Research articles for the 2020-10-16

Alternatives to Log-Normal and Normal Models in Market Risk: The Displaced Historical Simulation and the Mixed Model
Böinghoff, Christian,Sprenger, Martin
The historical simulation is a standard technique in market risk estimation, in which the key choice to be made is whether to use absolute or relative shifts for the observed returns of the risk factors. To avoid this ambiguity, Fries et al. develop an approach called displaced historical simulation, which dynamically interpolates between a normal and a log-normal model. In the estimation of value-at-risk, the parameter governing this interpolation fluctuates strongly over time, which could be considered an obstacle in using this approach in practical applications. However, in this paper we show that the fluctuations do not impact the resulting shift scenarios significantly for the time series examined. Additionally, we present an alternative approach which sheds light on the origin of these fluctuations and allows us to assess the impact of some further assumptions made in the displaced historical simulation.

Capital Regulations and the Management of Credit Commitments during Crisis Times
Pelzl, Paul,Valderrama, Maria Teresa
Drawdowns on credit commitments by firms reduce a bank’s capital buffer. Exploiting Austrian credit register data and the 2008-09 financial crisis as exogenous shock to bank health, we provide novel evidence that capital-constrained banks manage this concern by substantially cutting partly or fully unused credit commitments. Controlling for a bank’s capital position, we further find that also larger liquidity problems induce banks to cut such commitments. These results show that banks manage both capital and liquidity risk posed by undrawn credit commitments in periods of financial distress, but thereby reduce liquidity insurance to firms exactly when they need it most.

Catastrophe Bonds, Pandemics, and Risk Securitization
Schwarcz, Steven L.
In theory, governments could protect against the potential economic devastation of future pandemics by requiring businesses to insure against pandemic-related risks. In practice, though, insurers do not currently offer pandemic insurance. Even assuming companies could obtain sufficient statistical data to reliably set pandemic underwriting standards and rate tables, the insurance industry is concerned that it lacks sufficient capacity to cover those risks, which are likely to occur worldwide and be highly correlated. Pandemics therefore are in the class of risks, like nuclear accidents, war, and terrorism, that are sometimes defined as “uninsurable,” at least by private markets. This Article focuses on using risk securitizationâ€"a relatively recent and innovative private-sector alternative to government insurance, funded by the issuance of catastrophe (“CAT”) bondsâ€"to insure pandemic-related risks. Risk securitization would utilize the “deep pockets” of the global capital markets, which have a far greater capacity than the global insurance markets, to absorb these risks. The Article also examines how risk securitization could supplement public-private catastrophe insurance schemes, such as Chubb’s recent pandemic-coverage plan, to reduce the government’s shared exposure.

Corporate Governance and Enterprise Success of Selected Deposit Money Banks in Nigeria
Hassan, Adeyinka Tajudeen
The Enterprise Success (ES) of the banking industry is an important factor for the economic development of a nation. The success of deposit money banks (DMBs) in Nigeria in terms of market share, business sustainability, organizational survival and firm size has continued to dwindle, suggestive of ineffective corporate governance (CG) dimensions in terms of transparency, accountability, board diversity, director independence and board size. The study examined the effect of CG on ES of DMBs in Nigeria. The study adopted cross-sectional survey research design. The population comprised 226 board and management staff of the selected DMBs. Total enumeration was used. A validated questionnaire was administered to collect data. The Cronbach’s alpha reliability coefficients for the constructs ranged from 0.72 to 0.84. The response rate was 84.5%. Data were analysed using descriptive and inferential statistics.Findings revealed that CG had significant effect on ES of selected DMBs in Nigeria (Adj.R2 = 0.423, F(5, 185) = 59.142, p < 0.05). CG dimensions (transparency, accountability, board diversity, director independence and board Size) had significant effect on market share (Adj.R2 = 0.209, F(5, 185) = 11.054, p < 0.05). CG dimensions had significant effect on business sustainability (Adj.R2 = 0.488, F(5, 185) = 37.244, p < 0.05). CG dimensions had significant effect on organizational survival (Adj.R2 = 0.511, F(5, 185) = 40.727, p < 0.05). CG dimensions had significant effect on firm size (Adj.R2 = 0.208, F(5, 185) = 32.893, p < 0.05). Self-regulation had no significant moderating effect on the relationship between CG and ES of selected DMBs in Nigeria (R2 = 0.3795, Î"R2 = 0.0119, Î"F (3.5781)3u, p > 0.05). Social capital had significant moderating effect on the relationship between CG and ES (R2 = 0.6519, Î"R2 = 0.0187, Î"F = 6.0708, p < 0.05). Self-regulation and social capital had significant combined moderating effect on the relationship between CG and ES (Î"R2 = 0.0341, Î"F = 6.4669, p < 0.05).The study concluded that CG affects ES of DMBs. The study recommended that management of DMBs should ensure transparency, accountability, board diversity, director independence and adequate board size to ensure enterprise success. The management of DMBs should encourage self-regulation and social capital.

