Corporate Finance

April 7-8, 2016
Shai Bernstein of Stanford Graduate School of Business and C. Fritz Foley of Harvard University, Organizers

Adriano A. Rampini and S. Vish Viswanathan, Duke University and NBER, and Guillaume Vuillemey, HEC Paris

Risk Management in Financial Institutions

Rampini, Viswanathan, and Vuillemey study risk management in financial institutions using data on hedging of interest rate risk by U.S. banks and bank holding companies. Theory predicts that more financially constrained institutions hedge less and that institutions whose net worth declines due to adverse shocks reduce hedging. The researchers find strong evidence consistent with the theory both in the cross-section and within institutions over time. For identification, they exploit net worth shocks resulting from loan losses due to drops in house prices. Institutions which sustain such losses reduce hedging substantially relative to otherwise similar institutions. The authors find no evidence that risk shifting, changes in interest rate risk exposures, or regulatory capital explain hedging behavior.

Francesco D'Acunto, University of Maryland; Ryan Liu, University of California at Berkeley; Carolin Pflueger, University of British Columbia; and Michael Weber, University of Chicago

Flexible Prices and Leverage

The frequency with which firms adjust output prices is an important determinant of persistent differences in capital structure across firms. D'Acunto, Liu, Pflueger, and Weber show the most flexible-price firms have a 19% higher long-term financial leverage than the most inflexible-price firms, controlling for known determinants of capital structure. The researchers rationalize this novel fact in a costly-state-verification model, in which inflexible-price firms are more exposed to aggregate shocks, and face tighter financial constraints. In the model, bank lending relaxes financial constraints through monitoring and narrows the gap in financial leverage between inflexible- and flexible-price firms. Consistently, inflexible-price firms increased leverage more than flexible-price firms following the staggered implementation of the Interstate Bank Branching Efficiency Act across states and over time, which the authors use in a triple-differences identification strategy. Firms' frequency of price adjustment did not change around the deregulation.

Marieke Bos, Stockholm University; Emily L. Breza, Columbia University; and Andres Liberman, New York University

The Labor Market Effects of Credit Market Information

One function of public credit registries is to impose costs on defaulters. Bos, Breza, and Liberman exploit detailed data matching credit and labor market outcomes in Sweden and a policy change that provides quasi-experimental variation in the time information on past defaults remains publicly available to document an economically large cost of default in the labor market. When information on past defaults is removed earlier, an individual is more likely to have a job, is less likely to be self-employed, and earns a higher income. The employment cost of default may increase borrower repayment incentives and help sustain uncollateralized consumer credit markets, but may also amplify negative shocks, particularly for vulnerable households.

Mark L. Egan, University of Minnesota, and Gregor Matvos and Amit Seru, University of Chicago and NBER

The Market For Financial Adviser Misconduct (NBER Working Paper No. 22050)

Egan, Matvos, and Seru construct a novel database containing the universe of financial advisers in the United States from 2005 to 2015, representing approximately 10% of employment of the finance and insurance sector. Roughly 7% of advisers have misconduct records. At some of the largest financial advisory firms in the United States, more than 15% of advisers have misconduct records. Prior offenders are five times as likely to engage in new misconduct as the average financial adviser. Firms discipline misconduct: approximately half of financial advisers lose their job after misconduct. The labor market partially undoes firm-level discipline: of these advisers, 44% are reemployed in the financial services industry within a year. Reemployment is not costless. Following misconduct, advisers face longer unemployment spells, and move to less reputable firms, with a 10% reduction in compensation. Additionally, firms that hire these advisers also have higher rates of prior misconduct themselves. The researchers find similar results for advisers of dissolved firms, in which all advisers are forced to find new employment independent of past misconduct or performance. Firms that persistently engage in misconduct coexist with firms that have clean records. The authors show that differences in consumer sophistication may be partially responsible for this phenomenon: misconduct is concentrated in firms with retail customers and in counties with low education, elderly populations, and high incomes. The researchers' findings suggest that some firms "specialize" in misconduct and cater to unsophisticated consumers, while others use their clean reputation to attract sophisticated consumers.

