Knowledge that Transforms

This paper shows that firms with longer rating agency relationships have better credit ratings, conditional on observables. The paper also finds that (1) controlling for observables, firms with longer relationships, while having higher average ratings, do not have lower default rates, (2) relationship benefits are larger among firms with a greater incentive to game their information supplied to agencies or to pressure agencies into giving higher ratings, and (3) investors demand a (price) discount on bonds sold by relationship firms and the correlation between bond yield spreads and ratings is decreasing with relationship length. In sum, the evidence is inconsistent with first-order credit quality explanations but rather supports a “learning-to-gaming” and an “adverse incentives” story.

This paper investigates the role of banking supervision in controlling bank risk. Banking supervision is measured in terms of enforcement outputs (i.e., on-site audits and sanctions). Our results show an inverted U-shaped relationship between on-site audits and bank risk, while the relationship between sanctions and risk appears to be linear and negative. We also consider the combined effect of effective supervision and banking regulation (in the form of capital and market discipline requirements) on bank risk. We find that effective supervision and market discipline requirements are important and complementary mechanisms in reducing bank fragility. This is in contrast to capital requirements, which prove to be rather futile in controlling bank risk, even when supplemented with a higher volume of on-site audits and sanctions.

Existing theories advocate the exclusive use of equity-like instruments in executive compensation. However, recent empirical studies document the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also firm value in bankruptcy. Contrary to intuition, granting the manager equal proportions of debt and equity is typically inefficient. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as alleviate the agency costs of debt. The model generates a number of empirical predictions consistent with recent evidence.

We document that the deregulation of bank branching restrictions in the United States triggered a reallocation across sectors, with end effects on state-level volatility. The change cannot be explained simply by shifts in sector-level returns and volatility. A reallocation effect is at play, which we study in the context of mean-variance portfolio theory applied to sectoral returns. We find the reallocation is particularly strong in sectors characterized by young, small and external finance dependent firms, and for states that have a larger share of such sectors. The findings suggest that improving bank access to branching affects the sectoral specialization of output, in a manner that depends on the variance-covariance properties of sectoral returns, rather than on their average only.

A key distinction between some models of IPO pricing (e.g., auctions and bookbuilding) and others (e.g., fixed-priced models) is whether price discovery occurs in the primary or secondary market. Higher investment bank reputation is associated with 1) more active filing price revisions and 2) reduced secondary market volatility, indicating greater resolution of uncertainty before trading begins. Revisions of nonreputable banks cluster on exactly zero dollars. Finally, the “partial adjustment” phenomenon – often attributed to information aggregation – is primarily due to the behavior of reputable underwriters. We conclude that theoretical models of primary market information aggregation are better suited for reputable underwriters.

This paper derives optimal lifecycle asset allocations for consumers who select work hours and retirement ages given uncertain labor income and investment returns. These shocks shape retirement and asset allocation patterns in complex ways: negative labor market shocks and high stock returns influence the young to work less and buy more annuities, and later, to retire early. This flexibility enhances welfare; our model also fits several important empirical stylized facts including the two peaks in retirement rates, the hump-shaped pattern of work hours, the sizeable discontinuity in consumption at retirement, and low annuity take-ups of older households.

We investigate an IPO security design problem when information asymmetries across investors lead to a winner’s curse. Firms that are riskier in down markets can lower the cost of going public by using unit IPOs, in which equity and warrants are combined into a non-divisible package. Furthermore, firms that have a sizeable growth potential even in bad states of the world can fully eliminate the winner’s curse problem by making the warrants callable. Our theory is consistent with the prominent use of unit IPOs and produces empirical implications that differentiate it from existing theories.

Arguing that total consumer wealth is unobservable, we invert the (approximate) consumption function to reconstruct, in a world with Kreps-Porteus generalized isoelastic preferences, (i) the wealth that supports the agents' observed consumption as an optimal outcome and (ii) the rate of return on the consumers' wealth portfolio. This allows us to (approximately) price assets solely as a function of their payoffs and of consumption—in both homoskedastic or heteroskedastic environments. We compare implied equilibrium returns on the wealth portfolio to observed stock market returns and gauge whether the stock market is a good proxy for unobserved aggregate wealth.