Knowledge that Transforms

We study cross-subsidization among U.S. equity products managed by institutional asset management firms. We find returns-based evidence consistent with both cross-subsidization receipt by strong recent performers that are relatively small in their firms and provision by products that are relatively large in their firms. Tax-exempt investors and taxable investors do not have a clear ranking by expertise, but tax-exempt investors’ agency issues are more complex. Accordingly, taxable clients have more flow-performance nonlinearity and receive more (and provide less) cross-subsidization. Taxable investor flows appear more discerning, but only under the circumstances conducive to cross-subsidization, suggesting that “more discerning” likely means “more cross-subsidized.”

We exploit a natural experiment to provide one of the first measurements of the causal effect of negative credit information on employment and earnings. We estimate that one additional year of negative credit information reduces employment by 3 percentage points and wage earnings by $1, 000. In comparison, the decrease in credit is only one-fourth as large. Negative credit information also causes an increase in self-employment and a decrease in mobility. Further evidence suggests this cost of default is inefficiently borne by those most creditworthy among previous defaulters. Received April 5, 2017; editorial decision September 2, 2017 by Editor Andrew Karolyi.

I study managerial short-termism in a dynamic model of project development with hidden effort and imperfect observability of quality. The manager can complete the project faster by reducing quality. To preempt this behavior, the prin cipal makes payments contingent on long-term outcomes. I analyze the dynamics of the optimal contract and its implications for the level of managerial turnover. I show that optimal contracts might be stationary and entail no termination. In general, I show that the principal reduces the manager’s temptation to behave myopically by reducing the likelihood of termination and deferring compensation. The model predicts a negative relation between the rate of managerial turnover and the use of deferred compensation that is consistent with evidence of managerial compensation contracts. Received May 23, 2016; editorial decision May 27, 2017 by Editor Francesca Cornelli.

Low-income households with proximate access to payday loans exhibit greater economic distress, higher take-up of food assistance benefits, and greater delinquency on child support payments than peers without proximate loan access. These findings suggest that borrowing can exacerbate distress, leading borrowers to use transfer programs and to prioritize payday loan payments over other liabilities like child support. In that way, payday lending produces negative externalities—costs imposed on taxpayers that fund transfer programs and nonresident family members that fail to receive child support. Received August 13, 2014; editorial decision December 5, 2016 by Editor Alexander Ljungqvist.

A common belief held among researchers and policy makers is that regulatory reliance has inflated market demand for credit ratings, despite their decreasing informational value. Advances in information technology, coupled with reputation losses following the subprime crisis, renew the question of whether investors still rely on ratings to assess credit risk. Using Moody’s 2010 scale recalibration, which was unrelated to changing issuer fundamentals, we find that ratings still matter to investors and to issuers—apart from any regulatory implications. Our results commend improved disclosure to mitigate mechanistic reliance on ratings and inefficiencies due to rating standards that vary across asset classes. Received October 9, 2015; editorial decision June 7, 2017 by Editor Andrew Karolyi.

We compare the performance of time-series (TS) and cross-sectional (CS) strategies based on past returns. While CS strategies are zero-net investment long/short strategies, TS strategies take on a time-varying net long investment in risky assets. For individual stocks, the difference between the performances of TS and CS strategies is largely due to this time-varying net long investment. With multiple international asset classes with heterogeneous return distributions, scaled CS strategies significantly outperform similarly scaled TS strategies.

Compensation of mutual fund managers is paramount to understanding agency frictions in asset delegation. We collect a unique registry-based dataset on the compensation of Swedish mutual fund managers. We find a concave relationship between pay and revenue, in contrast to how investors compensate the fund company (firm). We also find a surprisingly weak sensitivity of pay to performance, even after accounting for the indirect effects of performance on revenue. Firm-level fixed effects, revenues, and profits add substantial explanatory power for compensation.

We examine how debt priority structure affects bank funding costs and soundness. Leveraging an unexplored natural experiment that changes the priority of claims on banks’ assets, we document asymmetric effects that are consistent with changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder. The enactment of depositor preference laws that confer priority on depositors reduces deposit rates but increases nondeposit rates. Importantly, subordinating nondepositor claims reduces bank risk-taking, consistent with market discipline. This insight highlights a role for debt priority structure in the regulatory framework. Received September 1, 2016; editorial decision August 31, 2017 by Editor Philip Strahan.

From 1973 to 2014, the common stock of U.S. banks with loan growth in the top quartile of banks over a three-year period significantly underperformed the common stock of banks with loan growth in the bottom quartile over the next three years. After the period of high growth, these banks have a lower return on assets and increase their loan loss reserves. The poorer performance of fast-growing banks is not explained by merger activity. The evidence is consistent with banks, analysts, and investors being overoptimistic about the risk of loans extended during bank-level periods of high loan growth.

We empirically assess industry tournament incentives for CEOs, as measured by the compensation gap between a CEO at one firm and the highest-paid CEO among similar (industry, size) firms. We find that firm performance, firm risk, and the riskiness of firm investment and financial policies are positively associated with the external industry pay gap. The industry tournament effects are stronger when industry, firm, and executive characteristics indicate high CEO mobility and a higher probability of the aspirant executive winning.