Pedro Bordalo, University of London; Nicola Gennaioli, Università Bocconi; and Andrei Shleifer, Harvard University and NBER

Diagnostic Expectations and Credit Cycles

Bordalo, Gennaioli, and Shleifer present a model of credit cycles arising from diagnostic expectations — a belief formation mechanism based on Kahneman and Tversky's (1972) representativeness heuristic. In this formulation, when revising their beliefs agents overweight future outcomes that have become more likely in light of incoming data. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. Diagnostic expectations exhibit excess volatility, over-reaction to news, and systematic reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

Joshua D. Gottlieb, University of British Columbia and NBER; Richard Townsend, Dartmouth College; and Ting Xu, University of British Columbia

Experimenting with Entrepreneurship: The Effect of Job-Protected Leave

Do potential entrepreneurs remain in wage employment because of the danger that they will face worse job opportunities should their entrepreneurial ventures fail? Gottlieb, Townsend, and Xu examine empirically whether granting employees extended leaves of absence, during which they are guaranteed the option to return to their previous job, increases entry into entrepreneurship. The researchers exploit a Canadian reform in 2000 that guaranteed extended job-protected leave of up to one year for women giving birth after a cutoff date. Using a regression discontinuity design, they find that the increase in job-protected leave increases the probability of becoming an entrepreneur by approximately 1.8%. The results are not driven by inconsequential businesses that quickly fail — the marginal entrepreneurs spurred to enter by the reform tend to hire paid employees. The effect is stronger for individuals with more human and financial capital as well as for individuals starting businesses in industries where experimentation is more important. Overall, the researchers conclude that career considerations are a major factor inhibiting entry into entrepreneurship.

Peter Koudijs, Stanford University and NBER, and Laura Salisbury, York University and NBER

Bankruptcy and Investment: Evidence from Changes in Marital Property Laws in the U.S. South, 1840-1850 (NBER Working Paper No. 21952)

Koudijs and Salisbury study the impact of a form of bankruptcy protection on household investment in the U.S. South in the 1840s, which pre-dated modern bankruptcy laws. During this period, a number of southern states passed laws that protected married women’s property from seizure in the case of insolvency, a departure from the common law default which vested a wife's property in her husband and thus allowed it to be seized for the repayment of his debts. Importantly, these laws only applied to newlyweds. The researchers compare couples married after the passage of a law with couples from the same state who married before the passage of a law. Since states passed laws at different points in time, the authors can exploit variation in protection conditional on state and year of marriage. They find that the effect on household investment was heterogeneous: if most household wealth came from the husband (wife), the law led to an increase (decrease) in investment. This is consistent with a simple model where downside protection leads to both an increase in the demand for credit and a reduction in supply. Demand effects will only dominate if a modest fraction of total wealth is protected.

Rick Harbaugh and John W. Maxwell, Indiana University, and Kelly Shue, University of Chicago and NBER

Consistent Good News and Inconsistent Bad News

Good news is more persuasive when it is more consistent, and bad news is less damaging when it is less consistent. Harbaugh, Maxwell, and Shue show when Bayesian updating supports this intuition so that a biased sender prefers more or less variance in the news depending on whether the mean of the news exceeds expectations, and they apply the result to selective news distortion by a manager of multiple projects. If news from the different projects is generally good, boosting relatively bad projects increases consistency across projects and provides a stronger signal that the manager is skilled. But if the news is generally bad, instead boosting relatively good projects reduces consistency and provides some hope that the manager is unlucky rather than incompetent. The authors test for evidence of such distortion by examining the consistency of reported segment earnings across different units in firms. As predicted by the model, they find that firms report more consistent earnings when overall earnings are above rather than below expectations. Firms appear to shift the allocation of overhead and other costs to help relatively weak units in good times and relatively strong units in bad times. The mean-variance news preferences that the researchers identify apply in a range of situations beyond their career concerns application, and differ from standard mean-variance preferences in that more variable news sometimes helps and better news sometimes hurts.

Erik Stafford, Harvard University

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

Stafford examines how private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge estimated fees of 5% per year.

Viral Acharya, Thomas Philippon, and Matthew Richardson, New York University and NBER

Measuring Systemic Risk for Insurance Companies

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