Posts Tagged ‘Credit supply’

Equity Overvaluation and Short Selling

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday April 18, 2014 at 9:02 am
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Editor’s Note: The following post comes to us from Messod Daniel Beneish, Professor of Accounting at Indiana University, Bloomington; Charles M. Lee, Professor of Accounting at Stanford University; and Craig Nichols, Assistant Professor of Accounting at Syracuse University.

In our paper, In Short Supply: Equity Overvaluation and Short Selling, which was recently made publicly available on SSRN, we use detailed equity lending data to examine the role of constraints on equity prices. We find that constrained stocks underperform, the short interest ratio (SIR) has a nonlinear association with constraints, constrained stocks have negative returns regardless of short interest ratio, high short interest yet unconstrained stocks do not underperform, yet low short interest unconstrained stocks outperform. Moreover, we show that limited supply is a key feature distinguishing constrained and unconstrained stocks, and that among constrained stocks, those with the lowest supply have the strongest negative returns. Our findings confirm that supply varies across firms (in contrast to SIR, which assumes supply is 100 percent of outstanding shares for all stocks) and short supply in the equity lending market has implications for the informational efficiency of equity prices.

…continue reading: Equity Overvaluation and Short Selling

The Capital Structure Decisions of New Firms

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday July 23, 2013 at 9:16 am
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Editor’s Note: The following post comes to us from Alicia Robb, Senior Fellow with the Ewing Marion Kauffman Foundation, and David Robinson, Professor of Finance at Duke University.

Understanding how capital markets affect the growth and survival of newly created firms is perhaps the central question of entrepreneurial finance. Yet, much of what we know about entrepreneurial finance comes from firms that are already established, have already received venture capital funding, or are on the verge of going public—the dearth of data on very-early-stage firms makes it difficult for researchers to look further back in firms’ life histories. Even data sets that are oriented toward small businesses do not allow us to measure systematically the decisions that firms make at their founding. This article uses a novel data set, the Kauffman Firm Survey (KFS), to study the behavior and decision-making of newly founded firms. As such, it provides a first-time glimpse into the capital structure decisions of nascent firms.

In our paper, The Capital Structure Decisions of New Firms, forthcoming in the Review of Financial Studies, we use the confidential, restricted-access version of the KFS, which tracks nearly 5,000 firms from their birth in 2004 through their early years of operation. Because the survey identifies firms at their founding and follows the cohort over time, recording growth, death, and any later funding events, it provides a rich picture of firms’ early fund-raising decisions.

…continue reading: The Capital Structure Decisions of New Firms

The Procyclical Effects of Bank Capital Regulation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday January 14, 2013 at 8:58 am
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Editor’s Note: The following post comes to us from Rafael Repullo, Professor of Economics at CEMFI, Madrid, Spain; and Javier Suarez, Professor of Finance at CEMFI, Madrid, Spain.

The basic argument about the procyclical effects of bank capital requirements is well-known. In recessions, losses erode banks’ capital, while risk-based capital requirements, such as those in Basel II, become higher. If banks cannot quickly raise sufficient new capital, their lending capacity falls and a credit crunch may follow. Yet, correcting the potential contractionary effect on credit supply by relaxing capital requirements in bad times may increase bank failure probabilities precisely when, because of high loan defaults, they are largest. Given the conflicting goals at stake, some observers think that procyclicality is a necessary evil, whereas others think that procyclicality should be explicitly corrected. Basel III is a compromise between these two views. It reinforces the quality and quantity of the minimum capital required to banks, but also establishes that part of the increased requirements be in terms of mandatory buffers—a capital preservation buffer and a countercyclical buffer—that are intended to be built up in good times and released in bad times.

In our paper, The Procyclical Effects of Bank Capital Regulation, forthcoming in the Review of Financial Studies, we develop a model that captures the key trade-offs in the debate. The model is constructed to highlight the primary microprudential role of capital requirements (containing banks’ risk of failure and, thus, deposit insurance payouts and other social costs due to bank failures) as well as their potential procyclical effect on the supply of bank credit.

