Knowledge that Transforms

Corporate governance theory predicts that leverage affects agency costs and thereby influences firm performance. We propose a new approach to test this theory using profit efficiency, or how close a firm’s profits are to the benchmark of a best-practice firm facing the same exogenous conditions. We are also the first to employ a simultaneous-equations model that accounts for reverse causality from performance to capital structure. We find that data on the US banking industry are consistent with the theory, and the results are statistically significant, economically significant, and robust.

H. Wang and C. Wang [Visibility of the compass rose in financial asset returns: A quantitative study, J. Bank. Financ. 26 (2002), 1099–1111] derive a measure of the visibility of the radial patterns that appear in a plot of current and past returns, which are more commonly known as the compass rose. In theory, this measure should be positively related to the tick/volatility ratio. In practice however, we find that this relationship does not hold for higher tick/volatility ratios that are common to stock market data. Thus, the use of this measure is limited in real world applications. We propose a correction factor that improves the behaviour of the quality measure over higher tick/volatility ratios, however, further research is required to fully identify and correct the problem.

We analyze if the value-weighted stock market portfolio is stochastic dominance (SD) efficient relative to benchmark portfolios formed on size, value, and momentum. In the process, we also develop several methodological improvements to the existing tests for SD efficiency. Interestingly, the market portfolio seems third-order SD (TSD) efficient relative to all benchmark sets. By contrast, the market portfolio is inefficient if we replace the TSD criterion with the traditional mean–variance criterion. Combined these results suggest that the mean–variance inefficiency of the market portfolio is caused by the omission of return moments other than variance. Especially downside risk seems to be important for explaining the high average returns of small/value/winner stocks.

Modern insurance products are becoming increasingly complex, offering various guarantees, surrender options and bonus provisions. A case in point are the with-profits insurance policies offered by UK insurers. While these policies have been offered in some form for centuries, in recent years their structure and management have become substantially more involved. The products are particularly complicated due to the wide discretion they afford insurers in determining the bonuses policyholders receive. In this paper, we study the problem of an insurance firm attempting to structure the portfolio underlying its with-profits fund. The resulting optimization problem, a non-linear program with stochastic variables, is presented in detail. Numerical results show how the model can be used to analyze the alternatives available to the insurer, such as different bonus policies and reserving methods.

This paper examines the role and determinants of collateral in emerging markets compared to mature ones. Analyzing a data set of 560 credit files of Thai commercial banks, we find that both the incidence and degree of collateralization are higher there than in developed markets. Thai banks use collateral primarily to reduce the higher credit risks of small and relatively young firms. Long credit relationships do not reduce collateral requirements by lowering information asymmetry. Market imperfections result from housebanks demanding higher collateral than non-housebanks, suggesting a lock-in effect for their borrowers, and from larger banks realizing higher collateral claims.

We investigate the international transmission of inflation among G-7 countries using data-determined vector autoregression analysis, as advocated by Swanson and Granger [Swanson, N., Granger, C., 1997. Impulse response functions based on a causal approach to residual orthogonalization in vector autoregressions. Journal of the American Statistical Association 92, 357–367]. Over the period 1973–2003, we find that unexpected changes in US inflation have large effects on inflation in other countries, although they are not always the dominant international factor. Similarly, shocks to some other countries also have a statistically and economically significant influence on US inflation. Moreover, our evidence indicates that US inflation has become less vulnerable to foreign shocks since the early 1990s, mainly because of the diminished influence from Germany and France.

The purpose of this paper is to discuss the issues related to international financial services, particularly foreign direct investment in banking. The paper discusses the challenges of measuring incomes generated from the activities of multinational banks, including their international lending and direct investment in host countries. The paper highlights the complementary role of FDI and trade in financial services and discusses investment in banking services. The patterns of FDI in banking in Eastern European countries, Latin America and East Asia are also analysed with a focus on the costs and benefits of FDI in banking in the emerging countries.

This paper investigates the existence and extent of economies of scale in depository and settlement systems. Evidence from 16 settlement institutions across different regions for the years 1993–2000 indicates the existence of significant economies of scale. The degree of such economies, however, differs by size of settlement institution and region. While smaller settlement service providers reveal a high potential of economies for scale, larger institutions show an increasing trend toward cost effectiveness. Clearing and settlement systems in countries in Europe and Asia report substantially larger economies of scale than those of the US system. European cross-border settlement seems to be more cost intensive than that on a domestic level, reflecting chiefly complexities of EU international securities settlement systems and differences in the scope of international settlement service providers. The evidence also reveals that investments in implementing new systems and upgrades of settlement technology continuously improved cost effectiveness over the sample period.

Using a database of SME credit approvals from a large Belgian bank, this paper extends the empirical evidence on the determinants of collateral by examining the determinants of business collateral simultaneously with the determinants of personal collateral/commitments. Our results suggest that firm and relationship characteristics seem to be more important determinants of collateral/commitment protection than loan and lender characteristics. Family firms are more likely to offer a higher degree of collateral/commitment protection while introducing competition between banks decreases this likelihood. The collateral requirement decreases in the length of the bank-borrower relationship. Furthermore, trade credit seems to have a signalling effect. The ‘lazy banks hypothesis’ was not supported. Our results suggest that beside risk arguments, also commercial arguments help explain the pledging of collateral. Using a continuation-ratio logit model, we discover several differences in the determinants of the collateralisation decision and the determinants of the type of collateral/commitments.

Grounded in agency theory, this study investigates how the strength of shareholder rights influences the extent of firm diversification and the excess value attributable to diversification. The empirical evidence reveals that the strength of shareholder rights is inversely related to the probability to diversify. Furthermore, firms where shareholder rights are more suppressed by restrictive corporate governance suffer a deeper diversification discount. Specifically, we document a 1.1–1.4% decline in firm value for each additional governance provision imposed on shareholders. An explicit distinction is made between global and industrial diversification. Our results support agency theory as an explanation for the value reduction in diversified firms. The evidence in favor of agency theory appears to be more pronounced for industrial diversification than for global diversification.