Research articles for the 2020-09-18
(In)Stability of the Cryptocurrency Market during the COVID-19 Pandemic: a Network Analysis
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In this letter, we analyse the effect of the COVID-19 pandemic on the network topology of the cryptocurrency market. Our results show that COVID-19 significantly affected this market during a short period of financial panic, from 12 March 2020 to 1 April 2020. Since then, it progressively recovered its initial state. Indeed, we observe that, after July, investors could safely trade again in cryptocurrencies given that the effect of COVID-19 completely disappeared from the market. Therefore, this network analysis allows scholars and investors to analyse the stability of the cryptocurrency system when faced with the pandemic and future new outbreaks.
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In this letter, we analyse the effect of the COVID-19 pandemic on the network topology of the cryptocurrency market. Our results show that COVID-19 significantly affected this market during a short period of financial panic, from 12 March 2020 to 1 April 2020. Since then, it progressively recovered its initial state. Indeed, we observe that, after July, investors could safely trade again in cryptocurrencies given that the effect of COVID-19 completely disappeared from the market. Therefore, this network analysis allows scholars and investors to analyse the stability of the cryptocurrency system when faced with the pandemic and future new outbreaks.
A Comprehensive Model for Cyber Risk Based on Marked Point Processes and Its Application to Insurance
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After scrutinizing technical, legal, financial, and actuarial aspects of cyber risk, a new approach for modelling cyber risk using marked point processes is proposed. Key co-variables, required to model frequency and severity of cyber claims, are identified. The presented framework explicitly takes into account incidents from un-targeted and targeted attacks as well as accidents and failures. The resulting model is able to include the dynamic nature of cyber risk, while capturing accumulation risk in a realistic way. The model is studied with respect to its statistical properties and applied to the pricing of cyber insurance and risk measurement. The results are illustrated in a simulation study.
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After scrutinizing technical, legal, financial, and actuarial aspects of cyber risk, a new approach for modelling cyber risk using marked point processes is proposed. Key co-variables, required to model frequency and severity of cyber claims, are identified. The presented framework explicitly takes into account incidents from un-targeted and targeted attacks as well as accidents and failures. The resulting model is able to include the dynamic nature of cyber risk, while capturing accumulation risk in a realistic way. The model is studied with respect to its statistical properties and applied to the pricing of cyber insurance and risk measurement. The results are illustrated in a simulation study.
A Simple Model of Corporate Fiduciary Duties: With an Application to Corporate Compliance
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This article models the duty of care as a response to moral hazard where the principal seeks to induce effort that is costly to the agent and unobservable by the principal. The duty of loyalty, by contrast, is modeled as a response to adverse selection where the principal seeks truthful disclosure of private information held by the agent. This model of corporate loyalty differs importantly with standard adverse selection models, however, in that the principal cannot use an observable and verifiable outcome as a screening mechanism to ensure honest disclosure and must rely upon an external third-party audit technology, such as the court system. This article extends these simple models to the issue of corporate compliance and argues that the optimal judicial approach would define the duty to monitor as a subset of due careâ€"and not loyaltyâ€"but hold that the usual legal protections provided for due care violations no longer apply. The framework set forth provides a theoretical justification for drawing such a conceptual distinction.
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This article models the duty of care as a response to moral hazard where the principal seeks to induce effort that is costly to the agent and unobservable by the principal. The duty of loyalty, by contrast, is modeled as a response to adverse selection where the principal seeks truthful disclosure of private information held by the agent. This model of corporate loyalty differs importantly with standard adverse selection models, however, in that the principal cannot use an observable and verifiable outcome as a screening mechanism to ensure honest disclosure and must rely upon an external third-party audit technology, such as the court system. This article extends these simple models to the issue of corporate compliance and argues that the optimal judicial approach would define the duty to monitor as a subset of due careâ€"and not loyaltyâ€"but hold that the usual legal protections provided for due care violations no longer apply. The framework set forth provides a theoretical justification for drawing such a conceptual distinction.
Asset Pricing under COVID-19 (Presentation Slides)
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Asset drops under COVID-19 periods and recovers quickly. This presentation slide reviews the literature concerning asset pricing under COVID-19 to see what has happened under this time. During the crisis period, both the discount rate and the expectation of growth has a huge impact on asset prices. Investor preferences shift to more ESG friendly firms during and after the crisis. Finally, one-third of the recover return after COVID-19 can be related to the Fed intervention.
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Asset drops under COVID-19 periods and recovers quickly. This presentation slide reviews the literature concerning asset pricing under COVID-19 to see what has happened under this time. During the crisis period, both the discount rate and the expectation of growth has a huge impact on asset prices. Investor preferences shift to more ESG friendly firms during and after the crisis. Finally, one-third of the recover return after COVID-19 can be related to the Fed intervention.