…continue reading: The Procyclical Effects of Bank Capital Regulation

Does Macropru Leak? Evidence from a UK Policy Experiment

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday September 13, 2012 at 10:34 am
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Editor’s Note: The following post comes to us from Shekhar Aiyar, Senior Economist at the International Monetary Fund; Charles Calomiris, Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business; and Tomasz Wieladek, MPC Adviser, External MPC Unit, Bank of England.

How can governments limit excessive and unstable credit growth? Should they raise capital requirements for banks? In our recent NBER working paper, Does Macropru Leak? Evidence from a UK Policy Experiment, we address these questions using evidence from a policy experiment in the UK. The minimum capital ratio requirements that national regulatory authorities impose on banks have two sets of objectives: (i) so-called ‘micro-prudential’ motives, to ensure the safety and soundness of individual banks; and (ii) ‘macro-prudential’ goals, especially to influence the aggregate supply of credit. Micro-prudential regulation has a long pedigree, but the focus on macro-prudential regulation has increased sharply in the wake of the global financial crisis. This sharpened focus underlies recent changes in the international regulatory regime for banks. Basel III, as the new regime is called, establishes a “countercyclical capital buffer”, under which national regulators would vary banks’ required capital-to-risk-weighted assets ratio over time, thereby helping smooth the credit cycle. For variation in minimum capital requirements to be effective in regulating the aggregate supply of credit, three conditions must be satisfied:

…continue reading: Does Macropru Leak? Evidence from a UK Policy Experiment

The Anatomy of a Credit Crisis

Posted by Raghuram G. Rajan, University of Chicago Graduate School of Business, on Friday August 17, 2012 at 9:19 am
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Editor’s Note: Raghuram Rajan is Professor of Finance at the University of Chicago.

How important is the role of credit availability in inflating asset prices? And what are the consequences of past greater credit availability when perceived fundamentals turn? In our recent NBER paper, The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s, my co-author, Rodney Ramcharan, and I broach answers to these questions by examining the rise (and fall) of farm land prices in the United States in the early twentieth century, attempting to identify the separate effects of changes in fundamentals and changes in the availability of credit on land prices. This period allows us to use the exogenous boom and bust in world commodity prices, inflated by World War I and the Russian Revolution and then unexpectedly deflated by the rapid recovery of European agricultural production, to identify an exogenous shock to local agricultural fundamentals. The ban on interstate banking and the cross-state variation in deposit insurance and ceilings on interest rates are important regulatory features of the time that allow us to identify the effects of credit availability that we incorporate in the empirical strategy.

…continue reading: The Anatomy of a Credit Crisis

Derivatives and the Legal Origin of the 2008 Credit Crisis

Posted by Lynn A. Stout, Cornell Law School, on Tuesday July 19, 2011 at 9:16 am
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Editor’s Note: Lynn A. Stout is the Paul Hastings Distinguished Professor of Corporate and Securities Law at the University of California, Los Angeles School of Law. This post is part of a series discussing articles appearing in the inaugural issue of the Harvard Business Law Review, which is published in partnership with the Harvard Law School Program on Corporate Governance.

In the paper Derivatives and the Legal Origin of the 2008 Credit Crisis (published in the inaugural issue of the Harvard Business Law Review), I argue that the credit crisis of 2008 can be traced first and foremost to a little-known statute Congress passed in 2000 called the Commodities Futures Modernization Act (CFMA). In particular, the crisis was the direct and foreseeable (and in fact foreseen, by myself and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivatives contracts are probabilistic bets on future events that can be used to hedge (which reduces risk) but also provide attractive vehicles for speculation on disagreement (which can increase risk). The common law recognized the differing welfare consequences of hedging and speculative trading in derivatives by applying a doctrine called “the rule against difference contracts” to discourage derivatives that did not serve a hedging purpose by treating them as unenforceable wagers. Speculators responded by shifting their trading onto organized exchanges that provided private enforcement mechanisms, in particular clearinghouses through which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives speculation risk. In the twentieth century, the common law rule was replaced by the federal Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades also kept derivatives speculation from posing significant problems for the larger economy.

