Corporate Finance

Members of the NBER's Corporate Finance Program met April 12 in Chicago. Research Associates Andrea L. Eisfeldt of University of California, Los Angeles and Victoria Ivashina of Harvard University organized the meeting. These researchers' papers were presented and discussed:

Antonio Falato and Filip Zikes, Federal Reserve Board, and Diana Iercosan, Federal Reserve System [FRS]

Banks as Regulated Traders

Banks use trading as a vehicle to take risk. Using unique high-frequency regulatory data, Falato, Iercosan, and Zikes estimate the sensitivity of weekly bank trading profits to aggregate equity, fixed-income, credit, currency and commodity risk factors. U.S. banks had large trading exposures to equity market risk before the Volcker Rule, which they curtailed afterwards. They also have exposures to credit and currency risk. The results hold up in a quasi-natural experimental design that exploits the phased-in introduction of reporting requirements to address identification. Timing, heterogeneity, and placebo tests further corroborate the results. Counterfactual and stress-test analyses quantify the financial stability implications.

Zhengyang Jiang, Northwestern University, and Arvind Krishnamurthy and Hanno Lustig, Stanford University and NBER

Dollar Safety and the Global Financial Cycle

U.S. monetary policy shocks have an outsized impact on the world economy, a phenomenon that is described by Rey's (2013) "global financial cycle". In contrast, shocks in foreign countries have smaller impacts on the U.S. Jiang, Krishnamurthy, and Lustig build a model to rationalize these facts based on the special demand for dollar safe assets. In the model, dollar safe assets trade at a premium: that is, they offer especially low returns. Banks and firms that have the collateral to issue dollar safe assets can collect this premium. U.S. institutions do so against dollar collateral, while foreign institutions do so against foreign currency collateral, taking on exchange rate risk in the process. U.S. monetary shocks impact the supply of dollar safe assets, affecting dollar safe assets' premium and the dollar's value. This impact transmits across the globe and generates a global risk factor. The researchers present evidence from movements in the Treasury basis to support the mechanism underlying the researchers' theory.

C. Fritz Foley, Harvard University and NBER; Agustin M. Hurtado, University of Chicago; Andres Liberman, New York University; and Alberto Sepulveda, SBIF

The Effects of Information on Credit Market Competition: Evidence from Credit Cards

Foley, Hurtado, Liberman, and Sepulveda investigate the effect of credit information on credit market competition. They first show theoretically how public credit information leads to more credit to borrowers in good standing but less credit to new, relatively riskier borrowers without credit histories. The researchers test the predictions of their model using individual by lender level data for the universe of credit card borrowers in Chile. They compare the initial credit card contracts offered by banks, which share their borrowers' credit histories through credit bureaus, with non-bank issuers, which only share information about borrowers who default and are thus privately informed about their own borrowers who are not in default. Consistent with the predictions of the model, non-bank issuers lend lower amounts to riskier borrowers and increase limits over time, while banks lend higher amounts to safer borrowers. To identify the causal effect of information sharing on ex post competition, the researchers exploit a natural experiment where a non-bank lender's credit card portfolio was sold to a bank. After the transaction, the lender's borrowers receive higher credit limits from other banks. The lender responds by increasing credit limits to existing borrowers and shifts to originating new cards with higher limits to observably safer borrowers. The results imply that public credit information increases competition but can hinder financial inclusion.

Joshua L. Krieger, Harvard University; Danielle Li, MIT and NBER; and Dimitris Papanikolaou, Northwestern University and NBER

Missing Novelty in Drug Development

Krieger, Li, and Papanikolaou provides evidence that risk aversion leads pharmaceutical firms to underinvest in radical innovation. They define a drug candidate as novel if it is molecularly distinct from prior candidates. Using their measure, the researchers show that firms face a risk-reward tradeoff when investing in novel drugs: While novel drug candidates are less likely to be approved by the FDA, they are based on patents with higher indicators of value. The researchers show that-counter to the predictions of frictionless models-firms respond to a plausibly exogenous positive shock to their net worth by developing more of these riskier novel candidates. This pattern suggests that financial market imperfections may lead even large public firms to behave as though they are risk averse, therefore hindering their willingness to invest in potentially valuable novel drugs.