Blind Portfolios’ Auctions in Two-Rounds
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This paper proposes a two-stage sealed-bid model for the execution of blind portfolios. An asset manager auctions a package of securities to a set of brokers who are unaware of the specific details about individual securities. We prove that our mechanism reduces the costs of execution for the asset manager and eliminates the winner's curse for participating brokers.
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This paper proposes a two-stage sealed-bid model for the execution of blind portfolios. An asset manager auctions a package of securities to a set of brokers who are unaware of the specific details about individual securities. We prove that our mechanism reduces the costs of execution for the asset manager and eliminates the winner's curse for participating brokers.
Common Ownership and Corporate Social Responsibility
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This paper studies the effect of common ownership on corporate social responsibility (CSR). We find that common ownership is positively associated with a firm's CSR score. The effect is stronger for firms in more competitive industries. We propose a two-stage duopoly game in which CSR serves as a commitment device to expand output aggressively to understand the empirical results.
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This paper studies the effect of common ownership on corporate social responsibility (CSR). We find that common ownership is positively associated with a firm's CSR score. The effect is stronger for firms in more competitive industries. We propose a two-stage duopoly game in which CSR serves as a commitment device to expand output aggressively to understand the empirical results.
Creative Destruction and Productive Preemption
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We develop a theory of innovation for entry and sale into oligopoly, and show that inventions of higher quality are more likely to be sold (or licensed) to an incumbent due to strategic product market effects on the sales price. Such preemptive acquisitions by incumbents are shown to stimulate the process of creative destruction by increasing the entrepreneurial effort allocated to high-quality invention projects. Using data on patents granted to small firms and individuals, we find evidence that high-quality inventions are sold under preemptive bidding competition. Asymmetric information problems are shown to be solved by verification through entry for sale.
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We develop a theory of innovation for entry and sale into oligopoly, and show that inventions of higher quality are more likely to be sold (or licensed) to an incumbent due to strategic product market effects on the sales price. Such preemptive acquisitions by incumbents are shown to stimulate the process of creative destruction by increasing the entrepreneurial effort allocated to high-quality invention projects. Using data on patents granted to small firms and individuals, we find evidence that high-quality inventions are sold under preemptive bidding competition. Asymmetric information problems are shown to be solved by verification through entry for sale.
Do M&A Delistings Impact U.S. Capital Markets? Evidence of Negative Information Externalities for Industry Peer Firms
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This study examines whether delistings due to mergers and acquisitions (i.e., M&A delistings) result in negative information externalities for industry peer firms. Prior research shows that firms’ disclosures provide useful information spillovers to other firms in the same industry; importantly, M&A delistings decrease the number of listed firms in an industry. We document that M&A delistings are associated with a decrease in the quality of analysts’ information environment (increases in absolute forecast errors and dispersion) for industry peer firms; further, this effect is greater when the delisted target firm is larger relative to its industry. Multiple additional analyses, including a comparison of individual analysts who previously followed the delisted firm with other analysts, and a falsification test using non-completed M&A, indicate that our main results are not due to endogeneity bias from correlated omitted industry shocks. Our results show negative information externalities from M&A delistings that persists for at least three years and provide evidence regarding the broader effects of M&A delistings for U.S. capital markets.
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This study examines whether delistings due to mergers and acquisitions (i.e., M&A delistings) result in negative information externalities for industry peer firms. Prior research shows that firms’ disclosures provide useful information spillovers to other firms in the same industry; importantly, M&A delistings decrease the number of listed firms in an industry. We document that M&A delistings are associated with a decrease in the quality of analysts’ information environment (increases in absolute forecast errors and dispersion) for industry peer firms; further, this effect is greater when the delisted target firm is larger relative to its industry. Multiple additional analyses, including a comparison of individual analysts who previously followed the delisted firm with other analysts, and a falsification test using non-completed M&A, indicate that our main results are not due to endogeneity bias from correlated omitted industry shocks. Our results show negative information externalities from M&A delistings that persists for at least three years and provide evidence regarding the broader effects of M&A delistings for U.S. capital markets.
Do Mutual Funds and ETFs Affect the Commonality in Liquidity of Corporate Bonds?
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The paper studies the effect of demand-side sources on the commonality in liquidity of corporate bonds as the growing mutual fund and ETF ownership in the corporate bond market may give rise to correlated trading across bonds. I document that there is a positive and significant relationship between ETF ownership and liquidity commonality of investment-grade corporate bonds. In contrast, and unlike for equities, I find that mutual fund ownership does not increase commonality in liquidity of corporate bonds. I show that three different channels explain the differential impact of ETFs and mutual funds on liquidity commonality: flow-driven trading, different investor clienteles, and ETF arbitrage mechanism.