Debt Covenants and the Value of Commitment
Gamba, Andrea,Mao, Lei
In a dynamic setup, the value of a capital structure policy for a firm depends on shareholders’ commitment. We analyze whether debt covenants can be com- mitment devices and their disciplinary effect on firm policies. While renegotiation following covenant violations allows for debt holders’ control and improves the ex post firm value, it weakens commitment on leverage policies and leads to ex ante firm value losses similar to those under no covenants, as well as a rigid debt issuance policy which is unable to respond to productivity shocks. Therefore, frictions that hinder ex post renegotiation are crucial for covenants to be commitment devices. Under commitment, covenants that discipline the leverage improve firm value the most because they restore the flexibility of debt policy. Instead, covenants de- signed to deliver ex post debt protections, like debt and asset sweeps, are less efficient, as they do not affect the dynamics of leverage. An efficient covenant also has a positive effect on investments.

Distorted Choice in Corporate Bankruptcy
Skeel, David A.
We ordinarily assume that a central objective of every voting process is assuring an undistorted vote. Recent developments in corporate bankruptcy, which culminates with an elaborate vote, are quite puzzling from this perspective. Two strategies now routinely used in big Chapter 11 cases, restructuring support agreements (“RSAs”) and “deathtrap” provisions, are intended to, and clearly do, distort the voting process.This Article offers the first comprehensive analysis of the new distortive techniques. One possible solution is simply to ban them. Although an anti-distortion rule would not be difficult to implement, I argue this would be a mistake. The distortive techniques respond to developments such as claims trading that have made reorganization difficult, and Chapter 11’s baseline was never intended to be neutral: it nudges the parties toward confirmation of a reorganization plan. There also are independent justifications for some distortive techniques, and the alternative to using them might be even worseâ€"it could lead to more fire sales of debtors’ assets.How can legitimate use of the new distortive techniques be distinguished from more pernicious practices? To answer this question, I outline four rules of thumb to assist in the process. Courts should consider whether holdouts are a serious threat, the magnitude of coercion, any independent justifications, and (in rare cases) the nature of the parties’ contracts. I then apply the rules of thumb to four prominent recent cases. I conclude by considering two obvious extensions of the analysis, so-called “gifting” transactions in Chapter 11 and bond exchange offers outside of bankruptcy.

Do Short Sellers Use Textual Information? Evidence from Annual Reports
Kot, Hung Wan,Li, Frank Weikai,Liu, Ming,Wei, K.C. John
We examine short sellers’ use of textual information in annual reports for shorting activities. We find that more uncertainty and negative words in annual reports are associated with greater abnormal shorting volume. Short selling motivated by textual information negatively predicts stock price reaction around the filing date of 10-K reports. We further provide some evidence that textual information used by short sellers are related to revisions of analysts’ earnings forecasts, changes in firm fundamentals, and increasing crash risk subsequently. Our results suggest that textual information in annual reports forms an important part of short sellers’ information advantage.

Falling Interest Rates and the Secular Rise in U.S. Common Stocks
Scott, William
This paper is a data-based analysis of how and why U.S. common stocks secularly rose in concert with falling interest rates. It finds that falling rates explained 76% of the increase in stocks between 1982 and 2019. Growth in financial wealth significantly outpaced growth in the real economy and jobs, fortuitously benefitting financial investors but not working families. Economists term this “asset price inflation.

