Do firm boundaries mediate the effect of shocks to the financial intermediation sector? When the functioning of the intermediation sector is impaired – as was the case in the recent financial crisis – shocks can be transmitted to the broader economy since funds may not flow to highest value use without incurring significant cost. This issue has been extensively explored in the credit channel literature (e.g., Kashyap and Stein [2000]; Bernanke and Blinder [1988; 1992], and Bernanke and Gertler [1995]). However, unlike what is assumed in this literature, firms may be able to reallocate resources internally – for instance, between divisions in different industries – to ameliorate the effect of financial shocks. If so, external credit market conditions will impact the nature of resource allocation inside firms and between industries differently than they would in an economy with no internal capital markets. Diversified firms constitute a large part of economies around the world; therefore, resource allocation within firms can be of significant importance. In this paper we propose that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model to quantify the forces driving this reallocation decision, and show that these forces dampen shocks to the financial sector in economically significant ways.

…continue reading: Resource Allocation within Firms and Financial Market Dislocation

I will first give some general remarks on the reasons for the low level of U.S. IPO volume this decade and the implications for job creation and economic growth, and then make some suggestions on the specific bills that the Senate is considering.

First, there is no doubt that fewer American companies have been going public since the tech stock bubble burst in 2000, and the drop is particularly pronounced for small companies. During 1980-2000, an average of 165 companies with less than $50 million in inflation-adjusted annual sales went public each year, but in 2001-2011, the average has fallen by more than 80%, to only 29 small firm IPOs per year. The patterns are illustrated in Figure 1.

…continue reading: Considering Causes and Remedies for Declining IPO Volume

Recently, the House of Representatives passed H.R. 3606, the “Jumpstart Our Business Startups Act.” It is clear to me that H.R. 3606 in its current form weakens or eliminates many regulations designed to safeguard investors. I must voice my concerns because as an SEC Commissioner, I cannot sit idly by when I see potential legislation that could harm investors. This bill seems to impose tremendous costs and potential harm on investors with little to no corresponding benefit.

H.R. 3606 concerns me for two important reasons. First, the bill would seriously hurt investors by reducing transparency and investor protection and, in turn, make securities law enforcement more difficult. That is bad for ordinary Americans and bad for the American economy. Investors are the source of capital needed to create jobs and expand businesses. True capital formation and economic growth require investors to have both confidence in the capital markets and access to the information needed to make good investment decisions.

…continue reading: Investor Protection is Needed for True Capital Formation

In our paper, The Flight Home Effect: Evidence from the Syndicated Loan Market During Financial Crises, forthcoming in the Journal of Financial Economics,  we study whether lenders, when hit by shocks that negatively affect bank wealth in their home market, have a tendency to rebalance their portfolio away from international markets to their domestic market. We explore this flight home effect in the context of the syndicated loan market, a large and highly internationalized financial market.

After controlling for demand shocks in foreign markets, we explore whether foreign lenders not only transmit shocks to foreign markets, as established in existing literature, but also whether they amplify these effects by substituting foreign loans for domestic loans. To establish whether this is the case, we analyze how the relative importance of a bank’s domestic and foreign loans varies following negative shocks.

Our results are consistent with the existence of a flight home effect. The proportion of loans granted to domestic borrowers increases by approximately 20 percent if the home country of the bank experiences a banking crisis, or more generally, if banks’ stock prices in the home country show a large decline. Lenders with less stable funding sources, being more vulnerable to negative liquidity shocks (Demirgüç-Kunt and Huizinga, 2010; Ivashina and Scharfstein, 2010), exhibit a stronger flight home effect. Overall, the results indicate that the home bias in the international allocation of syndicated loans increases in the presence of adverse economic shocks affecting the net wealth of international lenders.

…continue reading: The Flight Home Effect

In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich [1983]). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.

