Knowledge that Transforms

The recent financial crisis caused a shock to private wealth. Households with low financial literacy are less likely to own risky assets directly. Therefore, fewer of them report financial losses. More importantly, financially illiterate households are more prone to sell assets that have lost in value. Thereby losses become permanent, and these households do not participate in markets’ resurgence. This flight from risky assets is persistent—the financial crisis may prove to be a traumatic experience that shapes investment behavior and gives rise to serious distributional consequences, as households with lower financial literacy face lower returns in the long run.

Using a portfolio choice model, we derive the optimal demand for stocks, bonds, annuities, and term life insurance for a retired couple with uncertainty in both lifetimes. We show that the optimal portfolio is heavily weighted with joint annuities and that life insurance is purchased mainly to protect a surviving spouse from loss of annuitized income rather than for bequest. Consistent with these predictions, empirical analyses on Health and Retirement Study data indicate that life insurance holdings are related to the degree of asymmetry in the couple’s annuitized income distribution.

This article shows that former investment bankers become important clients for their previous employers and also provide access to profitable business opportunities to their new private equity employers through their previous employment networks. I observe 1,326 individuals directly involved in 1,285 transactions, of whom a large majority have changed their occupation from financial advisor to private equity professional. The social networks arising from these labor market movements affect private equity firms’ choices of financial advisors, as well as the sourcing, pricing, and performance of deals.

We evaluate US firms’ leverage determinants by studying how firms paid for 2,073 very large investments between 1989 and 2006. This approach complements existing empirical work on capital structure, which typically estimates regression models of leverage for a broad set of firms. Because large investments are mostly externally financed, security issuances should provide information about managers’ attitudes toward leverage. We find that issued securities move firms toward target debt ratios. Firms also tend to issue more equity following a share price run-up, consistent with both the tradeoff hypothesis and managerial efforts to time market sentiment. We find little support for the standard pecking order hypothesis.

We argue that salience—the extent to which a cost is visible and difficult to ignore—may have economically significant effects on homeowners’ borrowing behavior, through a bias toward less salient but more expensive loans. We first use a simple model to show that the presence of some biased consumers in the market will affect equilibrium prices. Next, we show that market data support the predictions of the model. We conduct several robustness checks to address unobserved heterogeneity. The observed effect is large. We finally report a survey evidence consistent with this bias.

The anomalies literature in capital markets research in finance and accounting is based (almost) exclusively on average realized returns. In contrast, we construct accounting-based expected returns for dollar-neutral long-short trading strategies formed on a wide array of anomaly variables, including book to market, size, composite issuance, net stock issues, abnormal investment, asset growth, investment to assets, accruals, earnings surprises, failure probability, return on assets, and short-term prior returns. Our findings are striking. Except for the value and the size premiums, the cost of equity estimates differ drastically from the average realized returns.

We show that lenders make price concessions for the right to resell loans and reveal a strong countervailing association between the ex ante probability of loan resale and the initial loan spreads. We disentangle the side effects (reduced monitoring) from the benefits (enhanced liquidity) brought by the secondary loan resales. The average net impact of simultaneously reducing the probability of the presence of resale constraint and raising the probability of resale across the full sample is to lower spreads by 14 basis points. On balance, the secondary loan market provides clear benefits to the issuers of debt.

Using a unique data set on French firms, we show that credit constrained firms that face liquidity shocks are more likely to default on their payments to suppliers. Credit constrained firms pass on a sizeable fraction of such shocks to their suppliers. This is consistent with the idea that firms provide liquidity insurance to each other and that this mechanism is able to alleviate credit constraints. We show that the chain of defaults stops when it reaches unconstrained firms. Liquidity appears to be allocated from firms with access to outside finance to credit constrained firms along supply chains.

Remuneration systems in the banking industry, in particular bonus payments, have frequently been blamed for contributing to the buildup of risks leading to the recent financial crisis. In our model, banks compete for managerial talent that is private information. Competition for talent sets incentives to offer bonuses inducing risk-taking that is excessive not only from society’s perspective but also from the viewpoint of the banks themselves. In fact, bonus payments and excessive risk-taking are increasing with competition. Thus, our model offers a rationale why bonuses are paid even when reducing the expected profits of banks.

This article examines how accounting transparency and corporate governance interact. Firms with better governance are associated with higher abnormal returns, but even more so if they also have higher transparency. The effect is largely monotonic—it is small and insignificant for opaque firms and large and significant for transparent firms—and survives numerous robustness tests. We find supportive evidence for firm value and operating performance. Hence, governance and transparency are complements. This complementarity effect is consistent with the view that more transparent firms are more likely takeover targets, because acquirers can bid more effectively and identify synergies more precisely.