Research articles for the 2021-04-16

Arbitrage Pricing Theory, the Stochastic Discount Factor and Estimation of Risk Premia from Portfolios
Pesaran, M. Hashem,Smith, Ron
The arbitrage pricing theory (APT) attributes differences in expected returns to exposure to systematic risk factors, which are typically assumed to be strong. In this paper we consider two aspects of the APT. Firstly we relate the factors in the statistical factor model to a theoretically consistent set of factors defined by their conditional covariation with the stochastic discount factor (mt) used to price securities within inter-temporal asset pricing models. We show that risk premia arise from non-zero correlation of observed factors with mt; and the pricing errors arise from the correlation of the errors in the statistical factor model with mt: Secondly we compare estimates of factor risk premia using portfolios with the ones obtained using individual securities, and show that the identification conditions in terms of the strength of the factor are the same and that, in general, no clear cut ranking of the small sample bias of the two estimators is possible.

Bank Credit and Market-Based Finance for Corporations: The Effects of Minibond Issuances
Ongena, Steven,Pinoli, Sara,Rossi, Paola,Scopelliti, Alessandro
We study the effects of diversifying funding sources on the financing conditions for firms. We exploit a regulatory reform that took place in Italy in 2012, i.e. the introduction of ‘minibonds’, which opened a new market-based funding opportunity for unlisted firms. Using the Italian Credit Register, we investigate the impact of minibond issuance on bank credit conditions for issuer firms, both at the firm-bank and firm level. We compare new loans granted to issuer firms with new loans concurrently granted to similar non-issuer firms. We find that issuer firms obtain lower interest rates on bank loans of the same maturity than non-issuer firms do, suggesting an improvement in their bargaining power with banks. In addition, issuer firms reduce the amount of used bank credit but increase the overall amount of available external funds, pointing to a substitution with bank credit and to a diversification of corporate funding sources. Studying their ex-post performance, we find that issuer firms expand their total assets and fixed assets, and also raise their leverage.

Big Broad Banks: How Does Cross-Selling Affect Lending?
Qi, Yingjie
I study the profit effects related to cross-selling in a banking relationship. Using internal information on all corporate customers of a large commercial bank, I show that non-loan profit within a relationship increases (1) credit supply; and (2) the likelihood of receiving lenient treatment in delinquency. The effects are not only driven by reduced information asymmetry (as suggested by existing literature), but also increased profit to the bank. To identify this new profit channel, I analyze difference-in-differences variation in the profitability of firms' non-loan relationships due to Basel II's impact on some non-loan products' cost of production. Firms who became less profitable to the bank experienced a reduction of 6.9% ($433,000) in credit supply and 24% (9.9 pp) in the likelihood of receiving lenient treatment in delinquency.

Does Accounting Conservatism Improve the Corporate Information Environment?
Hu, Jinshuai,Li, Annie,Zhang, Feida
This study investigates whether and how accounting conservatism improves the corporate information environment. We argue that conservatism facilitates the flow of firm-specific information from corporate insiders to outsiders and leads to a high-quality information environment. Using the Basu (1997) model to capture the extent of accounting conservatism and firm-specific return variation to proxy for the quality of information environment, we find that conservatism is positively associated with the improvement of the corporate information environment in our sample of 43 countries. We also find that the information role of conservatism is more pronounced in countries with weaker protection of private property rights, suggesting that conservatism substitutes for legal institutions in ensuring the quality of information environment.

Green Dies in Darkness? Environmental Externalities of Newspaper Closures
Jiang, John (Xuefeng),Kong, Jing
We examine how news coverage affects firms’ corporate social responsibility (CSR) activity regarding pollution. Using local newspaper closures as an exogenous shock to news coverage, we find that plants located in newspaper closure counties increase toxic emissions by 10 to 19 percent relative to plants of the same firm or plants located in neighboring counties. The increased pollution occurs because plants become less effective in pollution reduction instead of higher productions. The increase in pollution occurs when citizens rely on newspapers to monitor local pollution. Overall our results suggest that newspapers are important channels for environmentally conscious residents to monitor local firms’ environmental practices.