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The paper studies the effect of demand-side sources on the commonality in liquidity of corporate bonds as the growing mutual fund and ETF ownership in the corporate bond market may give rise to correlated trading across bonds. I document that there is a positive and significant relationship between ETF ownership and liquidity commonality of investment-grade corporate bonds. In contrast, and unlike for equities, I find that mutual fund ownership does not increase commonality in liquidity of corporate bonds. I show that three different channels explain the differential impact of ETFs and mutual funds on liquidity commonality: flow-driven trading, different investor clienteles, and ETF arbitrage mechanism.
Do Overseas Financial Institutions Experiences of Executives Reduce Stock Price Crash Risk?
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This study examines the effect of executives’ overseas working experiences in financial institutions on stock price crash risk in Chinese stock markets. We show that overseas experiences significantly alleviate crash risk, and the effect is more pronounced in firms with weak internal control, low accounting conservatism, high large shareholders’ holding, and weak investor protection. The effect is insignificant in stated-owned enterprises and firms with strong external monitoring. Our results are robust to alternative specifications and measures. Overall, this study highlights a new channel of international knowledge spillover and provides practical implication to regulators in emerging markets for attracting overseas talents.
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This study examines the effect of executives’ overseas working experiences in financial institutions on stock price crash risk in Chinese stock markets. We show that overseas experiences significantly alleviate crash risk, and the effect is more pronounced in firms with weak internal control, low accounting conservatism, high large shareholders’ holding, and weak investor protection. The effect is insignificant in stated-owned enterprises and firms with strong external monitoring. Our results are robust to alternative specifications and measures. Overall, this study highlights a new channel of international knowledge spillover and provides practical implication to regulators in emerging markets for attracting overseas talents.
Early Entry to Verify Quality Stimulates Breakthrough Innovations
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Most OECD-countries provide financial subsidy programs to stimulate the entry and growth of small entrepreneurial firms. However, the best strategy for innovative entrepreneurs might be to make an early entry to signal innovation quality and overcome asymmetry problems. Thereby, entrepreneurs can induce a preemptive bidding competition among incumbents and receive a higher acquisition price. This stimulates entrepreneurs to develop breakthrough innovations that will raise welfare.
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Most OECD-countries provide financial subsidy programs to stimulate the entry and growth of small entrepreneurial firms. However, the best strategy for innovative entrepreneurs might be to make an early entry to signal innovation quality and overcome asymmetry problems. Thereby, entrepreneurs can induce a preemptive bidding competition among incumbents and receive a higher acquisition price. This stimulates entrepreneurs to develop breakthrough innovations that will raise welfare.
Economic Significance in Corporate Finance
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Reporting the economic significance of findings in empirical corporate finance has become increasingly common, but a review of the literature from 2000 to 2018 reveals problems with standard practice that make it difficult to judge the importance of reported results. Common problems include making unsubstantiated absolute claims of economic significance, using nonstandardized and unreliable measures of significance, and failing to report benchmarks for evaluating significance. To help address these problems, I define standardized measures of economic significance, show which measures are reliable, and provide benchmarks for economic significance based on established findings.
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Reporting the economic significance of findings in empirical corporate finance has become increasingly common, but a review of the literature from 2000 to 2018 reveals problems with standard practice that make it difficult to judge the importance of reported results. Common problems include making unsubstantiated absolute claims of economic significance, using nonstandardized and unreliable measures of significance, and failing to report benchmarks for evaluating significance. To help address these problems, I define standardized measures of economic significance, show which measures are reliable, and provide benchmarks for economic significance based on established findings.
Expectation Anchoring and Brownian Motion in Financial Markets
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Expectation anchors are price levels that traders use as indications of whether the market is over- or under-priced. I develop the theory behind this well-documented behavioral notion, leading to the class of periodic demand functions. Because demands are not one-to-one, prices in this setting are non-revealing and agents learn little from observing the price history. When demand is aggregated I am able to analytically characterize an endogenous Brownian motion price process. I then extend the result to a broader class of equilibrium stochastic processes.
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Expectation anchors are price levels that traders use as indications of whether the market is over- or under-priced. I develop the theory behind this well-documented behavioral notion, leading to the class of periodic demand functions. Because demands are not one-to-one, prices in this setting are non-revealing and agents learn little from observing the price history. When demand is aggregated I am able to analytically characterize an endogenous Brownian motion price process. I then extend the result to a broader class of equilibrium stochastic processes.
