Knowledge that Transforms

Abstract In 2001, government guarantees for savings banks in Germany were removed following a lawsuit. We use this natural experiment to examine the effect of government guarantees on bank risk-taking. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. Using a difference-in-differences approach we show that none of these effects are present in a control group of German banks to whom the guarantee was not applicable. Furthermore, savings banks adjusted their liabilities away from risk-sensitive debt instruments after the removal of the guarantee, while we do not observe this for the control group. We also document that yield spreads of savings banks’ bonds increased significantly right after the announcement of the decision to remove guarantees, while the yield spread of a sample of bonds issued by the control group remained unchanged. The evidence implies that public guarantees may be associated with substantial moral hazard effects.

Abstract Using new monthly data, we investigate open-market repurchase executions of US firms. We find that firms repurchase at prices that are significantly lower than average market prices. This price discount is negatively related to size and positively related to market-to-book ratio. Firms’ repurchase activity is followed by a positive and significant abnormal return. Importantly, the market response occurs when firms disclose their actual repurchase data in earnings announcements, and this positive response is followed by a 1-month drift. Consistent with these results, we find that insider trading is positively related to actual repurchases.

Abstract This article develops a theory of the joint allocation of control and cash-flow rights in venture capital (VC) deals. When the need for VC advice and support calls for a high-powered outside claim, the entrepreneur should optimally retain control in order to avoid undue interference. Hence, I predict that more high-powered claims should be associated with fewer control rights. This challenges the idea that control should always be attached to equity-like claims and is in line with contractual terms used in venture capital, corporate venturing, and partnerships between biotech start-ups and large corporations. The article also rationalizes evidence that venture capital contracts include contingencies triggering both a reduction in VC control and the automatic conversion of VC’s preferred stock into common.

Abstract In this article we establish cautiousness as a new downside risk aversion measure, using a portfolio problem with a risk-free bond, a stock, and an option. We show that, an investor has higher cautiousness (i) if and only if she is always more likely to buy the option; and (ii) if and only if she always demands more options per share. As an option’s payoff is a convex function, increasing positions in the option increases the convexity of a portfolio, which leads to an increase in skewness. Thus the results in this article establish the link between cautiousness and skewness preference.

Abstract Monetary policy, as captured by changes in the Fed funds rate (FFR), is a useful signal for investors. I analyze the economic significance of trading strategies based on the “out-of-sample” forecasting power of FFR for excess equity returns. A simple market-timing strategy produces an annual Sharpe ratio of 0.55 and a certainty equivalent return (CER) gain of 3.37% per year, whereas a buy-hold strategy has a Sharpe ratio of 0.41. Rotation trading strategies for portfolios sorted on size, book-to-market, and momentum have a Sharpe ratio and CER gain as high as 0.73 and 9.60% per year, respectively. Dynamic strategies for other asset classes also produce economically significant gains. Generally, the strategies based on FFR outperform those associated with alternative predictors.

Abstract We study the effects of the interplay between deregulation and governance on risk-taking in the financial industry. We consider the removal of regulatory geographic constraints for savings banks in Spain, the cajas, which led to a nationwide expansion of these banks during the past two decades. Based on a unique dataset that combines information on the geographic distribution of bank lending, matched lender-borrower financial statements, and borrower defaults, we find that the governance of the savings banks significantly affects the way in which they expand their lending activities. Savings banks that are subject to political influence by regional governments exhibit higher ex ante risk-taking and higher ex post loan defaults. Our study highlights the broader implications of the impact of global deregulation and consolidation and their interaction with governance issues.

Abstract We examine the effect of information sharing via credit bureaus or credit registers on banks’ incentives to collect information about their borrowers. Information asymmetries have been identified as an important source of bank profits, and sharing knowledge about borrowers can reduce those rents. Despite that, we show that banks’ incentives to collect information actually increase in the presence of information sharing. The reason is that when hard, standardized information is shared, banks’ incentives to invest in soft, nonverifiable information increase. The result can be more accurate lending decisions and improved welfare.

Abstract We document a significant and robust connection between firm-level asset changes and return momentum. Momentum profits are large and significant for firms that have experienced large asset expansions or contractions, whereas they otherwise are small and often insignificant. The interaction pattern is not subsumed by previously documented drivers of momentum and shows up in market states where prior literature has documented an absence of momentum profits. Furthermore, we find a positive time series relationship between aggregate asset growth (AG) and return momentum, and the effect of aggregate AG is stronger than that of variables related to business cycles and investor sentiment. While most existing models of firm investment and momentum cannot explain our results, recent real options models appear to hold the most promise.

Abstract Existing evidence suggests that the Sarbanes–Oxley Act (SOX) may be beneficial to US investors, but that foreign firms are perhaps less likely to list in the USA after SOX. This raises the question of whether foreign firms avoid listing in the USA after SOX because the Act imposes unnecessary costs upon firms. The objective of this article is to reconcile the US and international evidence by distinguishing between the effect of SOX on controlling shareholders and managers of foreign firms and the effect on minority investors of these firms. Our results suggest that insiders of foreign firms believe that the regulation makes the extraction of value from minority investors more difficult and costly for them. Outside investors in foreign firms, on the other hand, seem on average to believe that SOX is beneficial to them. The combination of these results reconciles the existing US and international evidence regarding SOX.

Abstract Structural or no-arbitrage asset-pricing models emphasize risk factors that cannot be observed directly. We show that the term structure of risk implicit in option prices can reveal these risk factors. Empirically, the variance term structure reveals two predictors of the bond premium, the equity premium, and the variance premium, jointly. Similarly, the term structures of skewness and kurtosis measures also reveal risk factors, but these are subsumed in the predictive content of the variance. The predicted premium is countercyclical and robust to the inclusion of known returns predictors.