Identifying Deposits' Outflows in Real-Time
Rainone, Edoardo
We propose a method based on control charts to identify in real-time sudden deposits' outflows through payment systems. The performance of the methodology is assessed with both Monte Carlo simulations and real transaction-level TARGET2 data for a large sample of Italian banks. We identify a set of idiosyncratic bank stress episodes and show that deposits are generally shifted to other banks, mainly large and domestic, generating a size premium; only a limited amount migrates to foreign banks. Under the fixed-rate, full allotment regime, the liquidity drain is mostly offset through open market operations.

M-Payments, Financial Inclusion, and Full Market Coverage
Karamychev, Vladimir,Viaene, Jean-Marie
Mobile payments (m-payments) increase the accessibility of large segments of society to financial services while before the traditional banking system excluded these for lack of proof of identity and because of unsafe environments. This constitutes a key driver of new growth strategies of the developing world. Smartphones are essential to perform m-payments. In that regard, recent criticism from different sides has expressed the view that manufacturers’ strategies generate partial market coverage whereby the purchase of a phone and financial inclusion also remain out of reach for the group of poor consumers. Our aim in this paper is to examine the theoretical premises of this conjecture in a small open economy and uncover the conditions under which full market coverage is efficient and desirable. We analyze subgame perfect equilibria of a vertical duopoly model characterized by consumers’ taste for quality. The government uses taxes and/or subsidies to modify the market equilibrium. Given this, the following issues are considered: (a) What is the impact of different standards of payment security on the equilibrium number of low- and high-quality users? (b) What are the aggregate welfare gains of complete financial inclusion? (c) What happens if phone makers are foreign?

Market Uncertainty and Sentiment around USDA Announcements
Cao, An,Robe, Michel A.
We provide comprehensive evidence that USDA reports substantially impact uncertainty and sentiment in agricultural markets. For up to five trading days after a scheduled release (WASDE, GSâ€"Grain Stocks, Prospective Plantings, Acreage), option-implied volatilities (IVols) are significantly lower than a week earlier. On average, the reports’ uncertainty resolution power is similar in magnitude for corn, soybeans, and wheat. The benefit of the USDA information is greater when there is more disagreement among market analysts in the run-up to a report (WASDE). It is smaller when the USDA news surprise the marketâ€"typically when the surprise is price-bullish (WASDE and GS) but also when the surprise is bearish (GS). While commodity IVols are often positively related to financial-market sentiment and to macroeconomic uncertainty (jointly captured by the VIX index), this co-movement breaks down on USDA report daysâ€"with the VIX and commodity IVols moving in opposite directions. Finally, in the case of the critical GS reports, the market-calming effect of USDA news is larger when analysts had been pessimistic about stock levelsâ€"that is, expert sentiment matters.

Mean-Reversion in Commodity Futures Volatility: An Analysis of Daily Range-Based Stochastic Volatility Models
Figlewski, Stephen,Haase, Marco,Huss, Matthias,Zimmermann, Heinz
We analyse the dynamic behavior of conditional volatility in commodity markets using a novel, manually collected dataset of daily price ranges over a time span of more than 140 years, which allows more precise daily volatility estimates than are otherwise prevalent in the commodity literature. We find that a one-factor range-based EGARCH-model (REGARCH) is not adequate to capture the very distinct long-run and short-run dynamic volatility components. While the long memory effect of volatility is numerically very small, it strongly affects the parameters of the short-run dynamics which become more stable and plausible in size. Moreover, long-run persistency in volatility shocks is practically unaffected after controlling for regimes which indicates that the stochastic movement of the long-run mean is not a statistical artefact. We also find that consistent with the theory of storage, long run volatility is positively related to lagged returns. Thus, asymmetry in volatility is not a short-run phenomenon.