Finding the Persistence of Stock Volatility on the NSE, Nifty Indices
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This study is conducted to find if there is an existence of volatility persisting in any of the market capitalization indices from NSE NIFTY 500 for the sample period starting from April 2007 to December 2019. The following ARCH family models are tested to find the best model fit and use the most parsimonious model; Bollerslev and Taylor (1986) GARCH, Nelson's (1991) EGARCH and TGARCH. It is found that Smallcap and Midcap stock index is showing persistence in stock volatility with bad news having larger effects on its past residuals. Largecap stock index due to its model that is GARCH, can only find existence of volatility clustering instead it is found that there is evidence of the past errors not affecting the Largecap index. From the result analysis, it can be concluded that there is existence of persistence of volatility and that there is volatility clustering reflected in the present prices of the indices under study.
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This study is conducted to find if there is an existence of volatility persisting in any of the market capitalization indices from NSE NIFTY 500 for the sample period starting from April 2007 to December 2019. The following ARCH family models are tested to find the best model fit and use the most parsimonious model; Bollerslev and Taylor (1986) GARCH, Nelson's (1991) EGARCH and TGARCH. It is found that Smallcap and Midcap stock index is showing persistence in stock volatility with bad news having larger effects on its past residuals. Largecap stock index due to its model that is GARCH, can only find existence of volatility clustering instead it is found that there is evidence of the past errors not affecting the Largecap index. From the result analysis, it can be concluded that there is existence of persistence of volatility and that there is volatility clustering reflected in the present prices of the indices under study.
GSIB Surcharges and Bank Lending: Evidence from U.S. Corporate Loan Data
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Capital surcharges on global systemically important banks (GSIBs) decrease lending to firms but do not have any real effects. Banks subject to higher surcharges reduce loan commitments relative to other banks. In response to surcharges, GSIBs also lower their estimates of firm risk. Firms’ total borrowing, however, does not fall, as firms switch to other banks. We establish these results using supervisory data on corporate loans and variation in surcharges in the United States. These results contribute to the debate on the costs and benefits of surcharges and regulatory tailoring and their effects on the reallocation of credit supply across financial institutions.
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Capital surcharges on global systemically important banks (GSIBs) decrease lending to firms but do not have any real effects. Banks subject to higher surcharges reduce loan commitments relative to other banks. In response to surcharges, GSIBs also lower their estimates of firm risk. Firms’ total borrowing, however, does not fall, as firms switch to other banks. We establish these results using supervisory data on corporate loans and variation in surcharges in the United States. These results contribute to the debate on the costs and benefits of surcharges and regulatory tailoring and their effects on the reallocation of credit supply across financial institutions.
Hedge Fund Performance under Misspecified Models
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We develop a new approach for evaluating performance across hedge funds. Our approach allows for performance comparisons between models that are misspecified â€" a common feature given the numerous factors that drive hedge fund returns. The empirical results show that the standard models used in previous work omit similar factors because they (i) perform exactly like the CAPM, and (ii) produce large and positive alphas. In contrast, we observe a large and statistically significant decrease in performance with a new model formed with alternative factors that capture variance, correlation, liquidity, betting-against-beta, carry, and time-series momentum strategies. Overall, the results suggest that the average returns of hedge funds are largely explained by mechanical trading strategies.
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We develop a new approach for evaluating performance across hedge funds. Our approach allows for performance comparisons between models that are misspecified â€" a common feature given the numerous factors that drive hedge fund returns. The empirical results show that the standard models used in previous work omit similar factors because they (i) perform exactly like the CAPM, and (ii) produce large and positive alphas. In contrast, we observe a large and statistically significant decrease in performance with a new model formed with alternative factors that capture variance, correlation, liquidity, betting-against-beta, carry, and time-series momentum strategies. Overall, the results suggest that the average returns of hedge funds are largely explained by mechanical trading strategies.
Loans From My Neighbors: East Asian Commercial Banks, Banking Integration, and Bank Default Risk
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This study investigated the impact of banking integration on recipient country bank default risk and, in particular, whether the type of banking integration moderates that relationship. Using the system generalized method of moments (GMM), the study found that banking integration lowers bank default risk in recipient countries. The foreign claims that Asian lenders extend and the foreign claims that banks extend via local affiliates primarily drive the impact. These results show that the close proximity of lenders and borrowers or “local†knowledge via an affiliate’s presence alleviates information asymmetry, allowing for effective monitoring and disciplining of the loan relationship. The result supports the fostering of banking integration, promoting deeper intra-regional connectedness throughout East Asia. Where foreign claims come from outside East Asia, policy makers should encourage their presence through local affiliates, as this has an equivalent impact.
