Understanding the Capital Structures of Non-Financial and Financial Corporations
April 5 and 6, 2013
Alexander Ljungqvist, New York University and NBER, and Florian Heider, European Central Bank
Ljungqvist and Heider use a natural experiment in the form of staggered changes in corporate income tax rates across U.S. states to show that tax considerations are a first-order determinant of firms' capital structure choices. Over the period 1990-2011, firms increase long-term leverage by 116 basis points on average (equivalent to $59.4 million in extra debt) when their home state raises tax rates. Contrary to standard trade-off theory, the tax sensitivity of leverage is asymmetric: firms do not reduce leverage in response to tax cuts. Using treatment reversals, the researchers find this to be true even within-firm: tax increases that are later reversed nonetheless lead to permanent increases in a firm's leverage – an unexpected and novel form of hysteresis. These findings are robust to various confounds, such as unobserved variation in local business conditions or investment opportunities, union power, or states' political leanings. Treatment effects are heterogeneous: tax sensitivity is greater among profitable and investment-grade firms which have a greater marginal tax benefit and lower marginal cost of issuing debt respectively.
Jaewon Choi and Dirk Hackbarth, University of Illinois at Urbana-Champaign, and Josef Zechner, Vienna University of Economics and Business
Choi, Hackbarth, and Zechner study the extent to which firms spread out their debt maturity dates across time, termed "granularity of corporate debt." In their model, firms are unable to roll over expiring debt in high-uncertainty states and therefore are forced to engage in inefficient liquidations. Since multiple small asset sales are less costly than a single large one, it can be advantageous to diversify debt rollovers across maturity dates. Using a large sample of corporate bond issuers during 1991–2011, they find support for the model's predictions in cross-sectional and time-series tests. In the cross-section, corporate debt maturities are more dispersed for larger and more mature firms, for firms with better investment opportunities, with higher leverage ratios, and with lower levels of current cash flows. They further find that during the recent financial crisis in particular, firms with valuable investment opportunities implemented more dispersed maturity structures. In the time-series, they document that firms manage rollover risk, in that newly issued corporate bond maturities complement pre-existing bond maturity profiles.
Arvind Krishnamurthy and Annette Vissing-Jorgensen, Northwestern University and NBER
Krishnamurthy and Vissing-Jorgensen present a theory in which the key driver of short-term debt issued by the financial sector is the portfolio demand for safe and liquid assets by the non-financial sector. This demand drives a premium on safe and liquid assets that the financial sector exploits by owning risky and illiquid assets and writing safe and liquid claims against those. The central prediction of the theory is that government debt (in practice this is predominantly Treasuries) should crowd out the net supply of privately issued short-term debt (the private supply of short-term safe and liquid debt, net of the financial sector's holdings of Treasuries, reserves and currency). The authors verify this prediction in U.S. data from 1914 to 2011. They take a series of approaches to address potential endogeneity concerns and omitted variables issues: testing additional predictions of the model (notably that checking deposits should be crowded in by government debt supply), including controls for the business cycle; exploiting a demand shock for safe/liquid assets; and exploring the impact of government supply on the composition of consumption expenditures. They also show that accounting for the impact of Treasury supply on bank money results in a stable estimate for money demand and can help resolve the "missing money" puzzle of the post-1980 period. Finally, they show that short-term debt issued by the financial sector predicts financial crises better than standard measures such as private credit/GDP.
Isil Erel, Ohio State University; Stewart Myers, MIT and NBER; and James Read, The Brattle Group
Erel, Myers, and Read demonstrate that firms should allocate capital to lines of business based on marginal default values: that is, the derivative of the value of the firm's option to default with respect to the scale of the line. Marginal default values yield a unique allocation of capital that adds up exactly, regardless of the joint probability distribution of line-by-line returns. Capital allocations follow from the conditions for the firm's optimal portfolio of businesses. The allocations are systematically different from allocations based on VaR or contribution VaR.
Franklin Allen, University of Pennsylvania and NBER, and Elena Carletti, European University Institute
In a model with bankruptcy costs and segmented deposit and equity markets, Allen and Carletti endogenize the choice of bank and firm capital structure and the cost of equity and deposit finance. They find that despite risk neutrality, equity capital is more costly than deposits. When banks directly finance risky investments, they hold positive capital and diversify. When banks make risky loans to firms, they trade off the high cost of equity with the diversification benefits from a lower bankruptcy probability. When bankruptcy costs are high, banks use no capital and only lend to one sector. When they are low, banks hold capital and diversify.