…continue reading: Managerial Investment and Changes in GAAP

In the paper, On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX, which was recently made publicly available on SSRN, I investigate the effects of information problems across corporate hierarchies on internal capital allocation decisions by using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment of a shock to the level of information frictions across corporate hierarchies. SOX requires firms to enhance their internal control systems in order to improve the reliability of financial reporting across corporate hierarchies.

I find that after SOX the capital allocation decision is more sensitive to performance as reported by the business segments. The changes in sensitivity of investment to performance are more pronounced for conglomerates that are more prone to information problems across corporate hierarchies, such as conglomerates with more segments and conglomerates that restated their earnings in the past. Moreover, in the post-SOX era, firms do not rely on past performance in their capital allocation decision when auditors report material weaknesses in their internal controls. The productivity advantage of conglomerates over stand-alone firms increases after SOX. In addition, conglomerates and segments that are more affected by SOX exhibit a larger increase in future profitability after SOX. Furthermore, the excess value of conglomerate firms relative to stand-alone firms increases (i.e., the conglomerate discount decreases). These changes in the internal capital allocation process are not associated with economic activities, financial constraints, or tensions between the management and shareholders.

…continue reading: On the Importance of Internal Control Systems in the Capital Allocation Decision

In the paper, Why Does the Law Matter? Investor Protection and its Effects on Investment, Finance, and Growth, forthcoming in the Journal of Finance, we study how investor protection affects firm-level resource allocations. We test for these effects using both ex-ante and ex-post measures of efficiency. We conduct our analyses in a large sample of firms from 44 countries during the period 1990 to 2007. We show that the relations between q and investment and q and external finance are stronger in countries with stronger investor protection laws. These findings are consistent with the notion that investor protection laws encourage accurate share prices, efficient investment, and better access to external finance.

…continue reading: Investor Protection and Its Effects on Investment, Finance, and Growth

In my paper Empire-Building or Bridge-Building? Evidence from New CEOs’ Internal Capital Allocation Decisions, which was recently accepted for publication in the Review of Financial Studies, I examine CEOs’ decision-making processes for capital allocation in the context of power and relationships within corporations by investigating whether the job histories of CEOs influence their capital allocation decisions when they preside over multi-divisional firms. I investigate the capital allocation decisions made by 265 new CEOs at 230 diversified firms after turnovers between 1993 and 2002. CEO turnovers provide a good opportunity for this study because CEOs are likely to be most vulnerable to political complications at work when they are new to the post. In particular, I focus on the 98 new CEOs in my sample who advanced through the ranks from certain, but not all, divisions in their firms. I call these CEOs specialists and separate the segments in their firms into two groups based on their affiliation with the CEOs: divisions that the CEOs advanced through the ranks from (labeled the in-group), and the rest of the divisions (labeled the out-group). The empirical analysis in the paper focuses on changes in segment capital expenditures around CEO turnovers to determine whether specialist CEOs treat the in-group and the out-group segments differently when allocating capital after succession, and if so, whether they favor the in-group (“empire-building”) or the out-group (“bridge-building”) in their allocation decisions.

My results are broadly consistent with the bridge-building hypothesis. I find that, on average, the out-group segments experience a significant increase in capital expenditures after CEO turnover relative to the in-group segments. The average change in segment investment ratio (capital expenditures over assets) after a specialist CEO takes office is 0.013 higher for the out-group than the in-group, statistically significant at the 5% level or better. This difference of 0.013 is economically meaningful as it represents more than 20% of the average pre-turnover investment ratio of 0.06. Moreover, these findings also hold for specialist CEOs hired from outside the firm and are robust to the inclusion of segment-level, firm-level, and turnover-related controls as well as changes in the test specifications including the definition of specialists, the measure for capital expenditures, the time frame around turnover, and the sample period. I further test for the bridge-building hypothesis by examining whether the in-group and out-group difference in capital allocation change around turnover is related to the specialist CEO’s relative bargaining power within the firm. I find that the difference is more pronounced if the specialist CEO does not hold a corporate-level executive title such as chief operating officer or president before succession or if the in-group segments and the out-group segments are not in related industries. The results from the finer tests are consistent with the prediction of the bridge-building hypothesis that a specialist CEO with less power should engage in more bridge-building efforts, which imply a more pronounced pattern of reverse-favoritism in capital allocation.

