Review of Financial Studies - recent issues

Choosing to Cofinance: Analysis of Project-Specific Alliances in the Movie Industry

Palia, D., Ravid, S. A., Reisel, N. — 2008-03-24

We use a movie industry project-by-project dataset to analyze the choice of financing a project internally versus financing it through outside alliances. The results indicate that project risk is positively correlated with alliance formation. Movie studios produce a variety of films and tend to develop their safest projects internally. Our findings are consistent with internal capital market explanations. We find mixed evidence regarding resource pooling, i.e., sharing the cost of large projects. Finally, the evidence shows that projects developed internally perform similarly to projects developed through outside alliances.

Building Relationships Early: Banks in Venture Capital

Hellmann, T., Lindsey, L., Puri, M. — 2008-03-24

This paper examines bank behavior in venture capital. It considers the relation between a bank's venture capital investments and its subsequent lending, which can be thought of as intertemporal cross-selling. Theory suggests that unlike independent venture capital firms, banks may be strategic investors who seek complementarities between venture capital and lending activities. We find evidence that banks use venture capital investments to build lending relationships. Having a prior relationship with a company in the venture capital market increases a bank's chance of subsequently granting a loan to that company. Companies can benefit from these relationships through more favorable loan pricing.

Production in Entrepreneurial Firms: The Effects of Financial Constraints on Labor and Capital

Garmaise, M. J. — 2008-03-24

I model the contrasting capital-labor decisions of financially constrained and unconstrained firms. I show that financially restricted firms use relatively more labor than physical capital because informed employees provide more efficient financing than uninformed capital suppliers. I demonstrate that constrained firms cannot easily attract new employees to replace existing staff. Their greater employee retention aligns owner-worker incentives and encourages workers to make firm-specific investments. Constrained firms, however, gradually suffer from their inability to replace low-quality workers, such that their relative labor productivity decreases over time. Empirical tests utilizing instrumental variables confirm several implications of the theory.

Complex Ownership Structures and Corporate Valuations

Laeven, L., Levine, R. — 2008-03-24

The bulk of corporate governance theory examines the agency problems that arise from two extreme ownership structures: 100% small shareholders or one large, controlling owner combined with small shareholders. In this paper, we question the empirical validity of this dichotomy. In fact, one-third of publicly listed firms in Europe have multiple large owners, and the market value of firms with multiple blockholders differs from firms with a single large owner and from widely held firms. Moreover, the relationship between corporate valuations and the distribution of cash-flow rights across multiple large owners is consistent with the predictions of recent theoretical models.

The Value of Investor Protection: Firm Evidence from Cross-Border Mergers

Bris, A., Cabolis, C. — 2008-03-24

International law prescribes that in a cross-border acquisition of 100% of the target shares, the target firm becomes a national of the country of the acquiror, and consequently subject to its corporate governance system. Therefore, cross-border mergers provide a natural experiment to analyze the effects of changes in corporate governance on firm value. We construct measures of the change in investor protection in a sample of 506 acquisitions from 39 countries. We find that the better the shareholder protection and accounting standards in the acquiror's country, the higher the merger premium in cross-border mergers relative to matching domestic acquisitions.

Strategic Alliances and the Boundaries of the Firm

Robinson, D. T. — 2008-03-24

Strategic alliances are long-term contracts between legally distinct organizations that provide for sharing the costs and benefits of a mutually beneficial activity. In this paper, I develop and test a model that helps explain why firms sometimes prefer alliances over internally organized projects. I introduce managerial effort into a model of internal capital markets and show how strategic alliances help overcome incentive problems that arise when headquarters cannot pre-commit to particular capital allocations. The model generates a number of implications, which I test using a large sample of alliance transactions in conjunction with Compustat data.

Analytic Pricing of Employee Stock Options

Cvitanic, J., Wiener, Z., Zapatero, F. — 2008-03-24

We introduce a model that captures the main properties that characterize employee stock options (ESO). We discuss the likelihood of early voluntary ESO exercise, and the obligation to exercise immediately if the employee leaves the firm, except if this happens before options are vested, in which case the options are forfeited. We derive an analytic formula for the price of the ESO and in a case study compare it to alternative methods.

