Posts Tagged ‘René Stulz’

Governance, Risk Management, and Risk-Taking in Banks

Posted by René Stulz, Ohio State University Fisher College of Business, on Wednesday October 8, 2014 at 9:00 am
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Editor’s Note: René Stulz is Professor of Finance at Ohio State University.

One might be tempted to conclude that good risk management in banks reduces the exposure to danger. However, such a view of risk management ignores that banks cannot succeed without taking risks that are ex ante profitable. Consequently, taking actions that reduce risk can be costly for shareholders when lower risk means avoiding valuable investments and activities that have higher risk. Therefore, from the perspective of shareholders, better risk management cannot mean risk management that is more effective at reducing risk in general since reducing risk in general would mean not taking valuable projects. If good risk management does not mean low risk, then what does it mean? How is it implemented? What are its limitations? What can be done to make it more effective? In my article, Governance, Risk Management, and Risk-Taking in Banks, which was recently made publicly available on SSRN, I provide a framework to understand the role, the organization, and the limitations of risk management in banks when it is designed from the perspective of increasing the value of the bank for its shareholders and review the existing literature.

…continue reading: Governance, Risk Management, and Risk-Taking in Banks

Why High Leverage is Optimal for Banks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday June 27, 2013 at 9:25 am
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Editor’s Note: The following post comes to us from Harry DeAngelo, Professor of Finance at the University of Southern California, and René Stulz, Professor of Finance at Ohio State University.

In our paper, Why High Leverage is Optimal for Banks, which was recently made publicly available on SSRN, we focus on banks’ role as producers of liquid financial claims. Our model assumes uncertainty and excludes agency problems, deposit insurance, taxes, and other distortions that would lead banks to adopt levered capital structures. We show that, under these idealized conditions, high bank leverage is optimal when there is a market premium for the production of (socially valuable) liquid claims. The analysis thus implies that high bank leverage – not Modigliani and Miller’s (1958) leverage irrelevance principle – is the appropriate idealized-world baseline for analyzing bank capital structure in the presence of a demand for liquid financial claims per se.

…continue reading: Why High Leverage is Optimal for Banks

Aligning Incentives at Systemically Important Financial Institutions

Editor’s Note: Christopher Small is co-editor of the Harvard Law School Forum on Corporate Governance and Financial Regulation. This post is based on a memo received from members of the Squam Lake Group. The Squam Lake Group is a non-partisan group of academics who offer guidance on the reform of financial regulation. The members of the group include Martin N. Baily of the Brookings Institution, John Y. Campbell of Harvard University, John H. Cochrane of the University of Chicago, Douglas W. Diamond of the University of Chicago, Darrell Duffie of Stanford University, Kenneth R. French of Dartmouth College, Anil K. Kashyap of the University of Chicago, Frederic S. Mishkin of Columbia University, David S. Scharfstein of Harvard University, Robert J. Shiller of Yale University, Matthew J. Slaughter of Dartmouth College, Hyun Song Shin of Princeton University, and René M. Stulz of Ohio State University. The members of the group disclose their outside activities either directly on their web sites or as part of their curriculum vitae, available on their web sites.

UBS recently announced it would pay part of the bonuses of 6,500 highly compensated employees with bonds that would be forfeited if the bank does not meet its capital requirements. Taxpayers should applaud this initiative. Other financial institutions should be rewarded for emulating it.

As the global financial crisis of 2007-2009 reminds us, the impairment of large interconnected intermediaries can have devastating effects on economic activity. This threat can induce governments to bail out distressed financial institutions. The direct costs to taxpayers of these bailouts are apparent. Beyond the direct costs, the prospect of bailouts removes much of the downside risk that the owners and employees of financial institutions should bear, distorting their financing and investment decisions, as well as increasing the likelihood and expected magnitude of future bailouts. The UBS “bonus bonds,” which echo a recommendation we made in The Squam Lake Report (French et al, 2010), mitigate these distortions.

…continue reading: Aligning Incentives at Systemically Important Financial Institutions

Target CEO Retention in Acquisitions Involving Private Equity Acquirers

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday March 4, 2013 at 9:23 am
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Editor’s Note: The following post comes to us from Leonce Bargeron, Frederik Schlingemann, and Chad Zutter, all of the Finance Group at University of Pittsburgh, and René Stulz, Professor of Finance at Ohio State University.

In the paper, Does Target CEO Retention in Acquisitions Involving Private Equity Acquirers Harm Target Shareholders?, which was recently made publicly available on SSRN, we examine whether target shareholders are affected adversely when the target CEO is retained by the acquirer and if the effect differs when the acquisition involves a private equity firm. We find that private equity acquirers are more likely to retain target CEOs, and, given an acquisition is made by a private equity firm, target shareholders receive a higher premium when the CEO is retained. The difference in premium is economically large as it corresponds to 10% to 23% of pre-acquisition firm value.

The reason for this higher premium is that the CEOs retained by private equity acquirers appear to be CEOs who have performed better and hence can add more value to the firm that results from the acquisition. Further, a CEO who is retained cannot compete with her former firm and we show that the premium paid if a CEO is not retained falls with the ease with which that CEO can compete with her former firm. The fact that better CEOs are more likely to be retained and that targets receive higher premiums when the CEO is retained is inconsistent with the view that the target CEO conflict of interest leads to inefficient retention of CEOs in exchange of lower premiums.

