Research articles for the 2020-11-07
Are a Few Huge Outcomes Distorting Financial Misconduct Research?
SSRN
Research on financial misconduct uses data on enforcement outcomes, such as the penalties that the firm pays. The distribution of most enforcement outcomes shows extreme observations or outliers, but you wouldn’t necessarily glean that by a casual examination of some of the leading research on financial misconduct. In this paper I describe the public-policy context of such research and raise the issue of whether the extreme-values problem has been given adequate attention. I touch on a number of papers, and then focus on a 2018 Journal of Accounting Research article by Andrew Call, Gerald Martin, Nathan Sharp, and Jaron Wilde (CMSW), which purports to show a positive association between the severity of enforcement outcomes and the involvement of a whistle-blower. I show that the top one percent of the enforcement outcomes (11 observations) in CMSW’s large sample of 1,133 enforcement actions drive their results; a number of robustness checks suggest that the extreme-values problem is serious. Moreover, I explain numerous sources of fuzziness in their whistle-blower coding, and explain that research with the extreme-values problem is highly sensitive to such fuzziness because a few dubious codings can change the results. Unfortunately, CMSW do not disclose how each coding was arrived at, so we cannot peer into the fuzziness to see how the extreme observations came to be coded as they are. I suggest that CMSW could have been upfront about the looming problem of a few extreme values in enforcement outcomes, should have shown how the outliers affect their results, and should have explained and resolved (to the extent possible) the mysteries surrounding the coding. Furthermore, as regards the larger issue of public policy, it should be emphasized that we would expect strong and natural correlations among severity of misconduct, likelihood of penalties, and whistle-blowing, like the correlations among the severity of health emergencies, likelihood of medical interventions, and calls to 9-1-1. Correlation is not causation. CMSW do not give this point the emphasis that it deserves. It looms especially large in light of my findings that CMSW’s results are not robust to removing the outliers. Accordingly we should perhaps be surprised that CMSW did not find a statistically significant correlation for one of the enforcement-outcome categories.
SSRN
Research on financial misconduct uses data on enforcement outcomes, such as the penalties that the firm pays. The distribution of most enforcement outcomes shows extreme observations or outliers, but you wouldn’t necessarily glean that by a casual examination of some of the leading research on financial misconduct. In this paper I describe the public-policy context of such research and raise the issue of whether the extreme-values problem has been given adequate attention. I touch on a number of papers, and then focus on a 2018 Journal of Accounting Research article by Andrew Call, Gerald Martin, Nathan Sharp, and Jaron Wilde (CMSW), which purports to show a positive association between the severity of enforcement outcomes and the involvement of a whistle-blower. I show that the top one percent of the enforcement outcomes (11 observations) in CMSW’s large sample of 1,133 enforcement actions drive their results; a number of robustness checks suggest that the extreme-values problem is serious. Moreover, I explain numerous sources of fuzziness in their whistle-blower coding, and explain that research with the extreme-values problem is highly sensitive to such fuzziness because a few dubious codings can change the results. Unfortunately, CMSW do not disclose how each coding was arrived at, so we cannot peer into the fuzziness to see how the extreme observations came to be coded as they are. I suggest that CMSW could have been upfront about the looming problem of a few extreme values in enforcement outcomes, should have shown how the outliers affect their results, and should have explained and resolved (to the extent possible) the mysteries surrounding the coding. Furthermore, as regards the larger issue of public policy, it should be emphasized that we would expect strong and natural correlations among severity of misconduct, likelihood of penalties, and whistle-blowing, like the correlations among the severity of health emergencies, likelihood of medical interventions, and calls to 9-1-1. Correlation is not causation. CMSW do not give this point the emphasis that it deserves. It looms especially large in light of my findings that CMSW’s results are not robust to removing the outliers. Accordingly we should perhaps be surprised that CMSW did not find a statistically significant correlation for one of the enforcement-outcome categories.
Board Structure, Payout Policy, and Performance during the Crisis: An Unintended Consequence of the Sarbanes-Oxley Act and the Exchange Listing Rules
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Non-compliant firms required to raise board independence by the 2003 NYSE and NASDAQ listing rules significantly increased their dividend payouts and held less cash reserves. As the crisis unfolded, they were more likely to reduce investment and ultimately under-performed compliant firms. The under-performance was more severe for non-compliant firms facing higher costs of external financing and those with greater growth opportunities. Our evidence suggests that regulations requiring independent boards facilitate higher dividends and thereby mitigate agency costs of free cash flow. However, they may also make firms more dependent on external financing and more susceptible to adverse external financing shocks.