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This study investigated the impact of banking integration on recipient country bank default risk and, in particular, whether the type of banking integration moderates that relationship. Using the system generalized method of moments (GMM), the study found that banking integration lowers bank default risk in recipient countries. The foreign claims that Asian lenders extend and the foreign claims that banks extend via local affiliates primarily drive the impact. These results show that the close proximity of lenders and borrowers or “local†knowledge via an affiliate’s presence alleviates information asymmetry, allowing for effective monitoring and disciplining of the loan relationship. The result supports the fostering of banking integration, promoting deeper intra-regional connectedness throughout East Asia. Where foreign claims come from outside East Asia, policy makers should encourage their presence through local affiliates, as this has an equivalent impact.
Merger Rhetoric and the Credibility of Managerial Synergy Forecasts
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Managers frequently project high synergistic gains when announcing M&As. This paper analyzes when promised synergies are value-relevant. Using text analytical methods, we only find a positive relationship between synergy projections and announcement returns when promised numerical projections are credible, e.g., when accompanied by thorough verbal explanations and low impression management. Further, credibility increases when concrete instead of embellishing language is used. Hence, the more precise the information that firms disclose, the more it fosters trust in the underlying logic of the deal. Generally, investors seem to see through vacuous statements and value substance over form and verboseness of M&A announcements.
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Managers frequently project high synergistic gains when announcing M&As. This paper analyzes when promised synergies are value-relevant. Using text analytical methods, we only find a positive relationship between synergy projections and announcement returns when promised numerical projections are credible, e.g., when accompanied by thorough verbal explanations and low impression management. Further, credibility increases when concrete instead of embellishing language is used. Hence, the more precise the information that firms disclose, the more it fosters trust in the underlying logic of the deal. Generally, investors seem to see through vacuous statements and value substance over form and verboseness of M&A announcements.
Mergers and Acquisitions in the Data Economy
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In research, public, and policy debate, there is increasing interest in data intensive firms like Google, Facebook, and Amazon. As business models of data firms are often characterized by high scale economies and network externalities, they are expected to have a particularly large incentive to grow, among others through mergers and acqui- sitions (M&A). Adding to the up to now mainly theoretical or anecdotal discussion on data intensive firms, this study empirically analyzes the relationship between firms’ data intensity and M&A activity. Using text-based measures to identify data inten- sive firms, I find that data generators are more likely to become acquirers, whereas data analysis and storage companies are more likely to become targets. Transactions by data firms, on average, do not create value as abnormal announcement returns are zero. There is evidence for pre-emptive merger activity, i.e., data intensive firms acquiring particularly often rather small, non-public companies that are not (yet) on the radar of competition authorities.
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In research, public, and policy debate, there is increasing interest in data intensive firms like Google, Facebook, and Amazon. As business models of data firms are often characterized by high scale economies and network externalities, they are expected to have a particularly large incentive to grow, among others through mergers and acqui- sitions (M&A). Adding to the up to now mainly theoretical or anecdotal discussion on data intensive firms, this study empirically analyzes the relationship between firms’ data intensity and M&A activity. Using text-based measures to identify data inten- sive firms, I find that data generators are more likely to become acquirers, whereas data analysis and storage companies are more likely to become targets. Transactions by data firms, on average, do not create value as abnormal announcement returns are zero. There is evidence for pre-emptive merger activity, i.e., data intensive firms acquiring particularly often rather small, non-public companies that are not (yet) on the radar of competition authorities.
Monetary Stimulus Amidst the Infrastructure Investment Spree: Evidence from China's Loan-Level Data
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We study the impacts of the 2009 monetary stimulus and its interaction with infrastructure spending on credit allocation. We develop a two-stage estimation approach and apply it to China's loan-level data that covers all sectors in the economy. We find that except for the manufacturing sector, monetary stimulus itself did not favor SOEs over non-SOEs in credit access. Infrastructure investment driven by non-monetary factors, however, enhanced the monetary transmission to bank credit allocated to LGFVs in infrastructure and at the same time weakened the impacts of monetary stimulus on bank credit to non-SOEs in sectors other than infrastructure.
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We study the impacts of the 2009 monetary stimulus and its interaction with infrastructure spending on credit allocation. We develop a two-stage estimation approach and apply it to China's loan-level data that covers all sectors in the economy. We find that except for the manufacturing sector, monetary stimulus itself did not favor SOEs over non-SOEs in credit access. Infrastructure investment driven by non-monetary factors, however, enhanced the monetary transmission to bank credit allocated to LGFVs in infrastructure and at the same time weakened the impacts of monetary stimulus on bank credit to non-SOEs in sectors other than infrastructure.
Newspaper Censorship in China: Evidence from Tunneling Scandals
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Media dissemination plays an important role in facilitating price discovery. Political pressure that restricts media dissemination can hinder this function and affect investors’ perceptions. This paper studies the magnitude of newspaper censorship in China and its economic consequences using a setting of “tunneling†scandals. We find significant evidence of censorship of tunneling-related negative news at the national and local level. We further show that news that survives censorship reduces information asymmetry and improves pricing efficiency. We find that censorship blocks informative tunneling news and delays incorporation of tunneling reporting into prices.