Where Is the Market? Evidence from Cross-Listings in the United States

Halling, M., Pagano, M., Randl, O., Zechner, J. — 2008-03-24

We analyze the location of stock trading for firms with a US cross-listing. The fraction of trading that occurs in the United States tends to be larger for companies from countries that are geographically close to the United States and feature low financial development and poor insider trading protection. For companies based in developed countries, trading volume in the United States is larger if the company is small, volatile, and technology-oriented, while this does not apply to emerging country firms. The domestic turnover rate increases in the cross-listing year and remains higher for firms based in developed markets, but not for emerging market firms. Domestic trading volume actually declines for companies from countries with poor enforcement of insider trading regulation.

Distance Still Matters: Evidence from Municipal Bond Underwriting

Butler, A. W. — 2008-03-24

Using a sample of municipal bond offerings, I find that "local" investment banks have substantial comparative and absolute advantages over nonlocal counterparts-–locals charge lower fees and sell bonds at lower yields. Local investment banks’ strongest comparative advantage is at underwriting bonds with higher credit risk and bonds not rated by rating agencies. These findings suggest that high-risk bonds and nonrated bonds are more difficult to evaluate and market, and that investment banks with a local presence are better able to assess "soft" information and place difficult bond issues.

All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors

Barber, B. M., Odean, T. — 2008-03-24

We test and confirm the hypothesis that individual investors are net buyers of attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one-day returns. Attention-driven buying results from the difficulty that investors have searching the thousands of stocks they can potentially buy. Individual investors do not face the same search problem when selling because they tend to sell only stocks they already own. We hypothesize that many investors consider purchasing only stocks that have first caught their attention. Thus, preferences determine choices after attention has determined the choice set.

Identifying Term Structure Volatility from the LIBOR-Swap Curve

Thompson, S. — 2008-03-24

This paper proposes a new family of specification tests and applies them to affine term structure models of the London Interbank Offered Rate (LIBOR)-swap curve. Contrary to Dai and Singleton (2000), the tests show that when standard estimation techniques are used, affine models do a poor job of forecasting volatility at the short end of the term structure. Improving the volatility forecast does not require different models; rather, it requires a different estimation technique. The paper distinguishes between two econometric procedures for identifying volatility. The "cross-sectional" approach backs out volatility from a cross section of bond yields, and the "time-series" approach imputes volatility from time-series variation in yields. For an affine model, the volatility implied by the time-series procedure passes the specification tests, while the cross-sectionally identified volatility does not. This is surprising, since under correct specification, the "cross-sectional" approach is maximum likelihood. One explanation is that affine models are slightly misspecified; another is that bond yields do not span volatility, as in Collin-Dufresne and Goldstein (2002).

Endogenous Events and Long-Run Returns

Viswanathan, S., Wei, B. — 2008-03-24

We analyze event abnormal returns when returns predict events. In fixed samples, we show that the expected abnormal return is negative and becomes more negative as the holding period increases. Asymptotically, abnormal returns converge to zero provided that the process of the number of events is stationary. Nonstationarity in the process of the number of events is needed to generate a large negative bias. We present theory and simulations for the specific case of a lognormal model to characterize the magnitude of the small-sample bias. We illustrate the theory by analyzing long-term returns after initial public offerings (IPOs) and seasoned equity offerings (SEOs).

International asset allocation under regime switching, skew, and kurtosis preferences

Guidolin, M., Timmermann, A. — 2008-03-24

This paper investigates the international asset allocation effects of time-variations in higher-order moments of stock returns such as skewness and kurtosis. In the context of a four-moment International Capital Asset Pricing Model (ICAPM) specification that relates stock returns in five regions to returns on a global market portfolio and allows for time-varying prices of covariance, co-skewness, and co-kurtosis risk, we find evidence of distinct bull and bear regimes. Ignoring such regimes, an unhedged US investor's optimal portfolio is strongly diversified internationally. The presence of regimes in the return distribution leads to a substantial increase in the investor's optimal holdings of US stocks, as does the introduction of skewness and kurtosis preferences.