PSD2 and the Transformation of the Business Model of Payment Services Providers
Pozzolo, Alberto F.
The provision of payment services is one of the most important activities performed by the financial sector. Traditionally, most of these services have been offered by banks, although in the last decades non-bank financial institutions have gained a prominent role in some specific segments, for example in the credit card business. In the past, despite being a relevant source of revenues for banks and other financial intermediaries, payment services provision has ranked relatively low in the interests of policy makers and academics alike, with most of the attention focused on the soundness of the system rather than on its efficiency. In recent years, this landscape has changed dramatically. New players have entered the market, in some cases increasing the degree of competition to the benefit of customers, in other cases exploiting network economies of scale and their better and exclusive know-how to gain significant market power. The purpose of this chapter is to discuss how some of the innovations introduced by the PSD2 might impact the business model of payment service providers in the coming years, what the effect on the equilibrium in the industry will be, what new risks may emerge, and what actions should be taken to counter possibly undesired outcomes. The analysis in this chapter will focus mainly on the potential impact of the introduction of three new types of intermediaries, known as Third Party Providers (TPPs): Payment Initiation Service Providers (PISP), Account Information Service Providers (AISP) and Card-Based Payment Instrument Issuers (CBPII).

Redistribution of Return Inequality
Schulz, Karl
Wealthier households obtain higher returns on their investments than poorer ones. How should the tax system account for this return inequality? I study capital taxation in an economy in which return rates endogenously correlate with wealth. The leading example is a financial market, where the rich acquire more financial information than the poor. Contrary to conventional wisdom, rather than calling for more redistribution, the presence of this scale dependence provides a rationale for lower marginal tax rates. The endogeneity of returns generates an inequality multiplier effect between wealth and its returns. Therefore, standard elasticity measures that determine the responsiveness of capital to taxes must be revised upwards. At an aggregate level, a rise in redistribution induces a compression effect on the distribution of pre-tax returns. In the financial market, I identify general equilibrium trickle-up externalities that provide a force for more redistribution relative to the partial equilibrium. Finally, I estimate partial and general equilibrium responses and demonstrate the quantitative importance of scale dependence for tax policy.

Return of the NPLs to the Bright Side: Which Unlikely to Pay Firms are More Likely to Pay?
Affinito, Massimiliano,Meucci, Giorgio
Unlikely to pay loans (UTPs) are non-performing loans (NPLs) that have a non-zero probability of returning to the performing state. This paper draws on Italian Central Credit Register data on the entire population of Italian UTP firms from 2005 to 2019, matched with firm and bank balance sheet data, to detect the characteristics of UTP firms that have returned to the performing state. During the crises, even in the most acute phases, the share of UTP firms returning to the performing state has never been negligible. This suggests that the analysis of the factors most closely related to the return of UTP firms to the performing state could also provide policy guidance during the pandemic. Our results show that the factors that have a stronger statistical and economic correlation with the probability of a UTP firm recovering are (negatively) its size and the absolute value of its debt, and (positively) its capital. Results are strongly heterogeneous over time and across economic sectors and Italian regions. Lending bank characteristics matter, but less than firm characteristics.

Return on Investment on AI : The Case of Capital Requirement
Fraisse, Henri,LAPORTE, Matthias
Taking advantage of granular data we measure the change in bank capital requirement resulting from the implementation of AI techniques to predict corporate defaults. For each of the largest banks operating in France we design an algorithm to build pseudo-internal models of credit risk management for a range of methodologies extensively used in AI (random forest, gradient boosting, ridge regression, deep learning). We compare these models to the traditional model usually in place that basically relies on a combination of logistic regression and expert judgement. The comparison is made along two sets of criterias capturing : the ability to pass compliance tests used by the regulators during onsite missions of model validation (i), and the induced changes in capital requirement (ii). The different models show noticeable differences in their ability to pass the regulatory tests and to lead to a reduction in capital requirement. While displaying a similar ability than the traditional model to pass compliance tests, neural networks provide the strongest incentivefor banks to apply AI models for their internal model of credit risk of corporate businesses as they lead in some cases to sizeable reduction in capital requirement.