Fundamental Extrapolation and Stock Returns
Huang, Dashan,Zhang, Huacheng,Zhou, Guofu,Zhu, Yingzi
We explore the effects of fundamental extrapolation on stock returns. Empirically, we propose a novel approach to extrapolate firms' fundamental information and find that a strategy based on fundamental extrapolation earns an average return of 0.80% per month. Theoretically, we show that fundamental extrapolation has dual effects on stock price: a cash flow effect and a discount rate effect. The former pushes stock price up relative to its fundamental value, whereas the latter increases the representative investor's expected volatility and depresses today's stock price. Our empirical results suggest that the discount rate effect dominates the cash flow effect overall.

How Design Features Affect the Balance Sheet Presentation of CoCo-bonds
Petras, Matthias,Coufal, Kai
CoCo-bonds are hybrid capital instruments. Therefore, they can be classified as debt or as equity on the balance sheet. International Financial Reporting Standards do not yield clear guidance on how to account for CoCo-bonds. We investigate empirically how CoCo-bonds are accounted for in bank practice. We identify relevant design features which decide whether the bond is classified as debt or equity. Thereby, we shed light on the factors which determine the balance sheet representation and provide useful information for the process of designing the bonds, considering its consequent accounting treatment.

Is Regulatory Short Sale Data a Profitable Predictor of UK Stock Returns?
Ashby, Michael
Regulator-required public disclosures of net short positions do not provide a profitable investment signal for UK stocks. While long-short (zero initial outlay) portfolios based on this signal usually make a profit on average, it is rarely statistically significant in either gross or risk-adjusted terms. The issue is that the short sides of the portfolios make substantial losses. This is true even when using information in the trend in disclosures to form portfolios, rather than using the most recent disclosures, which is a more standard procedure. Unit initial outlay portfolios based on the disclosures that are allowed to take short positions do not reliably significantly outperform the market. Certain long-only unit initial outlay portfolios based on the disclosures do reliably significantly outperform the market. However, this out-performance is economically modest: about 1 percentage point a year in gross and risk-adjusted terms.

Lending Relationships in Loan Renegotiation: Evidence from Corporate Loans
Papoutsi, Melina
This paper presents evidence that personal relationships between corporate borrowers and bank loan officers improve the outcomes of loan renegotiation. Analyzing a bank reorganization in Greece in the mid-2010s, I find that firms that experience an exogenous interruption in their loan officer relationship confront three consequences: one, the firms are less likely to renegotiate their loans; two, conditional on renegotiation, the firms are given tougher loan terms; and three, the firms are more likely to alter their capital structure. These results point to the importance of lending relationships in mitigating the cost of distress for borrowers in loan renegotiation.

Manufacturing Risk-free Government Debt
Jiang, Zhengyang,Lustig, Hanno N.,Van Nieuwerburgh, Stijn,Xiaolan, Mindy Z.
When debt is priced fairly, governments face a trade-off between insuring bondholders and taxpayers. If the government decides to fully insure bondholders by manufacturing risk-free debt, then it cannot insure taxpayers against permanent macro-economic shocks over long horizons.Instead, taxpayers will pay more in taxes in bad times. Conversely, if the government insures taxpayers against adverse macro shocks, then the debt becomes at least as risky as un-levered equity. Only when government debt earns convenience yields, may governments be able to insure both bondholders and taxpayers, and then only if the convenience yields are sufficiently counter-cyclical.

Practical Guidance on Using and Interpreting Fixed Effects Models
deHaan, Ed
Fixed effects are ubiquitous in accounting and finance studies, but many new researchers have only a vague understanding of how they function. This manuscript provides plain-English explanations of how fixed effects can eliminate certain omitted variable biases, affect standard errors, and alter how we should think about sample composition and the interpretation of coefficient estimates. I emphasize that, while fixed effects can be a powerful tool, they can come at the cost of efficiency and can introduce subtle but important econometric problems of their own. Better understanding these issues will help us all make better choices about how to design fixed effects models and carefully interpret the results thereof.

