Knowledge that Transforms

This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into banks, direct lending to operating firms by the government, and the provision of government capital or guarantees to finance or encourage privately managed lending. Our analysis provides a framework for analyzing and evaluating the standard and nonstandard instruments used by authorities during the financial crisis of 2008-2009.

Traditional theories argue that governance is strongest under a single large blockholder, as she has high incentives to undertake value-enhancing interventions. However, most firms are held by multiple small blockholders. This article shows that, while such a structure generates free-rider problems that hinder intervention, the same coordination difficulties strengthen a second governance mechanism: disciplining the manager through trading. Since multiple blockholders cannot coordinate to limit their orders and maximize combined trading profits, they trade competitively, impounding more information into prices. This strengthens the threat of disciplinary trading, inducing higher managerial effort. The optimal blockholder structure depends on the relative effectiveness of manager and blockholder effort, the complementarities in their outputs, information asymmetry, liquidity, monitoring costs, and the manager's contract.

We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs that are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs.

Using new data for the universe of firms covered in Amadeus, we reconstruct the portfolios of shareholders who hold equity stakes in private- and publicly traded European firms. We find great heterogeneity in the degree of portfolio diversification across large shareholders. Exploiting this heterogeneity, we document that firms controlled by diversified large shareholders undertake riskier investments than firms controlled by nondiversified large shareholders. The impact of large shareholder diversification on corporate risk-taking is both economically and statistically significant. Our results have important implications at the policy level because they identify one channel through which policy changes can improve economic welfare.

Using loan-level data, we analyze the quality of subprime mortgage loans by adjusting their performance for differences in borrower characteristics, loan characteristics, and macroeconomic conditions. We find that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers were, to some extent, aware of it. We provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. Problems could have been detected long before the crisis, but they were masked by high house price appreciation between 2003 and 2005.

We relate trade credit to product characteristics and aspects of bank-rm relationships and document three main empirical regularities. First, the use of trade credit is associated with the nature of the transacted good. In particular, suppliers of dierentiated products and services have larger accounts receivable than suppliers of standardized goods and rms buying more services receive cheaper trade credit for longer periods. Second, rms receiving trade credit secure nancing from relatively uninformed banks. Third, a majority of the rms in our sample appears to receive trade credit at low cost.

This article analyzes corporate responses to the liability risk arising from workers' exposure to newly identified carcinogens. We find that firms, especially those with weak balance sheets, tend to respond to such risks by acquiring large, unrelated businesses with relatively high operating cash flows. The diversifying growth appears to be primarily motivated by managers' personal exposure to their firms' risk in that the growth has negative announcement returns and is related to firms' external governance, managerial stockholdings, and institutional ownership. The results suggest that corporate governance is particularly important when firms are exposed to the risk of large, adverse shocks.

This paper presents a dynamic equilibrium model of bond markets in which two groups of agents hold heterogeneous expectations about future economic conditions. The heterogeneous expectations cause agents to take on speculative positions against each other and therefore generate endogenous relative wealth fluctuation. The relative wealth fluctuation amplifies asset price volatility and contributes to the time variation in bond premia. Our model shows that a modest amount of heterogeneous expectations can help explain several puzzling phenomena, including the “excessive volatility” of bond yields, the failure of the expectations hypothesis, and the ability of a tent-shaped linear combination of forward rates to predict bond returns.

We model how lobbying by interest groups affects the level of investor protection. In our model, insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future, compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors that operate to reduce investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, as well as the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future reduces but does not eliminate the distortions arising from insiders' interest in extracting rents from the capital public firms already have. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.

China is often mentioned as a counterexample to the findings in the finance and growth literature since, despite the weaknesses in its banking system, it is one of the fastest growing economies in the world. The fast growth of Chinese private sector firms is taken as evidence that it is alternative financing and governance mechanisms that support China’s growth. This paper takes a closer look at firm financing patterns and growth using a database of 2400 Chinese firms. We find that a relatively small percentage of firms in our sample utilize formal bank finance with a much greater reliance on informal sources. However, our results suggest that despite its weaknesses, financing from the formal financial system is associated with faster firm growth, whereas fund raising from alternative channels is not. Using a selection model, we find no evidence that these results arise because of the selection of firms that have access to the formal financial system. While firms report bank corruption, we do not find evidence that it significantly affects the allocation of credit or the performance of firms that receive the credit. Our findings suggest that the role of reputation and relationship based financing and governance mechanisms in financing the fastest growing firms in China is likely to be overestimated.