Knowledge that Transforms

Why did the failure of Lehman Brothers make the financial crisis dramatically worse? Our answer is that the financial crisis was a process of a build-up of risk during the crisis prior to the Lehman failure. During the crisis market participants tried to preserve an option to withdraw by shortening maturities — the “flight from maturity”. We show that the flight from maturity was manifested in a steepening of the term structures of spreads in money markets. With increasingly short maturities, lenders created the possibility of fast exit. The failure of Lehman Brothers was the tipping point of this build-up of systemic fragility. A crisis is a dynamic process in which “tail risk” is endogenous.

Whether an inversion is associated with weaker firm governance is an open empirical question. While many inversions happen to countries that offer weaker protection to minority shareholders than the U.S., most firms that invert continue to be treated by the SEC as an “U.S. issuer”, and thus, their shareholders benefit from the full protection offered by the U.S. Federal Securities Laws. Our analysis shows that firms that invert exhibit an increase in their stock illiquidity, information asymmetries, and a decrease in their institutional shareholdings, indicating a weaker market-based governance following the inversion. Executives also receive a smaller proportion of equity-based compensation and their wealth is less sensitive to stock prices following the inversion. Thus, despite enjoying the full protection of federal securities laws, investors perceive inverted firms to have weaker governance relative to comparable U.S. firms.

How does management insulation from shareholder pressure influence banks’ resilience to crises? To address this question, we develop a measure of management insulation based on legal provisions. Unlike the existing alternatives, our measure considers the interactions between different provisions. We use this measure to study the relationship between management insulation and bank failure during the 2007–09 financial crisis. We find that banks in which managers were more insulated from shareholders in 2003 were less likely to be both bailed out in 2008/09 and targeted by activist shareholders. By contrast, alternative measures of management insulation fail to predict both bailouts and shareholder activism.

Regulators are concerned that large volumes of trading outside lit venues (i.e., dark trading) harms the functioning of financial markets. In contrast, regulators are neutral about hidden-order trading as these occur on lit venues and are associated with positive effects on market quality. An unanswered economic question concerns the interrelation between these two types of opaque trading, i.e., hidden orders and dark trading. Employing two different empirical methodologies we find that dark and hidden-order trading are substitutes. We also show that both types of opaque trading increase when markets are volatile and fewer algorithmic trading occurs. Smart order routing increases dark trading but reduces hidden-order activity.

When banks are hit by a severe liquidity shock, central banks have a key role as lenders of last resort. Despite the well-established importance of this mechanism, it is challenging to analyze it empirically. We explore a unique setting in which banks suddenly lost access to market funding due to contagion fears at the onset of the euro area sovereign debt crisis. Using monthly data at the loan, bank, and firm level, we test the role of the central bank in a scenario of imminent collapse. We find that the liquidity obtained from the central bank played a key role in temporarily supporting the supply of credit to the real economy. However, the subdued loan demand, together with moral suasion and carry trade incentives, led to an increase in banks’ sovereign bond holdings using central bank funding.

Some regulators grant contingent convertible bonds (CoCos) the status of “going-concern” capital. Theory, however, suggests that CoCos can induce debt overhang, thereby amplifying the leverage ratchet effect. In this paper, we provide empirical evidence consistent with this theory. Our results suggest that banks with more volatile assets (riskier banks) (i) are less likely to issue CoCos, (ii) conditional on having CoCos outstanding are less likely to issue equity, and (iii) prefer issuing equity over CoCos. Since riskier banks suffer from more debt overhang it is more costly for them to issue CoCos.

This paper studies the effects of the bank capital requirements imposed by the European authorities in October 2011 on loan collateral and personal guarantees usage to enhance capital ratios. We use detailed information on the loan contracts granted by a representative Spanish bank and several subsidiaries to nonfinancial corporations around that date. We document that personal guarantees usage increases more than that of collateral, especially at subsidiaries with lower capital ratios. However, although the former type of guarantees demonstrably disciplined firms in their risk-taking before 2011, their subsequent overuse may have blunted their impact and may have even undermined firm performance and investment.

We present a screening model of the risk sensitivity of bank capital regulation. A banker funds a project with uninsured deposits and costly capital. Capital resolves a moral hazard problem in the choice of the probability of default (PD). The project’s loss given default (LGD) is the banker’s private information. The regulator receives a noisy signal about the LGD and imposes a minimum capital requirement. We show that the optimal sensitivity of capital regulation is non-monotonic in the accuracy of risk assessment. If the signal is inaccurate, the regulator should use risk-insensitive capital requirements. Given sufficient accuracy, the regulator should separate types via risk-sensitive capital requirements, reducing the risk-sensitivity of bank capital as accuracy improves.

We provide a microfounded framework for the welfare analysis of macroprudential policy within a model of rational bubbles. For this, we posit an overlapping generation model where productivity and credit supply are subject to random shocks. We find that when real interest rates are lower than the rate of growth, credit financed bubbles may be welfare improving because of their role as a buffer in channeling excessive credit supply and inefficient investment at the firms’ level, but their sudden price decrease may cause a systemic crisis. Therefore, a well designed macroprudential policy plays a key role in improving efficiency while preserving financial stability. Our theoretical framework allows us to compare the efficiency of alternative macroprudential policies. Contrarily to conventional wisdom, we show that macroprudential policy (i) may be efficient even in the absence of systemic risk, (ii) has to be contingent on productivity shocks and (iii) must be contingent upon the level of real interest rates.

We analyze the financial leverage of firms that collude to soften product market competition by forming a cartel. We find that cartel firms have lower leverage during collusion periods. This is consistent with the idea that cartel firms strategically reduce leverage to make their cartels more stable, because high leverage makes deviations from a cartel agreement more attractive. Given that cartels have a large economic footprint, their study is also relevant for the capital structure literature, which has largely ignored the role of anti-competitive behavior.