Knowledge that Transforms

The search for a market design that ensures stable bank funding is at the top of regulators' policy agenda. This paper empirically shows that the central counterparty (CCP)-based euro interbank repo market features this stability. Using a unique and comprehensive data set, we show that the market is resilient during crisis episodes and may even act as a shock absorber, in the sense that repo lending increases with risk, while spreads, maturities, and haircuts remain stable. Our comparison across different repo markets shows that anonymous CCP-based trading, safe collateral, and the absence of an unwind mechanism are the key characteristics to ensure market resilience. Received October 22, 2014; accepted July 28, 2015 by Editor Stefan Nagel.

I empirically test whether firms engage in risk-shifting. Contrary to what risk-shifting theory predicts, I find that firms reduce investment risk when they approach financial distress. To identify the effect of distress on risk-taking, I use a natural experiment with exogenous changes to leverage. Risk reduction is most prevalent among firms that have shorter maturity debt, bank debt, and tighter bank loan financial covenants. These findings suggest that debt composition and financial covenants serve as important mechanisms to mitigate debt-equity agency conflicts, such as risk-shifting, that are not explicitly contracted on. Received January 8, 2015; accepted May 27, 2016 by Editor David Denis.

This paper documents the existence of a CEO investment cycle, in which disinvestment decreases over a CEO's tenure, while investment increases, leading to “cyclical” firm growth in assets and employment. The estimated variation in investment rate over the CEO investment cycle is of the same order of magnitude as the differences caused by business cycles or financial constraints. Results from a number of tests generally support the view that the investment cycle is caused by agency problems, leading to increasing investment quantity and decreasing investment quality over time as the CEO gains more control over his board. Received February 17, 2015; accepted October 1, 2015 by Editor David Denis.

We study the causal effect of bank credit rating downgrades on the supply of bank lending. The identification strategy exploits the asymmetric impact of sovereign downgrades on the ratings of banks at the sovereign bound relative to banks that are not at the bound as a result of rating agencies' sovereign ceiling policies. This asymmetric effect leads to greater reductions in ratings-sensitive funding and lending of banks at the bound relative to other banks. Results for foreign borrowers and within lender-borrower relationships confirm that credit demand does not explain our findings. Received February 10, 2015; accepted December 31, 2015 by Editor Philip Strahan.

This study shows that shifts in political climate influence stock prices. As the party in power changes, there are systematic changes in the industry-level composition of investor portfolios, which weaken arbitrage forces and generate predictable patterns in industry returns. A trading strategy that attempts to exploit demand-based return predictability generates an annualized risk-adjusted performance of 6% during the 1939 to 2011 period. This evidence of predictability spans 17%-27% of the market and is stronger during periods of political transition. Our demand-based predictability pattern is distinct from cash flow-based predictability identified in the recent literature. Received November 15, 2013; accepted April 5, 2016 by Editor Andrew Karolyi.

We examine how institutional ownership structure gives rise to limits to arbitrage through its impact on short-sale constraints. Stocks with lower, more concentrated, short-term, and less passive ownership exhibit lower lending supply, higher costs of shorting, and higher arbitrage risk. These constraints limit the ability of arbitrageurs to take short positions and delay the correction of mispricing. Stocks with more concentrated ownership exhibit smaller announcement day reactions, larger post-earnings announcement drift, and an additional negative abnormal return of -0.47% in the week following a positive shorting demand shock. Received June 16, 2014; accepted June 8, 2016 by Editor Laura Starks.

We document the existence of a strategy designed to circumvent limits to arbitrage. Faced with short-sale constraints and noise trader risk, small arbitrageurs publicly reveal their information to induce the target’s shareholders (“the longs”) to sell, thereby accelerating price discovery. Using data for 124 short-sale campaigns in the United States between 2006 and 2011, we show that investors respond strongly to the information, with spikes in SEC filing views, volatility, order imbalances, realized spreads, turnover, and selling by the longs. Share prices fall by an aggregate $14.8 billion. Our findings imply that even extreme short-sale constraints need not constrain arbitrage. Received June 18, 2014; accepted March 11, 2016 by Editor Andrew Karolyi.

Firms until recently were effectively constrained to hold liquid assets in non-interest-bearing accounts. As a result, the cost of capital of firms’ liquid-assets portfolios exceeded the return, especially when the risk-free interest rate was high. The spread between cost and return is the cost of carry. Changes in the cost of carry explain the dynamics of corporate “cash” holdings both in the United States and abroad, and the level of cost of carry explains the level of liquid-asset holdings across countries. We conclude that current US corporate cash holdings are not abnormal in a historical or international comparison. Received February 17, 2015; accepted October 1, 2015 by Editor David Denis.

We document substantial cross-individual dispersion in U.S. credit card borrowing costs, even after controlling for borrower risk and card characteristics. That remaining dispersion arises because cross-lender pricing heterogeneity generates dispersion in annual percentage rate (APR) offers to borrowers, and borrowers vary in shopping intensity. Our empirics match administrative data to self-reported card shopping intensity and use instruments suggested by fair lending law to account for the endogeneity between APRs and search. The results show that shoppers versus nonshoppers pay APRs as different as those paid by borrowers in the best versus worst credit score deciles. We discuss implications for policy and practice. Received August 2, 2014; accepted July 7, 2015 by Editor Philip Strahan.

Firm values can substantially change between the time deal terms are set and the actual deal closing, risking renegotiation, or termination. We find increases in market volatility decrease subsequent deal activity, but only for public targets subject to an interim period. The effect is strongest when volatility is highest, for deals taking longer to close, and for larger targets. Merging parties attempt to shorten the interim window as risk increases. Firm- and industry-level uncertainty measures reveal similar findings, ruling out an unobserved macro variable. We conclude interim uncertainty contributes to understanding the timing and intensity of public firms’ merger activity. Received February 12, 2015; accepted May 23, 2016 by Editor David Denis.