While my results are consistent with the bridge-building hypothesis, a key concern is the issue of endogeneity. CEOs are chosen by the board of directors, and the job histories of CEOs are observable by the board and may be an important selection criterion in the board’s choice for nomination. Even though the most obvious and natural endogeneity story is one that would lead to a bias that works in precisely the opposite direction to the empirical findings in this paper, I consider alternative versions of the endogeneity story in which the CEO might be chosen to grow the segments in the out-group or to reduce investments in the in-group, leading to the relative increase in the capital expenditures of the out-group segments observed in the data. I use two approaches to address this concern. First, I try to discriminate against this type of endogeneity story by identifying weak divisions in the firm based on segment cash flow and segment Q. I find that the in-group and the out-group segments experience differential capital allocation change regardless of segment operating performance and segment investment opportunity. The difference in capital expenditure change is significant and of the same magnitude even when one compares the strong segments in the in-group with the weak segments in the out-group, inconsistent with what the endogeneity story might suggest. Second, I estimate a segment’s propensity to be a member of the out-group based on pre-turnover segment characteristics, and use the propensity scores as a summary measure to match the out-group segments and the in-group segments. Again, I find a relative increase in the average change in capital expenditures for the out-group compared with those of the in-group after a specialist CEO takes office. The magnitude and significance level of the estimate are similar to those of the main results, further alleviating the concern that endogeneity might account for the findings.

Finally, I investigate whether having a specialist CEO affects segment investment efficiency by studying the changes in the sensitivity of segment investment to Q before and after the CEO turnover. My results show that the sensitivity of segment investment to Q increases significantly after CEO turnover in a generalist’s firm, indicating an improvement in investment efficiency. Segments under a specialist CEO, however, do not experience such improvements: the investment sensitivity to Q for these segments is virtually unchanged after the turnover. In addition, I examine the market’s reaction to the announcement of the appointment of specialist versus generalist CEOs and find that the cumulative abnormal returns around announcements are significantly higher for incoming CEOs who are generalists. The market’s response corroborates the finding that generalist CEOs are associated with improved segment investment efficiency after turnover and suggests that appointments of generalist CEOs are perceived by the market as positive news for the conglomerates.

Overall, my results suggest that the job histories of CEOs are an important determinant of their capital allocation decisions and that new specialist CEOs are affected by political concerns in the capital allocation process. New specialist CEOs use the capital budget as a bridge-building tool to elicit cooperation from powerful divisional managers in previously unaffiliated divisions.

The full paper is available for download here.

In October 2008, the U.S. Treasury launched the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), pursuant to which the Treasury has invested nearly $200 billion in over 500 financial institutions.[1] Almost from the start, the boards and managements of many TARP-recipient institutions have focused on when and how to get out from under Uncle Sam’s umbrella.

The stress test results have now been released, and Secretary Geithner has said that adequately capitalized financial institutions “will have the opportunity to repay” their TARP capital. Conventional wisdom has been that many institutions will rush to repay the government capital. Repurchasing this capital would appear to secure several clear advantages, including the opportunity to repurchase the related warrants at low valuations, the elimination of TARP-related restrictions on executive compensation and the reduction of government influence on governance and management.

There are several issues, however, that should be considered in determining whether to redeem TARP capital. The board and management of TARP recipients should consider whether repayment will require raising new capital today and the cost of that capital, the financial institution’s future capital needs and the potential sources of capital and the likelihood of continued government, shareholder and public scrutiny of compensation practices even after the TARP repayment.

The first part of this bulletin briefly describes the conditions to repayment and the requirements regarding the source of funds for repayment. The second part discusses issues that the board and management of financial institutions that received TARP capital should consider in determining whether to repay the Treasury.