Recapitalization, Bailout, and Long-run Welfare in a Dynamic Model of Banking
Modena, Andrea
This paper studies the link between bank recapitalization and welfare in a dynamic production economy. The model features financial frictions because banks benefit of a cost advantage at monitoring firms and face costly equity issuance. The competitive equilibrium outcome is inefficient because agents do not internalize the effects banks’ capitalization over the allocation of capital, its price and, in turn, firms investments. It follows, individual recapitalizations are sub-optimal and bailout policies may benefit social welfare in the long-run. Bailouts improve capital allocation in states where aggregate banks are poorly capitalized, therefore enhancing their market valuation, fostering investments, and stabilizing the economy recovery path.

Resiliency: Cross-Venue Dynamics with Hawkes Processes
Pelizzon, Loriana,Sagade, Satchit,Vozian, Katia
Market fragmentation and technological advances increasing the speed of trading altered the functioning and stability of global equity limit order markets. Taking market resiliency as an indicator of market quality, we investigate how resilient are trading venues in a high-frequency environment with cross-venue fragmented order flow. Employing a Hawkes process methodology on high-frequency data for FTSE 100 stocks on LSE, a traditional exchange, and on Chi-X, an alternative venue, we find that when liquidity becomes scarce Chi-X is a less resilient venue than LSE with variations existing across stocks and time. In comparison with LSE, Chi-X has more, longer, and severer liquidity shocks. Whereas the vast majority of liquidity droughts on both venues disappear within less than one minute, the recovery is not lasting, as liquidity shocks spiral over the time dimension. Over half of the shocks on both venues are caused by spiralling. Liquidity shocks tend to spiral more on Chi-X than on LSE for large stocks suggesting that the liquidity supply on Chi-X is thinner than on LSE. Finally, a significant amount of liquidity shocks spill over cross-venue providing supporting evidence for the competition for order flow between LSE and Chi-X.

Risk Committee, Corporate Risk-Taking, and Firm Value
Bhuiyan, Md. Borhan Uddin,Cheema, Muhammad A.,Man, Yimei
Purpose: We empirically examine the impact of the stand-alone risk committee on corporate risk-taking and firm value. Design/methodology/approach: We argue that the existence of a stand-alone risk committee enhances the quality of corporate governance, which reduces corporate risk-taking and strengthens the firm value that might improve investor protection. Findings: We find several measures of risk-taking decline significantly for firms that have a stand-alone risk committee compared with firms that have a joint audit and risk committee. We also find that the presence of a stand-alone risk committee is positively associated with firm value. Practical implications: The evidence is consistent with the proposition that firms with a stand-alone risk committee can effectively evaluate potential risks and implement a proper risk management system.Originality: This is the first paper that investigates the association between the existence of a stand-alone risk committee and firm risk-taking in a multi-industry setting. Also, our research extends the association between a stand-alone risk committee and firm value.

Riskless Principal Trades in Corporate Bond Markets
Harris, Lawrence ,Mehta, Anindya
We identify growth in riskless principal trades (“RPTs”) using TRACE corporate bond market trade data. An RPT is a brokered trade arranged by a dealer for which the dealer obtains compensation by marking up the price instead of charging a commission. Over the last 15 years, RPTs increased from 19% to 37% of all customer trades, while non-zero markups declined 43% on average, with most changes occurring recently. The growth in electronic trading systems undoubtedly explain these trends, but most traders cannot access these systems directly. Small changes to the bond market structure could further decrease investor transaction costs.

Securities Lending Haircuts
Lou, Wujiang
A securities lending transaction is collateralized with cash in the amount of securities’ market value plus a margin or haircut. Haircuts necessarily depend on the securities and the security borrowers. This article extends a repo haircut model to securities lending that captures asset volatility, asymmetric jumps, and dynamic credit spread for the borrower credit. Haircut computation results are given for US Treasury and main equity, and commercial mortgage-backed securities. We find that sec lending haircuts are broadly in line with repo haircuts and fall into empirically observed data range.