Shai Bernstein and Rebecca Diamond, Stanford University and NBER, and Timothy McQuade and Beatriz Pousada, Stanford University

The Contribution of High-Skilled Immigrants to Innovation in the United States

Bernstein, Diamond, McQuade, and Pousada characterize the contribution of immigrants to U.S. innovation, both through their direct productivity as well as through their indirect spillover effects on their native collaborators. To do so, the researchers link patent records to a database containing the first five digits of 160 million of Social Security Numbers (SSN). By combining this part of the SSN together with year of birth, the researchers identify whether individuals are immigrants based on the age at which their Social Security Number is assigned. They find that over the course of their careers, immigrants are more productive than natives, as measured by number of patents, patent citations, and the economic value of these patents. Immigrant inventors are more likely to rely on foreign technologies, to collaborate with foreign inventors, and to be cited in foreign markets, thus contributing to the importation and diffusion of ideas across borders. Using an identification strategy that exploits premature inventor deaths, the researchers find that immigrants collaborators create especially strong positive externalities on the innovation production of natives, while natives create especially large positive externalities on immigrant innovation production, suggesting that combining these different knowledge pools into inventor teams is important for innovation. A simple decomposition suggests that despite immigrants only making up 16% of inventors, they are responsible for 30% of aggregate U.S. innovation since 1976, with their indirect spillover effects accounting for more than twice their direct productivity contribution.

Jason R. Donaldson, Washington University in St Louis; Denis Gromb, INSEAD; and Giorgia Piacentino, Columbia University

Conflicting Priorities: A Theory of Covenants and Collateral

Debt secured by collateral has absolute priority in the event of default -- it is paid ahead of unsecured debt, even if unsecured debt is protected by negative pledge covenants prohibiting new secured debt. Donaldson, Gromb, and Piacentino develop a model of how this priority rule leads to conflicts among creditors, but can be optimal nonetheless: borrowers' option to use collateral in violation of covenants allows for the dilution of existing debt, and hence prevents under-investment, whereas creditors' option to accelerate debt following a covenant violation deters dilution, and hence prevents over-investment. The optimal investment policy is implementable via a mix of different types of debt, including secured and unsecured debt with tight and loose covenants. The model is consistent with a number of stylized facts about debt structure, covenants, and their violations.

Christopher A. Parsons, University of Washington; Casey Dougal, Drexel University; and Sheridan Titman, University of Texas at Austin and NBER

Urban Vibrancy and Value Creation

City level differences in industry-adjusted Tobin's q, an estimate of the value created for shareholders, are large, and have widened sharply over the last twenty years. Proxies for a city's appeal to high-skill workers, such as existing education rates and favorable weather, are strongly associated with Tobin's q, both in levels and changes. Parsons, Dougal, and Titman's results indicate that shareholders have recently captured a bigger part of the benefits associated with superior locations. The higher stock prices of firms in these locations appear to be driven by future growth opportunities, rather than improvements in current operating efficiency.

Xavier Gabaix, Harvard University and NBER, and Ralph S. J. Koijen, University of Chicago and NBER

Granular Instrumental Variables

In many settings, there is a dearth of instruments, which hampers economists' ability to investigate causal relations. Gabaix and Koijen propose a quite general way to construct instruments: "granular instrumental variables" (GIVs). In the economies studied, a few large firms or countries account for a large share of economic activity. As they are large, their idiosyncratic shocks affect aggregate outcomes. This makes those idiosyncratic shocks valid instruments for the aggregate shocks. The researchers provide a methodology to extract idiosyncratic shocks from the data, this way creating GIVs. Those GIVs allow the researchers to then estimate parameters of interest, including causal elasticities. They first illustrate the idea in the basic supply and demand framework: They achieve a novel identification of supply and demand elasticities, based on idiosyncratic shocks to supply or demand. The researchers then show how the procedure can be adapted to handle many enrichments. They illustrate the procedure in detail with a few applications. First, they measure how shocks to domestic banks causally affect sovereign yields. The researchers document how negative shocks to Italian banks adversely affect Italian government bond yields, and vice-versa. This gives the first causal measure of the "doom loop" between banks and sovereign yields. Second, the researchers study the impact of mega-firms on aggregates, such as aggregate competition (as idiosyncratic shocks to large firms change concentration ratios). This allows the researchers to find a causal relationship between the rise of mega firms and lower investment. This allows for the comparison of the GIV estimate to previous estimates, this way confirming the validity of the approach. Third, GIVs allow for a resolution of the still-open question of how to go from "micro-elasticities" to "macro-elasticities". The researchers study a simple model multi-region model with consumption linkages and pricing frictions. They find that, under some plausible conditions, macro-elasticities are the micro elasticities times the "GDP spillover" M (which indicates how much growth in one region affects growth in other regions), which the GIV method estimates to be about 1.5. Hence, the typical micro-elasticities need only to be multiplied by this M to become macro-elasticities. The researchers conclude that the GIVs are a good candidate to supplement the empirical economists' toolbox.

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