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Non-compliant firms required to raise board independence by the 2003 NYSE and NASDAQ listing rules significantly increased their dividend payouts and held less cash reserves. As the crisis unfolded, they were more likely to reduce investment and ultimately under-performed compliant firms. The under-performance was more severe for non-compliant firms facing higher costs of external financing and those with greater growth opportunities. Our evidence suggests that regulations requiring independent boards facilitate higher dividends and thereby mitigate agency costs of free cash flow. However, they may also make firms more dependent on external financing and more susceptible to adverse external financing shocks.
Do Pension Funds Manage Cash Efficiently?
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Using unexplored data on Swiss pension funds, we study whether pension funds manage their cash efficiently. While a share of cash is held to meet certain operational and investment needs, the remaining is accumulated from past activity and slowly invested. Most of the variation observed in pension fund cash holdings is, however, attributable to pension fund-specific time-invariant factors rather than to differences in pension funds’ needs. We estimate that pension funds with excessive cash holdings hold an average of 8.4% of total assets in excess cash. Investing this excess cash in a representative portfolio of assets could translate into an additional expected annual return of 30 basis points. Furthermore, we show that pension funds in a deccumulation phase, as well as large pension funds, are more efficient in managing their cash and that the introduction of negative interest rates by the Swiss National Bank triggered a systematic reduction in pension fund cash holdings.
SSRN
Using unexplored data on Swiss pension funds, we study whether pension funds manage their cash efficiently. While a share of cash is held to meet certain operational and investment needs, the remaining is accumulated from past activity and slowly invested. Most of the variation observed in pension fund cash holdings is, however, attributable to pension fund-specific time-invariant factors rather than to differences in pension funds’ needs. We estimate that pension funds with excessive cash holdings hold an average of 8.4% of total assets in excess cash. Investing this excess cash in a representative portfolio of assets could translate into an additional expected annual return of 30 basis points. Furthermore, we show that pension funds in a deccumulation phase, as well as large pension funds, are more efficient in managing their cash and that the introduction of negative interest rates by the Swiss National Bank triggered a systematic reduction in pension fund cash holdings.
Financing Correlated Drug Development Projects
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Current business models have struggled to support early-stage drug development. In this paper, we study an alternative financing model, the mega-fund structure, to fund drug discovery. We extend the framework proposed in previous studies to account for correlation between phase transitions in drug development projects, thus making the model a more realistic representation of bio-pharma research and development. In addition, we update the parameters used in our simulation with more recent estimates of the probability of success (PoS). We find that the performance of the mega-fund becomes less attractive when correlation between projects is introduced. However, the risk of default and the expected returns of the vanilla mega-fund remain promising even under moderate levels of correlation. In addition, we find that a leveraged mega-fund outperforms an equity-only structure over a wide range of assumptions about correlation and PoS.
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Current business models have struggled to support early-stage drug development. In this paper, we study an alternative financing model, the mega-fund structure, to fund drug discovery. We extend the framework proposed in previous studies to account for correlation between phase transitions in drug development projects, thus making the model a more realistic representation of bio-pharma research and development. In addition, we update the parameters used in our simulation with more recent estimates of the probability of success (PoS). We find that the performance of the mega-fund becomes less attractive when correlation between projects is introduced. However, the risk of default and the expected returns of the vanilla mega-fund remain promising even under moderate levels of correlation. In addition, we find that a leveraged mega-fund outperforms an equity-only structure over a wide range of assumptions about correlation and PoS.
Insurance, Banking and Financial Supervision in the Kingdom of Saudi Arabia (KSA) â€" A Survey
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Insurance, banking and financial supervision in Saudi Arabia is under the responsibility of the Central Bank of Saudi Arabia (which has the function of issuing the national currency, supervising banks, managing foreign exchange reserves, ensuring price and exchange rate stability, the soundness of the financial system and operating a number of cross-bank electronic financial systems) and the Capital Markets Authority of Saudi Arabia (who is regulating capital markets/the Saudi Stock Exchange by setting rules and making sure they are followed). The CMA is a government organization applying full financial, legal, and administrative independence, and has direct links with the Prime Minister.The most important laws regulating the financial sector are the Capital Markets Law (CML) and Cooperative Insurance Law (CIL), which aim to achieve compliance with the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) principles. Another important law is the Capital Market Law (Royal Decree No. (M/30) dated 2/6/1424H), which formally brought into existence the Capital Market Authority (CMA) and the Banking Control Law (BCL).