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Media dissemination plays an important role in facilitating price discovery. Political pressure that restricts media dissemination can hinder this function and affect investors’ perceptions. This paper studies the magnitude of newspaper censorship in China and its economic consequences using a setting of “tunneling†scandals. We find significant evidence of censorship of tunneling-related negative news at the national and local level. We further show that news that survives censorship reduces information asymmetry and improves pricing efficiency. We find that censorship blocks informative tunneling news and delays incorporation of tunneling reporting into prices.
Nondisclosure â€" A Good News Signal?
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I examine the implications of nondisclosure in a setting where there is a credible signal of the proprietary nature of the undisclosed information. Specifically, I investigate market and analyst responses to firms’ application to the Securities and Exchange Commission (SEC) for a confidential treatment order (CTO). I find that the market and analysts react favorably to the voluntary nondisclosure of proprietary information using the SEC confidential treatment process. Market and analyst reactions are more favorable to the redaction of information that is more likely to have proprietary value, such as information related to research and development. In addition, I show that the redacting firms experience superior accounting performance compared to that of their peers in the years following the redaction. These findings indicate that a firm’s willingness to submit to the CTO approval process serves as a credible signal of the proprietary nature of the withheld information. The results of this study suggest a possible role for a credible signaling channel to facilitate communication between insiders and outsiders regarding the nature of withheld information.
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I examine the implications of nondisclosure in a setting where there is a credible signal of the proprietary nature of the undisclosed information. Specifically, I investigate market and analyst responses to firms’ application to the Securities and Exchange Commission (SEC) for a confidential treatment order (CTO). I find that the market and analysts react favorably to the voluntary nondisclosure of proprietary information using the SEC confidential treatment process. Market and analyst reactions are more favorable to the redaction of information that is more likely to have proprietary value, such as information related to research and development. In addition, I show that the redacting firms experience superior accounting performance compared to that of their peers in the years following the redaction. These findings indicate that a firm’s willingness to submit to the CTO approval process serves as a credible signal of the proprietary nature of the withheld information. The results of this study suggest a possible role for a credible signaling channel to facilitate communication between insiders and outsiders regarding the nature of withheld information.
Risk Managers in Banks
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How do banks remunerate risk managers and what are the implications for risk-taking? Studying 127 German banks during the years 2003 to 2007, we show that risk managers' remuneration is positively aligned with performance-linked pay in front offices (FOs). When bonuses in FOs increase by one Euro, the bonus of a risk manager increases by 13.6 to 33.5 Cents, depending on the risk manager’s seniority. Risk-sharing among employees or labor market competition do not explain this finding. Banks with more aligned incentive pay between risk management and FOs during the years before the crisis of 2008-2009 performed better in the crisis.
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How do banks remunerate risk managers and what are the implications for risk-taking? Studying 127 German banks during the years 2003 to 2007, we show that risk managers' remuneration is positively aligned with performance-linked pay in front offices (FOs). When bonuses in FOs increase by one Euro, the bonus of a risk manager increases by 13.6 to 33.5 Cents, depending on the risk manager’s seniority. Risk-sharing among employees or labor market competition do not explain this finding. Banks with more aligned incentive pay between risk management and FOs during the years before the crisis of 2008-2009 performed better in the crisis.
Systematic risk of European banks
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Which factors determine the systematic risk of European banks? The issue is very important for regulators and decision-makers in financial markets. This study follows the Beaver-Kettler-Scholes (1970)’s pioneering approach, which estimates true betas of not-financial firms by correcting the observed market betas through the fundamental financial/accounting ratios that better explain the systematic risk; by extending this approach to commercial banks, we empirically estimate the fundamental betas of a sample of more than 100 European commercial banks in 2006-2015 period. The emerging findings show that size, diversification, derivatives, and TEXAS ratio increase the systematic risk of banks and that the risk weighting of assets, based on Basel rules, does not correctly catch the bank risks, since it influences negatively their beta. This evidence weakens the dominant belief that growing up through M&As is the panacea for European banks.
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Which factors determine the systematic risk of European banks? The issue is very important for regulators and decision-makers in financial markets. This study follows the Beaver-Kettler-Scholes (1970)’s pioneering approach, which estimates true betas of not-financial firms by correcting the observed market betas through the fundamental financial/accounting ratios that better explain the systematic risk; by extending this approach to commercial banks, we empirically estimate the fundamental betas of a sample of more than 100 European commercial banks in 2006-2015 period. The emerging findings show that size, diversification, derivatives, and TEXAS ratio increase the systematic risk of banks and that the risk weighting of assets, based on Basel rules, does not correctly catch the bank risks, since it influences negatively their beta. This evidence weakens the dominant belief that growing up through M&As is the panacea for European banks.
