Knowledge that Transforms

While operational risk is generally perceived as idiosyncratic with limited systemic implications, we document that operational risk threatens financial stability. Using supervisory data on large U.S. Bank Holding Companies (BHCs), we find operational losses increase systemic risk through a direct channel that impairs market values of loss-experiencing BHCs as well as a channel of correlated losses that impact multiple institutions simultaneously. Findings are driven by tail events, more pronounced for systemically important and closer-to-distress BHCs, and vary by business lines, event types, and financial/economic environments. Our results extend the operational and systemic risk literatures and have key policy implications.

Using loan-level data from the Mexican credit registry, we evaluate how bank characteristics affect the transmission of domestic and foreign shocks to credit supply. We find that banks with higher capital, liquidity, profitability, long-term funding and deposit funding show a smaller response to shocks. By contrast, banks with high credit risk and foreign funding show a larger response. Second, foreign banks respond more sensitively to shocks compared to domestic banks. Finally, the credit supply to firms that are small, have higher credit risk and weak banking-relationships shows a larger response to shocks. The evolution of bank characteristics in Mexico, through the lens of these results, has strengthen the resilience of its financial system.

In 2015 the Tokyo Stock Exchange (TSE) implemented Arrowhead Renewal improvements (ARI) that reduced latency from about one millisecond to less than 0.5 ms. Simultaneously, the ARI introduced new risk management functions to improve market fairness by reducing manipulative trading strategies. We find a dramatic improvement in market fairness as proxied by marking-the-close incidents, which declined by 61.19%. We find a much smaller improvement in market efficiency. Specifically, there was a reduction in the effective (quoted) spread of 6.45% (5.79%). The most dramatic improvement in market quality (fairness and efficiency) was for low-tick-size and high-market-capitalization stocks.

We examine how bank-specific capital requirements affect banks’ capital ratios and balance sheet composition over the period 1989-2013. We find that higher requirements, even when not binding in a regulatory sense, result in higher bank capital ratios, achieved by a combination of asset contraction, risk reduction and capital raising strategies. We find that after the 2007-09 financial crisis, banks place greater emphasis on raising capital, but that they continue to focus first on raising lower-quality capital. Our results have implications for evaluating the efficacy of bank-specific capital requirements as a policy tool to influence bank balance sheet behavior and resilience.

Natural catastrophe risk is increasingly being covered through alternative capital instead of reinsurance. Since most such instruments do not trade in an active market, their ongoing valuation is a challenge. As a solution, we propose to exploit pricing information embedded secondary market catastrophe bond quotes. Specifically, we use a reduced form model to extract implied Poisson intensities from regularly observed prices. Next, we show that the intensities can be explained by time to maturity and modeled probability of first loss. Along these two dimensions, we estimate smooth intensity surfaces that allow investors to mark illiquid catastrophe risk positions to market.

We analyze the impact of the Dodd–Frank Act on the shareholder wealth gains using a sample of 640 completed U.S. M&As announced between 1990 and 2014. Our results indicate a positive DFA effect on announcement period abnormal returns in small bank mergers. In fact, mergers with combined firm assets of less than $10 billion create more shareholder value after the DFA, than ever before. This positive announcement effect in small deals appears to be linked with merger-related compliance cost savings and profitability improvements. By examining long-run abnormal returns, we find that the documented DFA effect on small deals announcement abnormal returns does not disappear overtime. Finally, we do not find such effects for non-U.S. bank M&As over the same period.

Examining a sample of U.S. commercial loans originated between 1996 and 2017, we find that the propensity to employ performance pricing provisions (PPPs) in private loan contracts increases by about 10% when lenders are dual holders, that is, when they simultaneously hold equity in the borrowing firm. This finding supports the monitoring efficiency channel and is robust after accounting for the endogeneity bias from lenders’ dual holding. We also observe a substitution effect between PPP usage and covenant tightness, and the strength of this effect in dual-holder loans varies between spread-increasing and spread-decreasing PPPs. Borrowers of dual-holder loans are more likely to improve their accounting performance within one year of loan origination. These findings are consistent with dual holders’ incentive alignment role, which helps reduce monitoring costs, improve lenders’ monitoring effectiveness, and promote managerial flexibility.

This study demonstrates that Chinese stock mutual funds exhibit persistent preference for growth stocks over value stocks. Despite the positive premium of value stocks over growth stocks, funds in aggregate manage to beat the market. Moreover, growth-oriented funds do not underperform their value-oriented peers. To solve these puzzles, we provide evidence for funds’ superior skill in picking growth stocks over value stocks, and conclude that such skill helps explain their growth tilt. Furthermore, we show that mutual funds trade against the retail investors, more so in growth stocks than in value stocks. Coupled with our finding that retail investors make more mistakes trading growth stocks than trading value stocks, we conclude that mutual funds optimize their information production to focus more on growth stocks so as to maximize returns.

This paper investigates the impact of loan renegotiations on firms’ credit risk using the CDS market as a measure of credit risk. Using a sample of public US firms for 2010–2017, we document a significant decrease in CDS spreads and returns that we interpret as evidence of a certification effect. The finding suggests that the loan renegotiations are on average beneficial for the firm. The strongest reactions are for material amendments such as line of credit amount or tranche amount. Additionally, we find negative stock market returns, although barely statistically significant. Moreover, we identify an anticipation effect of up to 30 days before the announcement date on the CDS market, possibly due to informed trading by CDS banks of their speculative-rated borrowers’ CDS contracts. Finally, we show that firm-specific CDS returns lead idiosyncratic stock returns, especially around the announcement date and for speculative-rated firms.

We study the link between industrial policy and asset prices by using the Made in China 2025 industrial policy, announced in May 2015, as an external shock. We track Chinese firms and U.S. firms in ten high-tech industries targeted by the policy. In the short run, stock prices, measured by cumulative abnormal returns (CARs), increase significantly for both Chinese and U.S. firms, by 9.9% and 1.4%, respectively. However, in the long run, Chinese firms’ CARs drop heavily, while U.S. firms’ CARs continually increase. We further find that after the policy announcement, Chinese firms’ profitability declines dramatically by an average of 52.9% and firms’ leverage increase significantly, but they do not receive additional government subsidies. We conclude that the policy only boosts market reaction in the short run but does not promote targeted industries longer term.