Institutional Portfolio Flows and International Investments

Froot, K. A., Ramadorai, T. — 2008-03-24

Using a new technique, and weekly data for 25 countries from 1994 to 1998, we analyze the relationship between institutional cross-border portfolio flows, and domestic and foreign equity returns. In emerging markets, institutional flows forecast statistically indistinguishable movements in country closed-end fund NAV returns and price returns. In contrast, closed-end fund flows forecast price returns, but not NAV returns. Furthermore, institutional flows display trend-following (trend-reversing) behavior in response to symmetric (asymmetric) movements in NAV and price returns. The results suggest that institutional cross-border flows are linked to fundamentals, while closed-end fund flows are a source of price pressure in the short run.

State Dependence Can Explain the Risk Aversion Puzzle

Chabi-Yo, F., Garcia, R., Renault, E. — 2008-03-24

Risk aversion functions extracted from observed stock and option prices can be negative, as shown by Aït-Sahalia and Lo (2000), Journal of Econometrics 94: 9–51; and Jackwerth (2000), The Review of Financial Studies 13(2), 433–51. We rationalize this puzzle by a lack of conditioning on latent state variables. Once properly conditioned, risk aversion functions and pricing kernels are consistent with economic theory. To differentiate between the various theoretical explanations in terms of heterogeneity of beliefs or preferences, market sentiment, state-dependent utility, or regimes in fundamentals, we calibrate several consumption-based asset pricing models to match the empirical pricing kernel and risk aversion functions at different dates and over several years.

Tournaments in Mutual-Fund Families

Kempf, A., Ruenzi, S. — 2008-03-24

We examine intrafirm competition in the mutual-fund industry. We test the hypothesis that fund managers within mutual-fund families compete with each other in a tournament. Our empirical study of the US equity mutual-fund market shows that they adjust the risk they take depending on the relative position within their fund family. The direction of the adjustment depends on the competitive situation in that family. Risk adjustments are particularly pronounced among managers of funds with high expense ratios, which are managed by a single manager and which belong to large families.

A Note from the Editor

Spiegel, M. S. — 2008-02-29

The Causes and Consequences of Recent Financial Market Bubbles: An Introduction

Bhattacharya, U., Yu, X. — 2008-02-29

On August 12–13, 2005, the department of finance at the Kelley School of Business, Indiana University, collaborated with the Review of Financial Studies to host a conference titled "The Causes and Consequences of Recent Financial Market Bubbles." This article begins with our overview of the themes and findings of the conference, and it ends with the questions that the literature has yet to answer.

Bubbles: Some Perspectives (and Loose Talk) from History

O'Hara, M. — 2008-02-29

Bubbles are a topic of great importance and great controversy. This paper discusses alternative perspectives on the economic meaning and origin of bubbles. Drawing on historical approaches to bubbles, this article sets out a taxonomy of approaches used to explain the nature of bubbles. The paper also considers issues connected with the scientific thinking surrounding bubbles.

Relative Wealth Concerns and Financial Bubbles

DeMarzo, P. M., Kaniel, R., Kremer, I. — 2008-02-29

We present a rational general equilibrium model that highlights the fact that relative wealth concerns can play a role in explaining financial bubbles. We consider a finite-horizon overlapping generations model in which agents care only about their consumption. Though the horizon is finite, competition over future investment opportunities makes agents' utilities dependent on the wealth of their cohort and induces relative wealth concerns. Agents herd into risky securities and drive down their expected return. Even though the bubble is likely to burst and lead to a substantial loss, agents' relative wealth concerns make them afraid to trade against the crowd.

Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives

Dass, N., Massa, M., Patgiri, R. — 2008-02-29

This article studies one of the potential causes of the financial market bubble of the late 1990s: the herding behavior of mutual funds. We show that the incentives contained in the mutual funds' advisory contracts induce managers to overcome their tendency to herd. We argue that investing in bubble stocks amounts to herding and contracts with high incentives induce managers to diverge from the herd, thus reducing their holding of bubble stocks. The differential exposure to bubble stocks significantly impacted the funds' performance both in the period prior to March 2000, as well as afterwards.

Analyst Behavior Following IPOs: The "Bubble Period" Evidence

Bradley, D. J., Jordan, B. D., Ritter, J. R. — 2008-02-29

We examine over 7400 analyst recommendations made in the year after going public for IPOs from 1999 to 2000. Initiations of coverage at the end of the quiet period come almost exclusively from affiliated analysts, whereas initiations afterward are predominantly from unaffiliated analysts. Contrary to previous findings, we find no evidence that the market discounts recommendations from affiliated analysts once we control for recommendation characteristics and timing. Moreover, analyst coverage in the first year is not affected by underpricing, and after the flurry of initiations at the end of the quiet period, the number of analysts covering a firm during the following 11 months is unrelated to the number of managing underwriters. (JEL G12, G14, G24)

Money Illusion and Housing Frenzies

Brunnermeier, M. K., Julliard, C. — 2008-02-29

A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price–rent ratio into a rational component—meant to capture the "proxy effect" and risk premia—and an implied mispricing. We find that inflation and nominalinterest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.

Conditioning Information and Variance Bounds on Pricing Kernels with Higher- Order Moments: Theory and Evidence

Chabi-Yo, F. — 2008-02-29

We develop a strategy for utilizing higher moments, variance risk premia, and conditioning information efficiently, and hence improve on the variance bounds computed by Hansen and Jagannathan (1991); Gallant, Hansen, and Tauchen (1990); and Bekaert and Liu (2004). Our bounds reach existing bounds when nonlinearities in returns are not priced. We also use higher moments, variance risk premia, and conditioning information to provide distance measures that improve on the Hansen and Jagannathan (1997) distance measure. Empirical results indicate that when accounting for the impact of higher moments and variance risk premia, the existing pricing kernels have difficulty in explaining returns on the assets and derivatives.

Estimating the Dynamics of Mutual Fund Alphas and Betas

Mamaysky, H., Spiegel, M., Zhang, H. — 2008-02-29

This article develops a Kalman filter model to track dynamic mutual fund factor loadings. It then uses the estimates to analyze whether managers with market-timing ability can be identified ex ante. The primary findings are as follows: (i) Ordinary least squares (OLS) timing models produce false positives (nonzero alphas) at too high a rate with either daily or monthly data. In contrast, the Kalman filter model produces them at approximately the correct rate with monthly data; (ii) In monthly data, though the OLS models fail to detect any timing among fund managers, the Kalman filter does; (iii) The alpha and beta forecasts from the Kalman model are more accurate than those from the OLS timing models; (iv) The Kalman filter model tracks most fund alphas and betas better than OLS models that employ macroeconomic variables in addition to fund returns.

A Dynamic Model for the Forward Curve

Chua, C. T., Foster, D., Ramaswamy, K., Stine, R. — 2008-02-29

This article develops and estimates a dynamic arbitrage-free model of the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model, the Expectations Hypothesis (ET) and affine yield curve models; it permits a class of low-parameter, multiple state variable dynamic models for the forward curve. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton (HJM) conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6 months or longer, the forecasts of this model significantly outperform those from common benchmark models.

Is Nonlinear Drift Implied by the Short End of the Term Structure?

Takamizawa, H. — 2008-02-29

Nonlinear drift models of the short rate are estimated using data on the short end of the term structure, where the cross-sectional relation is obtained by an analytical approximation. The findings reveal that (i) nonlinear physical drift is not implied unless it is strongly affected by cross-sectional dimensions of the data; (ii) nonlinear risk-neutral drift that allows for fast mean reversion for high rates is desirable to explain and predict observed patterns of yield spreads; and (iii) for higher frequency data from which transitory shocks are removed, (ii) still remains valid although the nonlinearity is somewhat reduced.