Taxes Depress Corporate Borrowing: Evidence from Private Firms
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We re-examine the relation between taxes and corporate leverage, using variation in state corporate income tax rates. In contrast with prior research, we document that corporate leverage increases following tax cuts for both privately-held and publicly-listed firms. We use an estimated dynamic equilibrium model to show that tax cuts result in lower default spreads and more distant default thresholds. These effects outweigh the loss of benefits from the interest tax deduction and lead to higher leverage, especially for privately-held firms. Overall, debt tax shields appear to be a secondary capital structure consideration.
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We re-examine the relation between taxes and corporate leverage, using variation in state corporate income tax rates. In contrast with prior research, we document that corporate leverage increases following tax cuts for both privately-held and publicly-listed firms. We use an estimated dynamic equilibrium model to show that tax cuts result in lower default spreads and more distant default thresholds. These effects outweigh the loss of benefits from the interest tax deduction and lead to higher leverage, especially for privately-held firms. Overall, debt tax shields appear to be a secondary capital structure consideration.
The Better-of-Two Strategy for Active Management: Dynamically Combining (and Valuing) Active and Passive Portfolios Through Time
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The active-versus-passive asset debate falsely forces investors into an all-or-nothing decision between the two. Instead, following Margrabe, we use a “better-of-two†option to:(1) calculate the value of active management and,(2) find the optimal weights for an active-plus-passive portfolio that dynamically replicates this option through time. Using simulations, we found that for an at-the-money exchange option with a 10-year horizon, an investor would pay about 5.5% of the passive portfolio’s value. To replicate this option, the investor would allocate roughly 40% the active asset. We also accounted for borrowing costs, tracking error and active alpha, finding that replication cost and portfolio turnover decrease as time horizon increases and that results are robust to errors in expected volatility. Finally, we replaced hypothetical return distributions with historical mutual fund returns used in 60/40 equity/fixed income portfolios rebalanced monthly. Excess ending wealth distributions using the better-of-two strategy exceeded those of an all-active strategy with better downside protection. These values also came close or, in the case of funds that produced excess return, exceeded the ending value of the all-passive strategy while limiting downside relative risk. Gains from the dynamic option replication portfolio are particularly noticeable during periods when active excess returns are negative. Turnover for long-horizon portfolios is less than 4% per month and our results are statistically significant.
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The active-versus-passive asset debate falsely forces investors into an all-or-nothing decision between the two. Instead, following Margrabe, we use a “better-of-two†option to:(1) calculate the value of active management and,(2) find the optimal weights for an active-plus-passive portfolio that dynamically replicates this option through time. Using simulations, we found that for an at-the-money exchange option with a 10-year horizon, an investor would pay about 5.5% of the passive portfolio’s value. To replicate this option, the investor would allocate roughly 40% the active asset. We also accounted for borrowing costs, tracking error and active alpha, finding that replication cost and portfolio turnover decrease as time horizon increases and that results are robust to errors in expected volatility. Finally, we replaced hypothetical return distributions with historical mutual fund returns used in 60/40 equity/fixed income portfolios rebalanced monthly. Excess ending wealth distributions using the better-of-two strategy exceeded those of an all-active strategy with better downside protection. These values also came close or, in the case of funds that produced excess return, exceeded the ending value of the all-passive strategy while limiting downside relative risk. Gains from the dynamic option replication portfolio are particularly noticeable during periods when active excess returns are negative. Turnover for long-horizon portfolios is less than 4% per month and our results are statistically significant.
The COVID-19 Crisis: A Minskyan Approach to Mapping and Managing the (Western?) Financial Turmoil
SSRN
The COVID-19 crisis paralyzed huge parts of the planet in weeks. It not only infected the population but injected a gargantuan dose of uncertainty into the system. In that regard, as in many others, it is a phenomenon without precedent. As of the time of writing (Mayâ€"June 2020), we are witnessing, simultaneously, a health crisis, an economic crisis, and a crisis of global governance as well. In the forthcoming months, it could well turn into a set of financial, social, and political crises most governments and international organizations are ill-prepared to handle. In this paper, what concerns us is the financial dimension of the crisis. The paper is divided into four sections. Following the introduction, the second section maps the financial dimension of the pandemic through an extension of Hyman Minsky’s financial fragility analysis. The result is a three-pronged analytical framework that encompasses financial fragility, financial instability, and insolvency-triggered asset-liability restructuring processes. These are seen as three distinct but interconnected processes advancing financial fragility. The third section dissects how these three processes have been managed as they have unfolded since March 2020, underlining the key policy interventions and institutional innovations introduced so far, and suggesting further measures for addressing the forthcoming stages of the financial turmoil. The fourth section concludes the paper by pointing out the results as of June 2020 and highlights our intended analytical contribution to Minsky’s theoretical framework.
