things, these documents set the board's annual agenda, define the metes and bounds of boards' and committees' responsibilities, and memorialize the corporation's values. These are all exceptionally important corporate functions that are relegated to shadow governance documents, where shareholders and other corporate outsiders have little ability to influence change. Second, this Article presents a descriptive account of the scope of shadow governance in the modern U.S. corporation. It analyzes a hand-collected dataset of shadow governance documents from companies listed in the Standard and Poor's 1500 to show the array of and variation in shadow governance documents. This Article's exploration of shadow governance documents is both theoretically and practically important. Shadow governance documents are not just poorly understood"they are also largely overlooked by scholars and practitioners. This Article's account has the potential to open a new field for scholarly research, and also to provide a new field of battle for those who wish to influence corporate behavior.
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Corporations have something to say about some of the most important social and economic issues of our time"and one way they say it is through shadow governance. This Article spotlights a group of influential corporate policies that it calls "shadow governance." These non-charter, non-bylaw governance documents express a corporation's commitment in and process on issues as wide-ranging as campaign finance, environmental sustainability, and sexual harassment, but are largely overlooked by scholars and practitioners alike. This Article fills the gap: it reveals how shadow governance documents influence corporate decision-making and corporate behavior. This Article makes two contributions to the literature. First, it uses original interviews with directors and general counsels to show how shadow governance documents influence corporate decision-making. Among other things, these documents set the board's annual agenda, define the metes and bounds of boards' and committees' responsibilities, and memorialize the corporation's values. These are all exceptionally important corporate functions that are relegated to shadow governance documents, where shareholders and other corporate outsiders have little ability to influence change. Second, this Article presents a descriptive account of the scope of shadow governance in the modern U.S. corporation. It analyzes a hand-collected dataset of shadow governance documents from companies listed in the Standard and Poor's 1500 to show the array of and variation in shadow governance documents. This Article's exploration of shadow governance documents is both theoretically and practically important. Shadow governance documents are not just poorly understood"they are also largely overlooked by scholars and practitioners. This Article's account has the potential to open a new field for scholarly research, and also to provide a new field of battle for those who wish to influence corporate behavior.
Survival Scale: Marketplace Lending and Asymmetric Network Effects
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We utilize panel data of over 1,000 peer-to-peer (P2P) lending platforms in China to examine the determinants of platform dynamics in an emerging industry characterized by entries, exits, and network externalities. We find that cross-side network effects (CNEs) captured by simple elasticity measures alter platforms’ scale, which in turn affect future platform performances through customer matching and risk diversification. CNEs are persistent and strongly predict nascent platforms’ likelihood of survival. Moreover, lenders’ CNEs dominate borrowers’ in foretelling failures. Within lenders’ CNEs, increases in lenders’ number have greater effects than decreases. These asymmetries reflect distinguishing features of financial platforms from other two-sided platforms, inherent differences between lenders’ and borrowers’ objectives and risk preferences, and frictions arising from contract incompleteness and agency issues. Overall, these novel empirical findings and associated economic channels on the industry cross-section of marketplace lending shed light on the competition among multi-sided marketplaces and inform practitioners, investors, and regulators.
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We utilize panel data of over 1,000 peer-to-peer (P2P) lending platforms in China to examine the determinants of platform dynamics in an emerging industry characterized by entries, exits, and network externalities. We find that cross-side network effects (CNEs) captured by simple elasticity measures alter platforms’ scale, which in turn affect future platform performances through customer matching and risk diversification. CNEs are persistent and strongly predict nascent platforms’ likelihood of survival. Moreover, lenders’ CNEs dominate borrowers’ in foretelling failures. Within lenders’ CNEs, increases in lenders’ number have greater effects than decreases. These asymmetries reflect distinguishing features of financial platforms from other two-sided platforms, inherent differences between lenders’ and borrowers’ objectives and risk preferences, and frictions arising from contract incompleteness and agency issues. Overall, these novel empirical findings and associated economic channels on the industry cross-section of marketplace lending shed light on the competition among multi-sided marketplaces and inform practitioners, investors, and regulators.