Konstantin Milbradt, MIT, and Martin Oehmke, Columbia University
Financing terms and investment decisions are jointly determined. This interdependence links firms' asset and liability sides and can lead to short-termism in investment. Milbradt and Oehmke model how asymmetric information frictions increase with the investment horizon, so that financing for long-term projects is relatively expensive and, potentially, rationed. In response, firms whose first-best investment opportunities are long-term might distort their investment towards second-best projects of shorter maturities. This worsens financing terms for firms with shorter maturity projects, inducing them to distort their investment as well. In equilibrium, investment is inefficiently short-term. Equilibrium asset-side adjustments by firms can amplify shocks and, while privately optimal, can be socially undesirable.
Anat Admati and Paul Pfleiderer, Stanford University; Peter DeMarzo, Stanford University and NBER; and Martin Hellwig, Max Planck Institute
Admati, DeMarzo, Hellwig, and Pfleiderer analyze shareholders' incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies. This analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010), which argued that subsidies that favor debt over equity are the key reason that banks' funding costs would be lower if they "economize" on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that "equity is expensive" are flawed. Like reductions in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, the authors show that debt overhang creates inefficiency, because shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates a leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks' borrowing costs. The authors analyze shareholders' preferences when choosing among various ways that leverage can be reduced. They show that, with homogeneous assets, if the firm's security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to de-leverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, then asset sales are the preferred way to reduce leverage. This preference for asset sales, or "de-leveraging," can persist even if such sales are inefficient and reduce the total value of the firm.
Shekhar Aiyar, International Monetary Fund; Charles Calomiris, Columbia University and NBER; John Hooley and Yevgeniya Korniyenko, Bank of England; and Tomasz Wieladek, London Business School
Aiyar, Calomiris, Hooley, Korniyenko, and Wieladek use data on UK banks' minimum capital requirements to study the impact of changes to bank-specific capital requirements on cross-border bank loan supply. By examining a sample in which each recipient country has multiple relationships with UK-resident banks, they are able to control for demand effects, as in Khwaja and Mian (2008). They find a negative and statistically significant effect of changes to banks' capital requirements on cross-border lending: a 100 basis point increase in the requirement is associated with a reduction in the growth rate of cross-border credit of between 3 and 5.5 percentage points. They also find that banks tend to favor their most important country relationships, so that the cross-border credit supply response in "core" countries is significantly less than in others. Furthermore, banks tend to cut back cross-border credit to other banks (including foreign affiliates) more than to firms and households, consistent with shorter maturity, wholesale lending.
Andres Almazan, University of Texas at Austin; Adolfo de Motta, McGill University; and Sheridan Titman, University of Texas, Austin and NBER
Almazan, de Motta, and Titman analyze the financing and liquidation decisions of firms that face a labor market with search frictions. In their model, debt facilitates the process of creative destruction (that is, the elimination of inefficient firms and the creation of new firms) but may induce excessive liquidation and unemployment; in particular, during economic downturns. Within this setting, they examine policy interventions that influence the firms' financing and liquidation choices. Specifically, they consider the role of monetary policy, which can reduce debt burdens during economy-wide downturns, and tax policy, which can influence the incentives of firms to use debt financing.
John Graham, Duke University and NBER; Mark Leary, Washington University in St. Louis; and Michael Roberts, University of Pennsylvania and NBER
Graham, Leary, and Roberts document a substantial shift in capital structures of U.S. corporations over the past century. Unregulated industries increased their aggregate leverage ratio from 11 percent in 1945 to 35 percent in 1970. An increase occurred in all unregulated industries and affected firms of all sizes. The median firm in 1946 had no debt in its capital structure, but had a leverage ratio in excess of 30 percent by 1970 . By contrast, the aggregate leverage ratio of non-financial, regulated corporations was nearly constant. This analysis points to several potential explanations for the observed patterns including: competition for investors' funds, variation in expected default costs, and changes to the tax code.