Shale Shocked: Cash Windfalls and Household Debt Repayment
Cookson, J. Anthony,Gilje, Erik,Heimer, Rawley
How do persistent cash flow shocks affect debt repayment across the distribution of households? Using individual data on natural gas shale royalty payments matched with credit bureau data for 215,639 consumers, we estimate that individuals repay 33 cents of debt per dollar of windfall, and that initially-subprime individuals repay approximately 5 times more debt than initially-prime individuals do. This difference in debt repayment is driven by changes to revolving debt balances. Finally, we show that debt repayment precedes durable goods consumption, particularly for households who were initially financially constrained. These results shed new light on how deleveraging affects household consumption.

The Flight of the Millionaires: Freedom of Movement and Trade Credit
Luo, Changqin,Sun, Hanwen,Yang, Guochao,Zhang, Bohui
We examine whether entrepreneurs’ freedom of movement can be a potential concern for creditors when extending trade credit. Utilizing controlling shareholders’ overseas residency status as a proxy for freedom of movement in Chinese firms, we show that their mobility negatively influences firms’ ability to obtain trade credit, yet the negative association is mitigated if the overseas jurisdiction has an extradition treaty with China. The fleeing entrepreneurs concern of trade creditors is especially detrimental to firms that are perceived as less trustworthy ex ante (i.e., lower social trust, greater expropriation risk, and higher mobility of assets). Our results, through the lens of trade credit, shed light on the hidden costs of entrepreneurs’ freedom in corporate financing activities by echoing the idea that “freedom is never free”.

The Impact of Risk Cycles on Business Cycles: A Historical View
Danielsson, Jon,Valenzuela, Marcela,Zer, Ilknur
We investigate the effects of risk cycles on business cycles, using a panel spanning 150 years and 74 countries. We capture risk cycles by identifying periods when agents’ perception of financial risk is high and low. A long- lasting low-risk environment encourages risky investments that ultimately augment growth but at the cost of building up of vulnerabilities in the economy and thus, has a boom-to-bust effect on growth: an initial increase followed by a reversal in two years. Such an effect is particularly stronger for countries with excessive credit growth. Global risk cycles have a more pronounced effect on growth than local risk cycles, highlighting the relative importance of the global environment. Low-risk affects growth amid its notable impact on capital flows, investment, and lending quality.

The Value of Using Predictive Information Optimally
Ashby, Michael
For mean-variance investors, using predictive information unconditionally optimally produces better portfolios than using predictive information conditionally optimally. The latter is more usually done in practice. Empirically, the unconditionally optimal portfolios have higher Sharpe ratios and certainty equivalents than the conditionally optimal portfolios. They also have lower turnover, leverage, losses and draw-downs. Moreover, measures of the whole distribution tend to prefer the unconditionally optimal portfolios, especially once transaction costs are accounted for. With transaction costs, the unconditionally optimal portfolios often second-order stochastically dominate the conditionally optimal portfolios. The unconditionally optimal portfolios are also preferred in terms of Sharpe ratio, certainty equivalent, costs, losses, draw-downs and stochastic dominance to mean-variance optimal portfolios that do not use predictive information. However, whether unconditionally optimal portfolios are preferred to minimum variance or 1/N portfolios depends on the asset universe.

The “Value” of a Public Benefit Corporation
Fisch, Jill E.,Davidoff Solomon, Steven
We examine the “value” a PBC form provides for publicly-traded corporations. We analyze the structure of the PBC form and find that other than requiring a designated social purpose it does not differ significantly in siting control and direction with shareholders. We also examine the purpose statements in the charters of the most economically significant PBCs. We find that, independent of structural limitations on accountability, these purpose statements are, in most cases, too vague and aspirational to be legally significant, or even to serve as a reliable checks on PBC behavior. We theorize, and provide evidence, that without a legal or structural tool for binding a PBC to specific social objectives, the operational decisions of the publicly traded PBC may be subject to change according to the vision and preferences of individual officers, directors and shareholders. Our conclusions provide support for a more defined and enforceable PBC purpose statement for publicly-traded PBCs. Otherwise, publicly-traded PBCs are likely to operate no differently than traditional, publicly-traded corporations.