Rogue Brokers and the Limits of Agency Law
DeMott, Deborah
Rogue brokers and their counterparts among registered investment advisersâ€"overall a relatively small but persistent cohort among securities-market professionalsâ€"defraud their clients, execute unauthorized transactions, or otherwise betray the trust clients necessarily repose in them. Many rogues are recidivists: fired by one firm, they move to another and often engage in new misconduct. Firms that appear to welcome rogues may enhance the risks of harm imposed on clients as well the adverse reputational consequences that follow for the industry and its regulators. This paper, written as a chapter for a forthcoming book, introduces the vocabulary and structures of common law agency as a framework to examine structural features that underlie the challenges posed by individual rogues. This framework is also helps to situate the distinct role of securities-market regulation. The paper incorporates the results and implications of other scholars’ recent quantitative inquiries into securities-market rogues as well as other cohorts daunted by recidivists, in particular law-enforcement officers and insurance producers.A securities-market rogue links two distinct types of agent-principal relationships: (1) between an individual representative and the firm with which the professional is associated; and (2) between the firm, its representative, and the clients or customers with whom the representative interacts on the firm’s behalf. Both types of relationships are characterized by asymmetries that work to the disadvantage of investors, especially so for unsophisticated retail investors. This is because an individual rogue and the firm represented by the rogue have access to material information unavailable to the investor, in particular textured information about the rogue’s history and present propensities as well as the firm’s own practices. Separately, a firm’s powers of control over its representatives exceed an investor’s powers of control as a principal in an agency relationship once the investor engages the broker or adviser. Although agency-law doctrine accounts for both asymmetries, its responses operate only retrospectively once a client suspects problems with an account. In contrast, regulation can facilitate several distinct strategies for proactive intervention; it also can expand liability to encompass personnel charged with supervisory responsibilities. Within this framework, the paper examines recent proposals from FINRA to address persistent concerns with individual rogues and broker-dealer firms that employ them.

Short Selling and Firm Investment Efficiency
Yu, Chang
This paper investigates the informativeness of short sales on detecting a firm’s investment inefficiency. We document that short sellers adjust their short positions before the financial statement announcements to utilize their information advantage on firms’ investment inefficiency. The relationship between a firm’s short sale position and its future investment inefficiency is both statistically and economically significant, and robust to a broad set of control variables. Subsample analysis shows that the informativeness of short sales positions on future investment inefficiency concentrates on firms with low board independence and firms with low CEO incentive pay.

Strategic Trading by Insiders in Reaction to Institutions: A Rat-Race Effect
Hoang, Lai T.,Wee, Marvin,Yang, Joey (Wenling)
We examine how trading by institutional traders affects those by insiders. Using data at the trade level, we find insiders complete their trades faster when institutions trade on the same side in the stock. The effect of institutional activity on insider trading is more pronounced when insiders are more informed and if insider trades are associated with long-lived information. This finding supports the information-based hypothesis where insiders accelerate their trading due to competition with institutional investors for information. We identify two channels, brokerage and proximity, where insiders compete with institutional traders for information. We find the competition is more intense when (1) insiders and institutional investors share the same broker; and (2) institutional investors are local to the firm’s headquarter.

TLAC-Eligible Debt: Who Holds It? A View from the Euro Area
Attinà, Carmela Aurora,Bologna, Pierluigi
We identify two categories of potentially ‘bad investors’ in TLAC-eligible bonds for the purpose of bail-in, i.e. households and hedge funds. The exposure of households may create political economy problems for policy makers when they have to decide about bail-in, while holdings by hedge funds may increase the price volatility of these instruments in stress periods. We analyze the composition of the investor base of the TLAC bonds issued by euro area G-SIBs between 2013 and 2020 and make a first assessment of whether the observed developments could have lessened the above mentioned problems. We show that the composition of the holdings of the different sectors has changed significantly over time. The share directly held by households has declined, is low on aggregate, and should not necessarily be an obstacle to the resolution of a G-SIB. However, there is a negative correlation between households’ TLAC holdings and their financial education. The information gap around the holdings of hedge funds means a full assessment of their role is not feasible. The market tensions that followed the Covid-19 shock did not negatively affect investments in TLAC debt, except for those of households which fell markedly in the first half of 2020.