SSRN
Insurance, banking and financial supervision in Saudi Arabia is under the responsibility of the Central Bank of Saudi Arabia (which has the function of issuing the national currency, supervising banks, managing foreign exchange reserves, ensuring price and exchange rate stability, the soundness of the financial system and operating a number of cross-bank electronic financial systems) and the Capital Markets Authority of Saudi Arabia (who is regulating capital markets/the Saudi Stock Exchange by setting rules and making sure they are followed). The CMA is a government organization applying full financial, legal, and administrative independence, and has direct links with the Prime Minister.The most important laws regulating the financial sector are the Capital Markets Law (CML) and Cooperative Insurance Law (CIL), which aim to achieve compliance with the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) principles. Another important law is the Capital Market Law (Royal Decree No. (M/30) dated 2/6/1424H), which formally brought into existence the Capital Market Authority (CMA) and the Banking Control Law (BCL).
Managing Diversifiable Risk in Private Equity
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Risk models commonly used in practice disregard the diversifiable risk of LP's PE portfolios. Based on a unique data set we find evidence that the relevance of idiosyncratic portfolio risk might be underrated. Our simulation results show that diversification across the number deals significantly mitigates idiosyncratic portfolio risk in large LP portfolios. Especially for buyout investments, syndicated deals reduce idiosyncratic portfolio risk, whereas deals shared by several partners within the same LP portfolio increase this risk. Looking at a sample of real LPs, our findings indicate that some investors have particularly high skills in identifying the most diversified GPs and selecting the most diversified funds. Additionally, we find that certain LPs are simultaneously invested in several deal partners of a syndicated deal, more frequently than luck would have it, and that these deals show a favorable risk-return profile.
SSRN
Risk models commonly used in practice disregard the diversifiable risk of LP's PE portfolios. Based on a unique data set we find evidence that the relevance of idiosyncratic portfolio risk might be underrated. Our simulation results show that diversification across the number deals significantly mitigates idiosyncratic portfolio risk in large LP portfolios. Especially for buyout investments, syndicated deals reduce idiosyncratic portfolio risk, whereas deals shared by several partners within the same LP portfolio increase this risk. Looking at a sample of real LPs, our findings indicate that some investors have particularly high skills in identifying the most diversified GPs and selecting the most diversified funds. Additionally, we find that certain LPs are simultaneously invested in several deal partners of a syndicated deal, more frequently than luck would have it, and that these deals show a favorable risk-return profile.
Measuring 'State-level' Economic Policy Uncertainty
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We develop 50 novel indices of State-level Economic Policy Uncertainty (SEPU) based on newspaper coverage frequency using 204 million state newspaper articles from January 1990 to December 2019. We assess the validity of our measures. Our SEPU indices vary counter-cyclically with respect to state-specific economic conditions, rise before close gubernatorial elections, and exhibit a large cross-sectional variation. We demonstrate that SEPU indices explain the cross-sectional variation in state-level GDP, employment, income as well as industry investment decisions. Our findings highlight the importance of economic policy uncertainty at the state level in addition to the nationwide level.
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We develop 50 novel indices of State-level Economic Policy Uncertainty (SEPU) based on newspaper coverage frequency using 204 million state newspaper articles from January 1990 to December 2019. We assess the validity of our measures. Our SEPU indices vary counter-cyclically with respect to state-specific economic conditions, rise before close gubernatorial elections, and exhibit a large cross-sectional variation. We demonstrate that SEPU indices explain the cross-sectional variation in state-level GDP, employment, income as well as industry investment decisions. Our findings highlight the importance of economic policy uncertainty at the state level in addition to the nationwide level.