CONDITIONS TO REPAYMENT AND SOURCES OF FUNDS
The terms of the contracts governing the CPP investments permit repayment only with the consent of the financial institution’s primary Federal regulator and require repayment during the initial three-year period after issuance to be funded entirely with the proceeds of cash sales of Tier 1 perpetual preferred stock or common stock. The economic stimulus bill, however, directed the Secretary of the Treasury to permit a TARP recipient to redeem TARP capital, after consultation with its primary Federal regulator, without regard to the source of the funds or the lapse of any period of time.

The May 6th Joint Statement issued by Treasury Secretary Tim Geithner, Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair and Comptroller of the Currency John Dugan outlined several conditions to the repayment of TARP funds:

Previously, in testimony before the Congressional Oversight Panel on April 21, 2009, Secretary Geithner had said the “ultimate test” for repayment would be whether an individual bank’s repayment would result in a reduction in the overall credit available to the economy.

Based on the above, it appears that, legally and practically speaking, the required source of funds for repayment of TARP funds will depend primarily on an institution’s financial strength, capital adequacy and liquidity, as determined by the Federal Reserve (or Office of Thrift Supervision in the case of thrift holding companies). Moreover, the approval of the regulator for any redemption (as opposed to mere consultation) may be required under existing supervisory procedures (for example, under Federal Reserve regulations and policies, if the redemption would reduce consolidated net worth by 10 percent or more or have a “material effect” on the institution’s capital base). Strong financial institutions with adequate capital and liquidity may be allowed to repay TARP capital with funds from any source, including cash on hand or retained earnings. Less well-capitalized financial institutions, however, may be required to adhere more closely to the original terms of the CPP and repay at least a substantial portion of the TARP funds with the proceeds of Tier 1 capital issuances.

…continue reading: Throwing Off the TARP – Implications of Repaying Uncle Sam

In our forthcoming Review of Financial Studies paper entitled Do Foreigners Invest Less in Poorly Governed Firms? we investigate the factors that make investors shy away from providing capital to foreign firms. Poor corporate governance is one factor that draws considerable attention from outside investors and regulators. Institutional investors frequently claim that they avoid foreign firms that are poorly governed. In addition, regulators are concerned that weak governance and low transparency hinder foreign investment and impede financial development. At the same time, outside investors who fear governance problems and expropriation by insiders can reduce the price they are willing to pay for a firm’s shares. As a result of price protection, even poorly governed firms should offer an adequate return, raising the questions of whether and why governance concerns manifest themselves in fewer holdings by foreign outside investors.

Our sample consists of 4,409 firms from 29 countries for which we have comprehensive data on foreign holdings by U.S. investors in 1997. As there can be a host of reasons why foreign investors avoid or seek stocks from a particular country, such as the degree of market integration, benefits from diversification, transaction costs, restrictions on capital flows, proximity, and language, we control for country fixed effects in our tests. Thus, we analyze which stocks U.S. investors choose within a given country. We find strong evidence that U.S. investors hold significantly fewer shares in firms with high levels of managerial and family control when these firms are domiciled in countries with weaker disclosure requirements, securities regulations, and outside shareholder rights, or in code-law countries. In contrast, firms with substantial managerial and family control do not experience less foreign investment when they reside in countries with extensive disclosure requirements and strong investor protection. This effect is particularly pronounced when earnings are opaque, indicating that information asymmetry and monitoring costs faced by foreign investors likely drive the results.

Our results across countries with different institutions are consistent with the interpretation that, for foreign investors, information problems for firms with potentially problematic governance structures play an important role. Stringent disclosure requirements make it less costly to become informed about potential governance problems. They level the playing field among investors making it less likely that locals have an information advantage. Strongly enforced minority shareholder protection reduces the consumption of private control benefits and thus decreases the importance of information regarding these private benefits. In contrast, low disclosure requirements and weak investor protection exacerbate information problems and their consequences.

The full paper is available for download here.