Knowledge that Transforms

We examine the impact of the Global Settlement on affiliation bias in analyst recommendations. Using a broad measure of investment bank-firm relationships, we find a substantial reduction in analyst affiliation bias following the settlement for sanctioned banks. In contrast, we find strong evidence of bias both before and after the settlement for affiliated analysts at non-sanctioned banks. Our results suggest that the settlement led to an increase in the expected costs of issuing biased coverage at sanctioned banks, while concurrent self-regulatory organization rule changes were largely ineffective at reducing the influence of investment banking on analyst research at large non-sanctioned banks.

We exploit a novel natural experiment to establish a causal relation between media attention and consumer investment behavior, independent of the conveyed information. Our findings indicate a 31% local average increase in quarterly capital flows into mutual funds mentioned in a prominent Wall Street Journal “Category Kings” ranking list, compared to those funds which just missed making the list. This flow increase is about seven times larger than extra flows due to the well-documented performance-flow relation. Other funds in the same fund complex receive substantial extra flows as well, especially in smaller complexes. There is no increase in flows when the Wall Street Journal publishes similar lists absent the prominence of the Category Kings labeling. We show mutual fund managers react to the incentive created by the media effect in a strategic way predicted by theory, and present evidence for the existence of propagation mechanisms including increased fund complex advertising subsequent to having a Category King and increased efficacy of subsequent fund media mentions.

Institutions often offer a menu of contracts to consumers in an attempt to create a separating equilibrium that reveals borrower types and provides better pricing. We test the effectiveness of a specific set of contracts in the mortgage market: mortgage points. Points allow borrowers to exchange an upfront amount for a decrease in the mortgage rate. We document that, on average, points takers lose about $700. Also, points takers are less financially savvy (less educated, older), and they make mistakes on other dimensions (e.g., inefficiently refinancing their mortgages). Overall, our results show that borrowers overestimate how long they will stay with the mortgage.

This paper exploits a novel hand-collected data set to provide a comprehensive analysis of the social relationships that underlie illegal insider trading networks. I find that inside information flows through strong social ties based on family, friends, and geographic proximity. On average, inside tips originate from corporate executives and reach buy-side investors after three links in the network. Inside traders earn prodigious returns of 35% over 21 days, with more central traders earning greater returns, as information conveyed through social networks improves price efficiency. More broadly, this paper provides some of the only direct evidence of person-to-person communication among investors.

We quantify the effects of easy-to-read disclosure documents on firm value by analyzing shareholder reports of closed-end investment companies in which the company's value can be estimated separately from the value of the company's underlying assets. Using a copy-editing software application that counts the pervasiveness of the most important ‘writing faults’ that make a document harder to read, our analysis provides evidence that issuing financial disclosure documents with low readability causes firms to trade at significant discounts relative to the value of their fundamentals. Our estimates suggest that a one-standard-deviation decrease in readability decreases firm value by a full 2.5%. In situations in which investors are more likely to rely on annual reports, the readability effect on firm value increases to 3.3%.

This paper challenges the view that foreign investors lead firms to adopt a short-term orientation and forgo long-term investment. Using a comprehensive sample of publicly listed firms in 30 countries over the period 2001–2010, we find instead that greater foreign institutional ownership fosters long-term investment in tangible, intangible, and human capital. Foreign institutional ownership also leads to significant increases in innovation output. We identify these effects by exploiting the exogenous variation in foreign institutional ownership that follows the addition of a stock to the MSCI indexes. Our results suggest that foreign institutions exert a disciplinary role on entrenched corporate insiders worldwide.

This paper examines the impact of stock liquidity on firm bankruptcy risk. Using the Securities and Exchange Commission decimalization regulation as a shock to stock liquidity, we establish that enhanced liquidity decreases default risk. Stocks with the highest default risk experience the largest improvements. We find two mechanisms through which stock liquidity reduces firm default risk: improving stock price informational efficiency and facilitating corporate governance by blockholders. Of the two mechanisms, the informational efficiency channel has higher explanatory power than the corporate governance channel.

Do financial derivatives enhance or impede innovation? We answer this question by examining the relationship between equity options markets and standard measures of firm innovation. We find that firms with more options trading activity generate more patents and patent citations per dollar invested in research and development (R&D), after accounting for other confounding factors. These results are confirmed when we use a propensity score matching procedure and an instrumental variable approach to control for the potential endogeneity of options trading. The evidence is consistent with the notion that the enhanced informational efficiency induced by options leads to an improved allocation of corporate resources. We further discuss possible underlying economic mechanisms through which more active options markets boost innovation and show that the effect remains substantial even after controlling for these mechanisms. Considering the average increase in the dollar volume of options traded for our sample firms, we conclude that a 200% move in options volume increases firm innovation by about 31%.

Labor restructuring is a key driver of takeovers and the associated synergy gains worldwide. In a difference-in-differences research design, we show that major increases in employment protection reduce takeover activity by 14–27% and the combined firm gains (synergies) by over half. Consistent with the labor channel behind these effects, deals with greater potential for workforce restructuring show a greater reduction in volume, number, and synergies. Increases in employment protection impede layoffs, resulting in wage costs that match the magnitude of synergy losses. Offer prices are not fully adjusted, with both bidders and targets exhibiting lower returns following the reforms.

Why does the market discipline that financial intermediaries face seem too weak during booms and too strong during crises? This paper shows in a general equilibrium setting that rollover risk as a disciplining device is effective only if all intermediaries face purely idiosyncratic risk. However, if assets are correlated, a two-sided inefficiency arises: Good aggregate states have intermediaries taking excessive risks, while bad aggregate states suffer from costly fire sales. The driving force behind this inefficiency is an amplifying feedback loop between asset values and market discipline. In equilibrium, financial intermediaries inefficiently amplify both positive and negative aggregate shocks.