Measuring Misleading Information in IPO Prospectuses
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Newly public firms may provide misleading information about their business plans in their initial public offering (IPO) prospectuses. Using textual analysis, we develop a simple measure of such misleading information based on the difference between the emphasis placed on business lines in the main textual description and the corresponding information from the accounting tables. We examine our measure of misleading information using a sample of 1878 IPOs in China from 2010 to 2019. We find that the degree of misleading information is greater when firms find it more difficult to get regulatory approval for an IPO. Furthermore, the amount of misleading information is greater for firms with higher leverage and more segmented businesses. We also find some evidence that the stock returns of firms which present a greater amount of misleading information are lower.
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Newly public firms may provide misleading information about their business plans in their initial public offering (IPO) prospectuses. Using textual analysis, we develop a simple measure of such misleading information based on the difference between the emphasis placed on business lines in the main textual description and the corresponding information from the accounting tables. We examine our measure of misleading information using a sample of 1878 IPOs in China from 2010 to 2019. We find that the degree of misleading information is greater when firms find it more difficult to get regulatory approval for an IPO. Furthermore, the amount of misleading information is greater for firms with higher leverage and more segmented businesses. We also find some evidence that the stock returns of firms which present a greater amount of misleading information are lower.
Monetary Policy and Stock Market Valuation
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This paper estimates the effect of the European Central Banks’s monetary policy on the term structure of expected stock market risk premia. Expected stock market premia are solved using analysts’ dividend forecasts, the Eurostoxx 50 stock index and Eurostoxx 50 dividend futures. Although risk-free rates have decreased after the global financial crisis, the results indicate that the expected average stock market return has remained quite stable at around 9 percent. This implies that the expected average stock market risk premium has increased since the financial crisis. The effect of monetary policy on expected premia is analysed using VAR models and local projection methods. According to the results, monetary policy easing raises the average expected premium. The effect is explained by a rise in long-horizon expected premia.
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This paper estimates the effect of the European Central Banks’s monetary policy on the term structure of expected stock market risk premia. Expected stock market premia are solved using analysts’ dividend forecasts, the Eurostoxx 50 stock index and Eurostoxx 50 dividend futures. Although risk-free rates have decreased after the global financial crisis, the results indicate that the expected average stock market return has remained quite stable at around 9 percent. This implies that the expected average stock market risk premium has increased since the financial crisis. The effect of monetary policy on expected premia is analysed using VAR models and local projection methods. According to the results, monetary policy easing raises the average expected premium. The effect is explained by a rise in long-horizon expected premia.
On Testing Time Series Momentum Using Predictive Regressions
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In studies of time series momentum (TSM), the Newey-West t-test has size distortion for linear predictive regression with excess returns because of non-stationarity, endogeneity due to correlated errors, and a lack of finite moments due to heavy tails. To solve these problems, we propose a new test that features log-returns, a model of the error correlations, and weighted least squares estimation. Simulations confirm the proper size and increased power of the new test. Empirically, we find weak support for TSM regardless of the predictor's time horizon and a different set of assets with TSM compared with using the Newey-West t-test.
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In studies of time series momentum (TSM), the Newey-West t-test has size distortion for linear predictive regression with excess returns because of non-stationarity, endogeneity due to correlated errors, and a lack of finite moments due to heavy tails. To solve these problems, we propose a new test that features log-returns, a model of the error correlations, and weighted least squares estimation. Simulations confirm the proper size and increased power of the new test. Empirically, we find weak support for TSM regardless of the predictor's time horizon and a different set of assets with TSM compared with using the Newey-West t-test.
Remittances and FDI as Privately Provided International Aid
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This article elaborates on the role of personal remittances and Foreign Direct Investment (FDI) as the forms of international private aid most compatible with sustainable economic growth and development. We argue that remittances and FDIs are not only the most prevalent forms of private aid, but also the most effective forms for improving standards of living, market complexity, and the institutional prospects in poor nations. Globalization has led to increased flows of remittances and FDI from developed to developing economies. The increased flow of funds across borders helped stimulate the emergence of alternative payment technologies and microfinance institutions. These private initiatives are better suited to address the specific needs of local communities than foreign aid and other top-downstate-led measures. We also argue that remittances may positively interact with the existing policies and economic and political institutions in the recipient nations over time.