The EU Bank Insolvency Framework: Could Less Be More?
Majnoni d'Intignano, Giovanni,Trapanese, Maurizio,Bernardini, Gabriele,Dal Santo, Andreas
The framework for bank crisis management in the Banking Union (BU) complies with multiple criteria. Each of these criteria is based on a sound policy rationale; however, when combined, they can generate unintended consequences that undermine the effectiveness of the system, highlighting a case of fallacy of composition. This paper suggests that a piecemeal reform is not adequate to tackle the framework’s shortcomings. A broader effort is required to streamline the current criteria into a single rulebook, achieving effectiveness through simplification. The successful experience of the US framework for bank failure management provides a useful benchmark. It shows that the generalized, if not exclusive, reliance on a single, clearly defined, easily measurable and quickly actionable criterion â€" the Least Cost Test â€" makes it possible to offer full protection to taxpayers and to contain the destruction of value caused by bank failures, thereby safeguarding the economy. We suggest that its adoption by the BU would help to frame a common approach to failing banks of all sizes and would provide a unifying force and a solution to the geographic and institutional fragmentation of the current set-up.

The Puzzle of Chinese Bankruptcy Law
Mrockova, Natalie
The new Chinese Enterprise Bankruptcy Law 2006 has been written in accordance with the best international practice. We would therefore expect to see it being used to resolve most cases of corporate financial distress. However, the law is only rarely used in practice which prompts search for explanations and alternative mechanisms that the creditors rely on when trying to enforce their claims. In this paper I analyse this puzzle focusing in particular on debtors’ and creditors’ incentives for using extra-legal substitutes and formal law. Based on this analysis, I propose two major reasons for the law’s limited use, and explore three alternative enforcement mechanisms that have been used instead of the formal law. I argue that the main reason for low use of the new law is that in practice it produces low payoffs: private creditors don’t use bankruptcy procedures because they produce low financial payoffs, and that the government- controlled players (state-owned enterprises, state banks, etc.) are not allowed and/or willing to rely on bankruptcy procedures because they disregard the socio-political interests. Instead, the players in bankruptcy rely on extra-legal alternatives which provide higher payoffs. Private creditors rely on the reputation mechanism to enforce repayment, and the government uses various forms of bailouts and financial support for the ailing state enterprises. In companies with a mixed public-private ownership, hybrid solutions are adopted to satisfy the interests of both groups.

Whose Voice, Whose Interests?
Mrockova, Natalie
This paper looks at whose voice is heard and whose interests are protected in the making of finance-related laws in China. To ensure its accuracy, the paper focuses on a real-life case study of the making of bankruptcy laws in 1986 and 2006. Laws provide a set of incentives and constraints on their intended users and beneficiaries. In the context of bankruptcy law this means determining who shall bear the risk of corporate failure, whose interests shall be prioritized in corporate exit or reorganization, and who shall be the mediator/decision-maker in a case of conflict. Exploring bankruptcy law-making process in China sheds light on the interaction between and pressures exerted by the various stakeholders, which in turn informs the debate of representation and participation in China’s legislative process. While it is generally accepted that the key and dominant player is the Party-state whose representatives prepare, debate, vote on and promulgate the law, I propose that that is not a complete picture. The Party-state is subject to multiple internal influences and interests they wish to protect. These internal motives are influenced by certain powerful external users and stakeholders of the proposed law who try to protect their own interests. Although the Party-state is the ultimate law-maker, it allows deliberations and interjections by the interested parties. As a result, the interests and motivations of the two groups interact and affect each other leading to a compromise formulation of the new law.The discussion in this paper is informed by what we know about the passage of the 2006 bankruptcy law. The experience with making the older 1986 law will also be included where relevant. Thanks to the fundamentally opposed interests at play it took many years, numerous drafts and uniquely bumpy and disharmonious legislative run to reach an acceptable compromise each time which makes the bankruptcy law a perfect case study of the interests at play in corporate law-making in China and in transition from plan to market in general. The key clashes included ideology, the position and adequate protection of workers, the role and rights of financial creditors (as represented by the banks) and the admissibility of international pressure and experience. In other words, the key to passing the 1986 and 2006 laws was whether and to what extent should the ingrained demand for worker protection and social welfare provision be compromised to accommodate the need for further economic growth and how far to accommodate the demands of the increasingly powerful and independent financial creditors (i.e. mostly private companies and banks) and the international community.Although the paper focuses on bankruptcy law, the findings may be applicable to a variety of corporate finance-related laws since it uncovers the process and mechanisms used in law-making more broadly.