Corporate Finance

November 4, 2011
Bruce Carlin of the University of California, Los Angeles, and Ilya Strebulaev of Stanford University's Graduate School of Business, Organizers

Andrea Eisfeldt, University of California, Los Angeles, and Tyler Muir, Northwestern University
The Joint Dynamics of Internal and External Finance

Eisfeldt and Muir document the fact that at both the aggregate and the firm level, corporations tend to simultaneously raise external finance and accumulate liquid assets. For all but the very largest firms, the aggregate correlation between external finance raised and liquidity accumulation is 0.6, and the average firm level correlation is 0.2. This seems puzzling if internal and external finance are substitutes and external finance is costly. In fact, static pecking order intuition predicts that firms will first draw down liquid balances and only then issue external finance. On the other hand, if one believes that the cost of external finance varies over time, then the fact that there appear to be aggregate waves of issuance and savings activity may not be surprising. The authors show that a simple dynamic model with constant costs of external finance can easily match the observed positive correlation between liquidity accumulation and external finance. They compare the results of this simple model to those from a model which features a shock to the cost of external finance.

Hans B. Christensen, University of Chicago Booth School of Business; Luzi Hail, Wharton School,University of Pennsylvania; and Christian Leuz, University of Chicago and NBER

Capital-Market Effects of Securities Regulation: The Role of Prior Regulation, Implementation and Enforcement (NBER Working Paper No. 16737)

Christensen, Hail, and Leuz examine capital market effects of changes in securities regulation. They analyze two key directives in the European Union (EU) that tightened market abuse and transparency regulation and its enforcement. All EU member states were required to adopt these two directives but did so at different points in time. The research design exploits this differential timing of the same regulatory change to identify the capital-market effects. They then use cross0sectional variation in the strictness of implementation and enforcement, as well as prior regulation, to analyze the role of these factors for regulatory outcomes. They find that, on average, market liquidity increases as EU member states tighten market abuse and transparency regulation. The effects are larger in countries that implement and enforce the directives more strictly. They are also stronger in countries with traditionally stricter securities regulation and with a better track record of implementing regulation and government policies in general. These findings show that the effects of regulation depend crucially on implementation and enforcement. Moreover, the results indicate that the same forces that have limited the effectiveness of regulation in the past are still at play when new rules are introduced, which has important implications for the expected outcomes of regulatory reforms as well as efforts to harmonize regulation across countries.

Alex Edmans, University of Pennsylvania and NBER
Feedback Effects and the Limits to Arbitrage

Edmans identifies a limit to arbitrage that arises from the fact that a fim's fundamental value is endogenous to the act of exploiting the arbitrage. Trading on private information reveals this information to managers and helps them to improve their real decisions, in turn enhancing fundamental value. While this increases the profitability of a long position, it reduces the profitability of a short position -selling on negative information reveals that firm prospects are poor, causing the manager to cancel investment. Optimal abandonment increases firm value and may cause the speculator to realize a loss on her initial sale. Thus, investors may strategically refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. The effect has potentially important real consequences -if negative information is not incorporated into stock prices, negative-NPV projects may not be abandoned, leading to over-investment.

Archishman Chakraborty and Bilge Yilmaz, University of Pennsylvania
Authority, Consensus and Governance

Chakraborty and Yilmaz characterize optimal corporate boards when shareholders face a trade-off between improving information sharing between the board and management and reducing distortions in decisionmaking arising out of managerial agency. The authors show that allocating authority to management is suboptimal. Authority should be held by a supervisory board that may be imperfectly aligned with both shareholders and management. Even when management has captured all authority and the board only has an advisory role, the optimal board may be designed to withhold information from management. However, optimal advisory boards must be able to create consensus with management, making the allocation of authority irrelevant.

Raymond Fisman and Daniel Paravisini, Columbia University and NBER; and Vikrant Vig, London Business School
Cultural Proximity and Loan Outcomes

Fisman, Paravisini, and Vig present evidence that shared codes, religious beliefs, ethnicity -cultural proximity- between lenders and borrowers improves the efficiency of credit allocation. They identify in-group preferential treatment using dyadic data on the religion and caste of bank officers and borrowers from a bank in India, and a rotation policy that induces quasi-random matching between officers and borrowers. Cultural proximity increases the intensive and extensive margins of lending, and reduces the collateral rate. Ex post, cultural proximity increases repayment performance, even after the in-group officer is replaced by an out-group one. These results suggest that the information benefits of cultural proximity may outweigh the misallocation costs of taste-based discrimination.

Shawn A. Cole, Harvard University, and Martin Kanz and Leora F. Klapper, The World Bank
Incentivizing Calculated Risk-Taking: Evidence from a Series of Experiments with Commercial Bank Loan Officers

How does performance-based compensation at commercial banks affect risk-assessment and lending? Cole, Kanz, and Klapper describe a series of experiments with commercial bank loan officers to answer this question. They analyze the underwriting process of small-business loans to entrepreneurs in an emerging market and test the impact of performance pay by comparing three commonly implemented types of incentive schemes: 1) volume incentives that reward loan origination; 2) low-powered incentives that reward origination conditional on performance; and 3) high-powered incentives that reward performance and penalize default. They provide evidence that the structure of performance incentives has a strong and significant effect on risk-assessment, lending decisions, and the profitability of originated loans. In additional treatments, they show that deferring performance pay reduces the ability of high-powered incentives to induce screening effort, but moderates the adverse effects of volume incentives. Finally, they document considerable heterogeneity in the effect of performance pay on loan officer behavior: more experienced loan officers exert greater screening effort, irrespective of the incentive scheme in place. The results from these experiments can provide guidance for lenders seeking to develop staff incentives to reduce bias and default-risk in lending.

Andrew Hertzberg, Columbia University
Exponential Individuals, Hyperbolic Households

Hertzberg introduces a model of household consumption and savings in which household members have imperfectly aligned altruistic preferences. Specifically, member A values his own consumption more than member B values A's consumption. Each s period, members independently choose the amount of household wealth to consume as Nash-best responses. At each point in time, the household consumes a higher fraction of wealth than under the full commitment Pareto optimum. Ex-ante Pareto-optimal household consumption plans are not sub-game perfect because both members wish to deviate to increase their own consumption. As a result, the household is willing to pay for a technology that commits it to an optimal lifetime consumption plan. Despite both members individually having time-consistent exponential discount rates, equilibrium household consumption dynamics are captured by a single representative agent with a hyperbolic discount factor that is microfounded in the degree of preference misalignment within the household.