Two Trees

Cochrane, J. H., Longstaff, F. A., Santa-Clara, P. — 2008-02-29

We solve a model with two i.i.d. Lucas trees. Although the corresponding one-tree model produces a constant price-dividend ratio and i.i.d. returns, the two-tree model produces interesting asset-pricing dynamics. Investors want to rebalance their portfolios after any change in value. Because the size of the trees is fixed, prices must adjust to offset this desire. As a result, expected returns, excess returns, and return volatility all vary through time. Returns display serial correlation and are predictable from price-dividend ratios. Return volatility differs from cash-flow volatility, and return shocks can occur without news about cash flows.

Investor Sentiment and Option Prices

Han, B. — 2008-02-29

This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.

Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Gomes, F., Michaelides, A. — 2008-02-29

We develop a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk-premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints, and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk-premium, contrary to the results of models where it is imposed exogenously.

Stocks or Options? Moral Hazard, Firm Viability, and the Design of Compensation Contracts

Kadan, O., Swinkels, J. M. — 2008-02-29

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock.

Turning over Turnover

Cremers, K. J. M., Mei, J. — 2007-10-18

This article applies the methodology of Bai and Ng (2002, 2004) for decomposing panel data into systematic and idiosyncratic components to both stock returns and turnover panels. This approach works well for both returns and turnover, despite the presence of severe heteroscedasticity and nonstationarity of individual stocks' turnover. We test the mutual fund separation model of Lo and Wang (2000). Trading due to systematic risk in returns can account for 66% of systematic turnover. Thus, portfolio rebalancing due to systematic risk is a very important motive for stock trading. Finally, several common turnover measures may understate the impact of stock trading.

Liquidity and Expected Returns: Lessons from Emerging Markets

Bekaert, G., Harvey, C. R., Lundblad, C. — 2007-10-18

Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that it significantly predicts future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset-pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.

Insider Trades and Private Information: The Special Case of Delayed-Disclosure Trades

Cheng, S., Nagar, V., Rajan, M. V. — 2007-10-18

In certain circumstances, insider trades such as private transactions between executives and their firms could be disclosed after the end of the firm's fiscal year, on a Form-5 filing. We find that insider sales disclosed in such a delayed manner for large firms are predictive of negative future returns (–6 to –8 percent), as well as lower future annual earnings relative to analyst forecasts. These results stand in contrast to existing findings on the uninformativeness of quickly disclosed open-market insider sales. The Sarbanes-Oxley Act curtailed the use of Form 5 under the presumption that managers used this vehicle opportunistically. Our systematic evidence supports this presumption.

Valuation in Over-the-Counter Markets

Duffie, D., Garleanu, N., Pedersen, L. H. — 2007-10-18

We provide the impact on asset prices of search-and-bargaining frictions in over-the-counter markets. Under certain conditions, illiquidity discounts are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, or when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then "recover" over time, with a time signature that is exaggerated by search frictions: The price jump is larger and the recovery is slower in less liquid markets. We discuss a variety of empirical implications.

Strategic Cost of Diversification

Lyandres, E. — 2007-10-18

This article proposes a new explanation for the large cross-sectional variation in the excess values of diversified firms. The model applies the idea of shareholders' limited liability affecting firms' output market strategies to the analysis of financial and operating choices of conglomerates. The inability of conglomerates to commit to unconstrained optimal operating strategies, following from the lack of flexibility in choosing their divisions' capital structures, reduces their value. Thus, the model highlights a new type of inefficiency of the conglomerate organizational structure, which is suboptimal financing. The predictions of the model are generally supported by the data.