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This article elaborates on the role of personal remittances and Foreign Direct Investment (FDI) as the forms of international private aid most compatible with sustainable economic growth and development. We argue that remittances and FDIs are not only the most prevalent forms of private aid, but also the most effective forms for improving standards of living, market complexity, and the institutional prospects in poor nations. Globalization has led to increased flows of remittances and FDI from developed to developing economies. The increased flow of funds across borders helped stimulate the emergence of alternative payment technologies and microfinance institutions. These private initiatives are better suited to address the specific needs of local communities than foreign aid and other top-downstate-led measures. We also argue that remittances may positively interact with the existing policies and economic and political institutions in the recipient nations over time.
The Impact of Natural Disasters on Bank Performance and the Moderating Role of Financial Integration
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Using a sample of East Asian banks covering the period 1999-2014, this paper analyses the impact of natural disasters on commercial bank performance and how financial integration moderates this relationship. A dynamic GMM model reveals that natural disasters significantly lower deposit ratios but have no contemporaneous relationship with liquidity, credit risk, profitability and default risk. The paper also shows that foreign banking claims, specifically those extended by regional Asian lenders, help to alleviate the deposits decline in the aftermath of natural disasters. These results highlight the role of commercial bank deposits and foreign banking claims as sources of finance for post-disaster recovery. In particular, the resilience of Asian foreign claims in the event of natural disasters provides evidence to support intra-regional financial integration in East Asia.
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Using a sample of East Asian banks covering the period 1999-2014, this paper analyses the impact of natural disasters on commercial bank performance and how financial integration moderates this relationship. A dynamic GMM model reveals that natural disasters significantly lower deposit ratios but have no contemporaneous relationship with liquidity, credit risk, profitability and default risk. The paper also shows that foreign banking claims, specifically those extended by regional Asian lenders, help to alleviate the deposits decline in the aftermath of natural disasters. These results highlight the role of commercial bank deposits and foreign banking claims as sources of finance for post-disaster recovery. In particular, the resilience of Asian foreign claims in the event of natural disasters provides evidence to support intra-regional financial integration in East Asia.
The Non-Monotonic Relationship Between Financial Integration and Cost Efficiency: Evidence From East Asian Commercial Banks
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This is the first study to investigate how financial integration affects bank cost efficiency by applying the non-monotonic stochastic frontier model developed by Wang (2002) to a sample of East Asian commercial banks over the period 1997â€"2014. We consistently report a non-monotonic association between financial integration and bank cost efficiency. Financial integration improves bank cost efficiency but then becomes efficiency-impeding. Our empirical results support the existence of an optimal level of financial integration and validate the IMF’s nuanced ‘institutional view’ toward full capital account openness as well as being meaningful to further financial integration in East Asia.
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This is the first study to investigate how financial integration affects bank cost efficiency by applying the non-monotonic stochastic frontier model developed by Wang (2002) to a sample of East Asian commercial banks over the period 1997â€"2014. We consistently report a non-monotonic association between financial integration and bank cost efficiency. Financial integration improves bank cost efficiency but then becomes efficiency-impeding. Our empirical results support the existence of an optimal level of financial integration and validate the IMF’s nuanced ‘institutional view’ toward full capital account openness as well as being meaningful to further financial integration in East Asia.
Why Do Firms Forecast Earnings for Multiple Years Simultaneously?
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By issuing earnings forecasts for both current and future years simultaneously, managers provide the multi-year data required for many valuation models and help investors sort out transitory and permanent shocks. We find that firms that are overpriced and have more transitory earnings tend to issue multi-year forecasts simultaneously. Overpriced firms are more likely to issue both short- and long-term bad news than only short-term bad news forecasts. Mis-pricing tends to be corrected after firms’ multi-year forecasts, especially when overpriced firms issue both long- and short-term bad news forecasts. We also find a more linear current period earningsâ€"return relation when firms issue multi-year forecasts, which suggests that investors under-react less to extreme news because the future year forecasts embed earnings persistence information.
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By issuing earnings forecasts for both current and future years simultaneously, managers provide the multi-year data required for many valuation models and help investors sort out transitory and permanent shocks. We find that firms that are overpriced and have more transitory earnings tend to issue multi-year forecasts simultaneously. Overpriced firms are more likely to issue both short- and long-term bad news than only short-term bad news forecasts. Mis-pricing tends to be corrected after firms’ multi-year forecasts, especially when overpriced firms issue both long- and short-term bad news forecasts. We also find a more linear current period earningsâ€"return relation when firms issue multi-year forecasts, which suggests that investors under-react less to extreme news because the future year forecasts embed earnings persistence information.
