Corporate Finance Program Meeting

November 20, 2009
Christian Leuz and Morten Sorensen, Organizers

Todd Gormley, University of Pennsylvania; Bong H. Kim, Washington University in St. Louis; and Xiumin Martin, Washington University in St. Louis
Can Firms Adjust Their Opaqueness to Lenders? Evidence from Foreign Bank Entry into India

Gormley, Kim, and Martin use the entry of foreign banks into India during the 1990s - analyzing variation in the timing of the new foreign banks' entries and in their location - to estimate the effect of increased banking competition on firms' timely recognition of economic losses, an important aspect of accounting quality to lenders. Their estimates indicate that foreign bank entry is associated with improved accounting quality among firms, and this improvement is positively related to a firm's subsequent debt level. The change in accounting quality appears to be driven by a shift in firms' incentives to supply higher quality information to lenders; lenders seem to value this information. The increase in accounting quality is also greatest among private firms, smaller firms, less profitable firms, and firms more dependent on external financing. Overall, the evidence suggests that a firm's opaqueness is not static, and that a firm's choice regarding accounting quality is a function of credit market competition.

Itay Goldstein, University of Pennsylvania; Emre Ozdenoren, University of Michigan; and Kathy Yuan, University of Michigan
Trading Frenzies and Their Impact on Real Investment

Goldstein, Ozdenoren, and Yuan model a capital provider that learns from the price of a firm's security in deciding how much capital to make available for new investment. This feedback effect -- from the financial market to the investment decision -- gives rise to trading frenzies, where speculators all wish to trade like others, generating large shifts in prices and firms' investments. Coordination among speculators is sometimes desirable for price informativeness and investment efficiency, but speculators' incentives push in the opposite direction, so that they coordinate exactly when it is undesirable. The authors analyze the determinants of coordination among speculators and study policy measures that affect patterns of coordination to improve price informativeness and investment efficiency.

Ivo Welch, Brown University and NBER; and Peter Iliev, Penn State University
How Quickly Do Firms Readjust Capital Structure?

Iliev and Welch seek to reconcile the different results from prominent estimators of the speed of adjustment (SOA) of firms' leverage ratios. Previous papers overlooked the simple fact that leverage ratios below zero or greater than 100 percent are not possible. This made some of them find mean reversion, which they mistakenly considered as readjustment. When corrected, the best reconciled estimate for the SOA is not positive: on average, firms do not seem to adjust. Moreover, the data is so plentiful that SOA estimates can be extremely accurate even when the firm-specific target is not known. Finally, this paper suggests both a method of reconciling estimators from prior research and a better way of modeling the underlying leverage ratio process.

Michael R. Roberts, University of Pennsylvania; and Mark Leary, Cornell University
Do Peer Firms Affect Corporate Financial Policy?

Roberts and Leary highlight the interdependent nature of corporate financial policies: firms do not make financing decisions in isolation of one another, as often assumed in theoretical and empirical studies of corporate capital structure. They show that firms' industry peers or competitors play an important role in shaping corporate financial policies. Both the characteristics and financial policies of competitors are important determinants of capital structure. On average, a single standard deviation change in peer firms' leverage ratios is associated with a 9 percent change in own-firm leverage ratios - a marginal effect that is significantly larger than that of any other observable determinant. Driving this leverage effect is a linkage among firms' security (debt and equity) issuance decisions. The researchers also show that these effects are driven largely by the efforts of younger, less successful firms that mimic industry leaders.

Efraim Benmelech, Harvard University and NBER; and Nittai Bergman, MIT and NBER
Negotiating with Labor Under Financial Distress

Benmelech and Bergman analyze how firms strategically renegotiate labor contracts to extract concessions from labor. While anecdotal evidence suggests that firms tend to renegotiate wages down in times of financial distress, there is no empirical evidence that documents such renegotiation, its determinants, and its magnitude. Using a unique dataset of airlines that includes detailed information on wages and pension plans, the authors demonstrate an empirical link between airline financial distress, pension underfunding, and wage concessions. They show that airlines in financial distress obtain wage concession from employees whose pension plans are underfunded. As part of their identification strategy, they exploit the fact that pension plans in the United States are partially insured by the Pension Benefit Guaranty Corporation (PBGC). Using variation in the degree of pension coverage provided by the PBGC, they show that employees' outside option in bargaining is crucial in determining the degree of wage concessions during labor contract renegotiation. Their empirical evidence highlights the strategic use of pension underfunding by firms and the resultant wage cuts which employees endure as a result.

Elena Simintzi, London Business School; Vikrant Vig, London Business School; and Paolo Volpin, London Business School
Labor and Capital:Is Debt a Bargaining Tool?

Simintzi, Vig, and Volpin examine the effect of labor bargaining power on the equilibrium choice of debt by firms, using firm-level data from 21 countries over the 1985-2004 period. In contrast to the existing literature that emphasizes the strategic role of debt and thus predicts an increase in financial leverage to counteract increases in labor bargaining power, they find that increases in employment protection are associated with decreases in the use of debt by firms. Their interpretation of this result is that strong labor laws constrain firms' ability to raise debt as they make labor claims effectively senior to debt claim. Consistent with this view, they show that firms react to increases in employment protection by increasing their reliance on short-term debt and trade credit. Furthermore, they find that the effect of labor bargaining power is more pronounced for firms that have lower liquidation value and in countries where bargaining is more decentralized. These results are robust to changes in empirical specifications, including different definitions of leverage and a differences-in-differences approach that exploits inter-temporal variations in labor laws across countries.

Hannah Lin, IMF; and Daniel Paravisini, Columbia University
What's Bank Reputation Worth? The Effect of Fraud on Financial Contracts and Investment

The risk of a reputation loss can provide an informal enforcement mechanism when contracts are incomplete. Lin and Paravisini show that reputation and formal incentives to monitor are substitutes in the context of syndicated credit. Monitoring in a loan syndicate is delegated to lead banks, whose formal incentives are determined by their share of the loan. Exploiting as a source of variation the reputation loss suffered by banks actively lending to firms subsequently involved in fraud scandals, the researchers use within-firm estimators to show that monitoring banks face higher-powered contracts - higher loan shares - after a reputation loss. Despite the substitution towards higher contractual incentives, banks supply less credit and borrower financial policy and investment are affected, indicating that formal incentives are an imperfect substitute for reputation.

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