Knowledge that Transforms

Buy-and-hedge intermediaries are important investors in the convertible bond market as they intermediate between firms that require capital quickly and investors requiring time to assess the security. Their strategy requires them to manage the trade-offs involved with the costs and benefits of hedging. We find that prices of convertible securities reflect the costs that intermediaries incur when managing their positions. Especially cross-sectional and within-bond variation of intermediaries’ loan costs helps explain variation in convertible bond underpricing.

We develop a model in which credit ratings are endogenously coarse relative to the underlying default probabilities, and ratings precision is countercyclical. Ratings coarseness arises from the profit-maximizing behavior of rating agencies, and coarseness may maximize welfare even when greater ratings precision is costlessly available. Because the private outcome may differ from the socially desirable outcome, a social planner can improve welfare by putting a ceiling (floor) on the rating agency’s fee if the desired outcome is coarseness (precision). Strikingly, when information production is costless, ratings coarseness is socially optimal, but it does not arise in the laissez-faire equilibrium, thus inviting regulatory intervention.

Private equity (PE) managers are required to invest their own money in the funds they manage. We examine the incentive effects of this ownership on the delegated acquisition decision. A simple model shows that PE managers select less risky firms and use more debt, the higher their ownership. We test these predictions for a sample of Norwegian PE funds, using managers’ wealth to capture their relative risk aversion. As predicted, the target company’s cash-flow risk decreases and leverage increases with the manager’s ownership scaled by wealth. Moreover, the overall portfolio risk decreases with ownership, mitigating widespread concerns about excessive risk-taking.

I study a registry-based dataset of Swedish mutual fund managers’ personal portfolios. The majority of managers do not invest personal wealth into the very same funds they professionally manage. The managers who do invest personal money into their funds subsequently outperform the managers who do not. The results suggest that fund managers, in contrast to regular investors, are certain about their ability to generate an abnormal return, or lack thereof, and invest their personal wealth accordingly.

We document that reliance on internal ratings-based (IRB) models to compute credit risk and capital requirements reduces bank opacity. Greater reliance on IRB models is associated with lower absolute forecast error and reduced disagreement among analysts regarding expected bank earnings per share. These results are stronger for banks that apply internal ratings to the most opaque loans and adopt the advanced version of IRB models, which entail a more granular risk assessment and greater disclosure of risk parameters. The results stem from the higher earnings informativeness and the more comprehensive disclosure of credit risk in banks adopting internal ratings. We employ an instrumental variables approach to validate our findings.

Firms insure themselves from liquidity shocks by contracting on credit lines from banks. I document novel empirical evidence on how the risk of contract nonperformance by banks is priced. Firms pay a higher price for loan commitments from safer banks. A one standard deviation increase in the cross-sectional mean of bank capital increases the commitment fees by 5%. To investigate a potential causal effect of lender stability on commitment fees, I exploit exogenous variation in the market value of banks’ assets from natural disasters. The sensitivity of the fees is higher for firms with higher short-term liabilities and higher income uncertainty.

Increasing the cost associated with gathering information can hamper the monitoring activity of the market even when information remains public. Using the 2015 US money market funds (MMFs) reform as a quasi-natural experiment, I find a positive effect of removing information requirements over credit ratings on the allocation by MMFs toward securities rated as second tier. The effect is driven by monitored MMFs catering to retail investors and by monitored MMFs that do not voluntarily report credit ratings after the reform. The verfied increase in the relative demand by MMFs for second tier securities is associated with a decrease in the spread paid at issuance by second tier commercial paper.

Relying on confidential supervisory data related to the 2016 EU-wide stress test, this paper presents novel empirical evidence that supervisory scrutiny associated to stress testing has a disciplining effect on bank risk. We find that banks that participated in the 2016 EU-wide stress test subsequently reduced their credit risk relative to banks that were not part of this exercise. Relying on new metrics for supervisory scrutiny that measure the quantity, potential impact, and duration of interactions between banks and supervisors during the stress test, we find that the disciplining effect is stronger for banks subject to more intrusive supervisory scrutiny during the exercise. We also find that a strong risk management culture is a prerequisite for the supervisory scrutiny to be effective. Finally, we show that a similar disciplining effect is not exerted neither by higher capital charges nor by more transparency and related market discipline induced by the stress test.

We use Call Report data to examine the effects of the Paycheck Protection Program (PPP) and the PPP Liquidity Facility (PPPLF) on small business and farm lending by individual commercial banks. As program participation was associated with small business lending, we adopt an instrumental variables approach to identify causal implications based on historical bank relationships with the Small Business Administration and the Federal Reserve’s discount window. Our results indicate that both programs encouraged lending growth over the first half of 2020. However, while the PPP encouraged greater lending across all banks, only small and medium-sized bank lending growth was significantly related to participation in the PPPLF.

We assemble a unique dataset containing population-level information on loan applications in a region hosting two cultural groups to study the role of culture in firm borrowing decisions. We find that firms are more likely to apply for loans from culturally close banks. This effect is stronger for opaque firms, but not for less performing firms, indicating that firms do not expect preferential treatment from same-culture banks. Loan applications to culturally distant banks increase sharply with firms’ size and age, suggesting a role of information asymmetry in firm-bank matching. In contrast, we find no effect of cultural proximity on loan supply. Overall, our results show that demand-side factors play a key role in the formation of same-culture lending relationships.