SSRN
The COVID-19 crisis paralyzed huge parts of the planet in weeks. It not only infected the population but injected a gargantuan dose of uncertainty into the system. In that regard, as in many others, it is a phenomenon without precedent. As of the time of writing (Mayâ€"June 2020), we are witnessing, simultaneously, a health crisis, an economic crisis, and a crisis of global governance as well. In the forthcoming months, it could well turn into a set of financial, social, and political crises most governments and international organizations are ill-prepared to handle. In this paper, what concerns us is the financial dimension of the crisis. The paper is divided into four sections. Following the introduction, the second section maps the financial dimension of the pandemic through an extension of Hyman Minsky’s financial fragility analysis. The result is a three-pronged analytical framework that encompasses financial fragility, financial instability, and insolvency-triggered asset-liability restructuring processes. These are seen as three distinct but interconnected processes advancing financial fragility. The third section dissects how these three processes have been managed as they have unfolded since March 2020, underlining the key policy interventions and institutional innovations introduced so far, and suggesting further measures for addressing the forthcoming stages of the financial turmoil. The fourth section concludes the paper by pointing out the results as of June 2020 and highlights our intended analytical contribution to Minsky’s theoretical framework.
The Pass-Through of Uncertainty Shocks to Households
SSRN
Using new employer-employee matched data, this paper investigates the impact of uncertainty, as measured by idiosyncratic stock market volatility, on individual outcomes. We find that firms provide at best partial insurance to their workers. An increase in firm-level uncertainty is associated with a decline in total compensation, especially in variable pay. In turn, individuals reduce their durable goods consumption in response to these uncertainty shocks. These shocks also lead to greater financial fragility among lower-income earners. We also construct a new county-level uncertainty shock and find that local uncertainty shocks reduce county level durable consumption.
SSRN
Using new employer-employee matched data, this paper investigates the impact of uncertainty, as measured by idiosyncratic stock market volatility, on individual outcomes. We find that firms provide at best partial insurance to their workers. An increase in firm-level uncertainty is associated with a decline in total compensation, especially in variable pay. In turn, individuals reduce their durable goods consumption in response to these uncertainty shocks. These shocks also lead to greater financial fragility among lower-income earners. We also construct a new county-level uncertainty shock and find that local uncertainty shocks reduce county level durable consumption.
Trading Signatures: Investor Attention Allocation in Stock Markets
SSRN
Investors who trade in stock markets and follow financial news must choose how to distribute their limited attention across different securities. This may require significant cognitive effort and time investment. Drawing on recent findings on social behavior, we ask whether there are persistent, characteristic patterns in how household investors distribute their attention in stock markets. Our study builds on a large data set that contains every transaction of hundreds of thousands of households in a stock market for over 20 years. We find that individual investors consistently allocate their attention across securities in a highly heterogeneous yet persistent way, trading some securities much more often than others, indicating the use of so-called mental accounting in the context of stock markets. Interestingly, the way how investors distribute their attention is independent of the turnover of securities in the investor's portfolio. These observations are strikingly similar to the recent findings on how people manage their social networks and could indicate that there are similar underlying cognitive processes. However, in contrast to social relationships, we find that time constraints do not appear to limit investors' activeness in the markets, possibly because investors can switch between cognitively 'cheaper' and more 'expensive' trading strategies. Our findings are in stark contrast to the financially optimal behavior predicted by the portfolio theory.
SSRN
Investors who trade in stock markets and follow financial news must choose how to distribute their limited attention across different securities. This may require significant cognitive effort and time investment. Drawing on recent findings on social behavior, we ask whether there are persistent, characteristic patterns in how household investors distribute their attention in stock markets. Our study builds on a large data set that contains every transaction of hundreds of thousands of households in a stock market for over 20 years. We find that individual investors consistently allocate their attention across securities in a highly heterogeneous yet persistent way, trading some securities much more often than others, indicating the use of so-called mental accounting in the context of stock markets. Interestingly, the way how investors distribute their attention is independent of the turnover of securities in the investor's portfolio. These observations are strikingly similar to the recent findings on how people manage their social networks and could indicate that there are similar underlying cognitive processes. However, in contrast to social relationships, we find that time constraints do not appear to limit investors' activeness in the markets, possibly because investors can switch between cognitively 'cheaper' and more 'expensive' trading strategies. Our findings are in stark contrast to the financially optimal behavior predicted by the portfolio theory.
