Corporate Finance

October 29, 2010
Program Director Raghuram Rajan of the University of Chicago, Organizer

Ran Duchin and Denis Sosyura, University of Michigan
TARP Investments: Financials and Politics

Duchin and Sosyura investigate the determinants of capital allocation to financial institutions under the Troubled Asset Relief Program (TARP). They find that banks' political ties played a significant role in TARP fund distribution. Connections to Congressmen on finance committees and representation at the Federal Reserve via board members are positively related to banks' likelihood of receiving TARP capital. The TARP investment amounts are positively related to banks' political contributions and lobbying expenditures. The effect of political influence is stronger for underperforming banks, thus shifting capital toward weaker institutions. Overall, this paper provides evidence about various channels through which political activism affects government spending.

Bernadette Minton, Ohio State University; Jerome P. Taillard, Boston College; and Rohan Williamson, Georgetown University
Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?

Minton, Taillard, and Williamson examine how risk taking and firm value are related to independence and financial expertise of the board for a large sample of U.S. financial institutions both before and during the financial crisis. During the crisis, financial expertise is negatively related to both changes in Tobin's Q and cumulative stock returns. The effect is stronger for larger banks. Results on independence and performance during the crisis are mixed. However, independence is associated with a significantly higher probability of getting TARP funds, while financial expertise is not. In the run-up to the crisis, market-based measures of risk are negatively related to the percent of independent directors and positively related to financial expertise. Furthermore, both stock performance prior to the crisis and leverage are positively related to the financial expertise of the board. These associations are again primarily driven by large banks in our sample. Overall, these results are consistent with financial expertise being associated with more risk taking and higher firm value prior to the crisis and lower performance when the crisis hits.

Kathleen Kahle, University of Arizona, and Rene M. Stulz, Ohio State University and NBER
Financial Policies and the Financial Crisis: Impaired Credit Channel or Diminished Demand for Capital?

Kahle and Stulz examine the relative importance of three factors that affect the financial policies of firms during the financial crisis: 1) a contraction in credit supply; 2) a loss of investment opportunities; and 3) an increase in risk. Before September 2008, the evidence is not consistent with a dominant role for a contraction in credit supply. Small firms do not experience a decrease in net debt issuance in the first year of the crisis. In contrast, their net equity issuance is extremely low throughout the crisis, whereas an impaired credit supply by itself would have encouraged firms to increase their equity issuance. After September 2008, the evidence shows a dominant role for the increase in risk, but more so for large firms than small ones. Though small and unrated firms have exceptionally low net debt issuance at the peak of the crisis, large firms do not. Instead of decreasing their cash holdings, as would be expected with a temporarily impaired credit supply, large and investment grade firms increase their cash holdings sharply (by 17.8 percent in the case of investment-grade firms) from September 2008 to the end of the sample period. The fact that firms with no debt also decrease their net equity issuance and increase their cash holdings contradicts a credit channel explanation for the observed change in capital flows and cash accumulation.

Robin Greenwood and Jeremy C. Stein, Harvard University and NBER, and Samuel Hanson, Harvard University
A Comparative-Advantage Approach to Government Debt Maturity

Greenwood, Hanson, and Stein study optimal government debt maturity in a model where investors derive monetary services from holding riskless short-term securities. In a simple setting where the government is the only issuer of such riskless paper, it trades off the monetary premium associated with short-term debt against the refinancing risk implied by the need to roll over its debt more often. The authors then extend the model to allow private financial intermediaries to compete with the government in the provision of money-like claims. They argue that if there are negative externalities associated with private money creation, the government should tilt its issuance more towards short maturities. The idea is that the government may have a comparative advantage relative to the private sector in bearing refinancing risk, and hence should aim to partially crowd out the private sectora's use of short-term debt.

Bruce I. Carlin, University of California, Los Angeles and NBER, and David T. Robinson, Duke University and NBER
What Does Financial Literacy Training Teach Us?

Carlin and Robinson use a quasi-natural experiment to explore how financial education changes savings, investment, and consumer behavior. They use data from a Junior Achievement Finance Park to measure the effect of a financial literacy program on students who are assigned fictitious life situations and asked to create household budgets for these roles. The y find that the treatment effects of the financial literacy program are strong. Students who experienced training were somewhat better at making current-cost/current-benefit tradeoff decisions (spending more today versus spending less today). However, the tendency to try to save more today often led them to make poor choices when they faced tradeoffs between current-costs and future-benefits today (that is, when spending more today is cheaper in present value terms). Most importantly, students who had attended training showed greater up-take of decision support that was offered in the Park. This indicates that decision support and financial literacy training are complements, not substitutes.

Ji-Woong Chung, Berk Sensoy, and Lea H. Stern, Ohio State University, and Michael Weisbach, Ohio State University and NBER
Pay for Performance from Future Fund Flows: The Case of Private Equity

Chung, Sensoy, Stern, and Weisbach present a learning-based framework for estimating the market-based pay-for-performance arising from future fund raising among private equity partners. They estimate that implicit pay-for-performance from expected future fund raising for the typical first-time private equity fund is approximately the same order of magnitude as the explicit pay-for-performance that general partners receive from carried interest in their current fund This implies that the performance-sensitive component of general partner revenue is about twice as large as commonly discussed. Consistent with the learning framework, the researchers find that implicit pay for performance is stronger when managerial abilities are more scalable and weaker when current performance contains less new information about ability. Specifically, implicit pay for performance is stronger for buyout funds than venture capital funds, and declines in the sequence of a partnership's funds. This framework can be adapted to estimate implicit pay-for-performance in other asset management settings in which future fund inflows and compensation depend on current performance.

Ashwini Agrawal, New York University, and David Matsa, Northwestern University
Labor Unemployment Risk and Corporate Financing Decisions

Agrawal and Matsa examine the impact of labor unemployment risk on corporate financing decisions. Theory suggests that firms choose conservative financial policies partly as a means of mitigating worker exposure to unemployment risk. Using changes in state unemployment insurance benefit laws as a source of variation in the costs borne by workers during layoff spells, the researchers explore the connection between unemployment risk and the corporate financing decisions of public firms in the United States. They find that increases in legally mandated unemployment benefits lead to increases in corporate leverage. The impact of reduced unemployment risk on financial policy is especially strong for firms that have greater layoff separation rates, labor intensity, and financing constraints. The estimated premium required to compensate workers for unemployment risk due to financial distress is about 57 basis points of firm value for a BBB-rated firm. These findings suggest that labor market frictions have a significant impact on corporate financing decisions.

Mark Garmaise, University of California, Los Angeles, and Gabriel Natividad, New York University
Cheap Credit for Financial Institutions: The Case of Global Microfinance

Lending terms in the microfinance industry are often influenced by non-market considerations. Garmaise and Natividad exploit shifting international relationships to analyze political shocks to the cost of financing for microfinance institutions (MFIs). MFIs whose host nations improve their relationships with their lenders' nations enjoy reduced borrowing costs. These MFIs operate less efficiently, lending less per credit officer and increasing administrative expenses. MFIs expand lending only 2-3 years after a beneficial political shift, suggesting that the bank lending credit channel is effective only with a significant lag. Young MFIs, however, use cheap credit to improve their financial positions and change their personnel policies.