The Real Effects of Asset Market Bubbles: Loan- and Firm-Level Evidence of a Lending Channel

Gan, J. — 2007-10-18

This article studies how a shock to the financial health of banks, caused by a decline in the asset markets, affects the real economy. The land market collapse in Japan provides an ideal testing field in separating the impact of a loan supply shock from demand shocks. I find that banks with greater real estate exposure have to reduce lending. Firms' investment and market valuation are negatively associated with their top lender's real estate exposure. The lending channel is economically important: it accounts for one-third of lending contraction, one-fifth of the decline in investment, and a quarter of value loss.

Informed and Strategic Order Flow in the Bond Markets

Pasquariello, P., Vega, C. — 2007-10-18

We study the role played by private and public information in the process of price formation in the U.S. Treasury bond market. To guide our analysis, we develop a parsimonious model of speculative trading in the presence of two realistic market frictions—information heterogeneity and imperfect competition among informed traders—and a public signal. We test its equilibrium implications by analyzing the response of two-year, five-year, and ten-year U.S. bond yields to order flow and real-time U.S. macroeconomic news. We find strong evidence of informational effects in the U.S. Treasury bond market: unanticipated order flow has a significant and permanent impact on daily bond yield changes during both announcement and nonannouncement days. Our analysis further shows that, consistent with our stylized model, the contemporaneous correlation between order flow and yield changes is higher when the dispersion of beliefs among market participants is high and public announcements are noisy.

Underpricing in the Corporate Bond Market

Cai, N., Helwege, J., Warga, A. — 2007-10-18

This article examines underpricing of initial public offerings (IPOs) and seasoned offerings in the corporate bond market. We investigate whether underpricing represents a solution to an information problem or a liquidity problem. We find that underpricing occurs with both IPOs and seasoned offerings and is highest among riskier, unknown firms. Our evidence suggests that information problems drive underpricing, with support for both the bookbuilding view of underpricing and the asymmetric information theory. We do not find evidence in favor of the Rock model of underpricing or any evidence that illiquidity causes underpricing.

How Do Diversity of Opinion and Information Asymmetry Affect Acquirer Returns?

Moeller, S. B., Schlingemann, F. P., Stulz, R. M. — 2007-10-18

We examine the theoretical predictions that link acquirer returns to diversity of opinion and information asymmetry. Theory suggests that acquirer abnormal returns should be negatively related to information asymmetry and diversity-of-opinion proxies for equity offers but not cash offers. We find that this is the case and that, more strikingly, there is no difference in abnormal returns between cash offers for public firms, equity offers for public firms, and equity offers for private firms after controlling for one of these proxies, idiosyncratic volatility.

Optimal Long-Term Financial Contracting

DeMarzo, P. M., Fishman, M. J. — 2007-10-18

We develop an agency model of financial contracting. We derive long-term debt, a line of credit, and equity as optimal securities, capturing the debt coupon and maturity; the interest rate and limits on the credit line; inside versus outside equity; dividend policy; and capital structure dynamics. The optimal debt-equity ratio is history dependent, but debt and credit line terms are independent of the amount financed and, in some cases, the severity of the agency problem. In our model, the agent can divert cash flows; we also consider settings in which the agent undertakes hidden effort, or can control cash flow risk.

Relationship Banking, Fragility, and the Asset-Liability Matching Problem

Song, F., Thakor, A. V. — 2007-10-18

We address a fundamental question in relationship banking: why do banks that make relationship loans finance themselves primarily with core deposits and when would it be optimal to finance such loans with purchased money? We show that not only are relationship loans informationally opaque and illiquid, but they also require the relationship between the bank and the borrower to endure in order for the bank to add value. However, the informational opacity of relationship loans gives rise to endogenous withdrawal risk that makes the bank fragile. Core deposits are an attractive funding source for such loans because the bank provides liquidity services to core depositors and this diminishes the likelihood of premature deposit withdrawal, thereby facilitating the continuity of relationship loans. That is, we show that banks will wish to match the highest value-added liabilities with the highest value-added loans and that doing so simultaneously minimizes the bank's fragility owing to withdrawal risk and maximizes the value the bank adds in relationship lending. We also examine the impact of interbank competition on the bank's asset-liability matching and extract numerous testable predictions.