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Did Structured Credit Fuel the LBO Boom?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday March 25, 2011 at 9:20 am
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Editor’s Note: The following post comes to us from Anil Shivdasani, Professor of Finance at the University of North Carolina, and Yi Hui Wang of the Department of Finance at the Chinese University of Hong Kong.

In our forthcoming Journal of Finance paper, Did Structured Credit Fuel the LBO Boom? we study how large shifts in the availability of credit affected the corporate use of leverage by examining LBO transactions that rely heavily on debt financing. We argue that developments that led to the growth of structured credit contributed to increased credit supply that at least partially fueled the recent LBO boom. Our evidence highlights important linkages between structured credit, the dual role of banks in the structured credit markets as loan originators and underwriters, and the corporate use of leverage.

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Credit Quality as a Bonus Underpin

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday February 14, 2011 at 10:43 am
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Editor’s Note: This post comes to us from George Dallas, Director of Corporate Governance at F&C Management Ltd., and is based on a concept paper prepared by F&C Management.

In the aftermath of the recent financial crisis, bank remuneration remains a critically sensitive issue – for shareholders, creditors, regulators, governments and the general public. This is particularly the case for those systemically important financial institutions that received government bailouts. While many of these institutions are beginning to recover, the negative effects of increased debt taken on at the public sector level to protect the financial system have resulted in serious and lingering economic problems in many countries, including the UK and the US. Indeed, the impact of public sector balance sheets absorbing losses of the banking sector has had the after-effect of contributing to sovereign debt crises in several smaller European jurisdictions — which continue to plague investors, taxpayers and the wider economy.

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Leverage, Moral Hazard, and Liquidity

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday December 15, 2010 at 8:52 am
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Editor’s Note: The following post comes to us from Viral Acharya, Professor of Finance at New York University, and S. Viswanathan, Professor of Investment Banking at Duke University.

In the paper, Leverage, Moral Hazard, and Liquidity, forthcoming in the Journal of Finance (February 2011), the authors argue that the buildup of leverage in the financial sector in good economic times helps explain why adverse asset shocks in such times are associated with a severe drying-up of liquidity and deep discounts in asset prices. We illustrate that while the incidence of financial crises is lower when expectations of fundamentals are good, their severity can in fact be greater in such times due to greater system-wide leverage.

The core foundation of their theoretical model lies in the idea that when adverse asset shocks wipe out capital base of financial intermediaries, their short-term debt cannot be rolled over due to attendant agency problems, in particular, due to the problem that intermediaries may gamble excessively if leverage is not reduced. They tie this problem of rollover risk with the following facts: (i) the prominence of short-term rollover debt in the capital structure of financial firms, and (ii) the low cost of rollover debt in good economic times, which leads to the entry of highly leveraged firms in the financial sector. All of these factors played an important role in the financial crisis of 2007 to 2009 and the period preceding it.

…continue reading: Leverage, Moral Hazard, and Liquidity

Cyclicality of Credit Supply

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday August 9, 2010 at 9:12 am
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Editor’s Note: The following post comes to us from Bo Becker and Victoria Ivashina, both of the Finance Unit at Harvard Business School.

In the paper, Cyclicality of Credit Supply: Firm Level Evidence, which was recently made publicly available on SSRN, we study bank loan supply through the business cycle using firm level data from 1990 to 2009. It is well known that lending is cyclical. The contribution of our paper is to address two of the main empirical challenges in identifying whether this reflects the effects of bank credit supply. First, we focus on firms’ choice between two close forms of external debt financing: bank debt and public bonds. By conditioning the sample on firms raising new debt, we can rule out a demand explanation for the drop in bank borrowing which coincides with downturns. Second, by doing the analysis at the firm level, we can directly address how the composition of firms raising finance varies through time. This allows us to rule out compositional changes in the pool of firms seeking debt finance as an explanation of our findings.

…continue reading: Cyclicality of Credit Supply

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