…continue reading: Target CEO Retention in Acquisitions Involving Private Equity Acquirers

Financial Globalization and the Rise of IPOs Outside the U.S.

Posted by René Stulz, Ohio State University Fisher College of Business, on Monday December 3, 2012 at 8:44 am
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Editor’s Note: René Stulz is Professor Finance at Ohio State University.

In the paper, Financial Globalization and the Rise of IPOs Outside the U.S., which was recently made publicly available on SSRN, my co-authors (Craige Doidge and George Karolyi) and I document dramatic changes in the IPO landscape around the world over the past two decades. U.S. IPOs have become less important and IPOs in other countries have become more important, whether one looks at counts or at proceeds. In fact, U.S. IPO activity has generally not kept pace with the economic importance of the U.S. We show that financial globalization plays a critical role in facilitating the increasing importance of IPOs by non-U.S. Firms.

…continue reading: Financial Globalization and the Rise of IPOs Outside the U.S.

Multinationals and the High Cash Holdings Puzzle

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday July 13, 2012 at 9:23 am
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Editor’s Note: The following post comes to us from Lee Pinkowitz of the Department of Finance at Georgetown University; René Stulz, Professor of Finance at Ohio State University; and Rohan Williamson, Professor of Finance at Georgetown University.

In the paper, Multinationals and the High Cash Holdings Puzzle, which was recently made publicly available on SSRN, we investigate whether the cash holdings of American companies are abnormally high after the financial crisis and whether these cash holdings can be explained by the theories summarized in the previous paragraph. We show that the extent to which cash holdings are unusually high after the crisis depends critically on the measure used. We would expect larger firms to hold more cash. Since corporate assets tend to grow over time, the dollar amount of cash holdings would grow even if the ratio of cash to assets stays constant. Consequently, at the very least, cash holdings should be measured relative to a firm’s assets. Using all non-financial and non-regulated public firms with assets and market capitalization greater than $5 million per year, the average cash/assets ratio is 20.18% in 2009-2010 compared to 20.50% in the 2004-2006 pre-crisis period. However, when we consider the median ratio, it is higher by 0.87% in 2009-2010 than in 2004-2006. Similarly, the asset-weighted ratio is higher by 0.74% in the recent period. The larger increase in the asset-weighted ratio than in the equally-weighted ratio suggests that large firms increased their holdings more and we show that this is the case. However, the changes in cash holdings from 2004-2006 to 2009-2010 are dwarfed by the changes in cash holdings from 1998-2000 to 2004-2006. Over that latter period, the average cash/assets ratio increases by 3.77%, the median by 6.39%, and the asset-weighted average by 3.62%. When we distinguish between private and public firms, we show that there is no evidence of an increase in the cash/assets ratio for private firms.

…continue reading: Multinationals and the High Cash Holdings Puzzle

Bebchuk Wins Debate about the Contribution of Executive Pay to the Financial Crisis

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday February 21, 2012 at 9:35 am
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Over the past two weeks, Lucian Bebchuk and René Stulz engaged in an online debate on the question: Has Executive Compensation Contributed to the Financial Crisis? Bebchuk supported a “yes” answer, and Stulz argued for a “no” answer. The debate, which was hosted by the World Bank’s All about Finance blog, was followed by a poll in which readers cast their votes. The votes are now in, and 79.9% of the votes were cast in support of the position supported by Bebchuk.

The opening statements by Bebchuk and Stulz are available here and here. The second-round responses by Bebchuk and Stulz are available here and here. The results of the readers’ poll are available here.

Banks and the Global Credit Crisis

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 15, 2012 at 9:50 am
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Editor’s Note: The following post comes to us from Andrea Beltratti, Professor of Finance at the Università Bocconi, and René Stulz, Professor of Finance at Ohio State University.

In our paper, The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?, forthcoming in the Journal of Financial Economics, we investigate the determinants of the relative stock return performance of large banks across the world during the period from the beginning of July 2007 to the end of December 2008. Our study does not focus on why the crisis happened. Rather, it is an investigation of the validity of various hypotheses advanced in the literature and the press as to why banks performed so poorly during the crisis.

Analyses of the crisis that emphasize the fragility of banks financed with short-term funds raised in the money markets are strongly supported by our empirical work, as are analyses that emphasize the role of bank capital. We find that large banks with more Tier 1 capital, more deposits, and less funding fragility performed better. Banks from countries with current account surpluses fared significantly better during the crisis, while banks from countries with banking systems more exposed to the U.S. fared worse. These latter results show that macroeconomic imbalances and the traditional asset contagion channel are related to bank performance during the crisis.

…continue reading: Banks and the Global Credit Crisis

Executive Pay and the Financial Crisis: A Response to René Stulz

Posted by Lucian Bebchuk, Harvard Law School, on Tuesday February 14, 2012 at 9:38 am
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Editor’s Note: Below is the response by Professor Lucian Bebchuk to the opening statement of Professor René Stulz in an online debate between the two of them at a World Bank forum. The debate focused on the question: Has executive compensation contributed to the financial crisis? The moderator’s introduction to the debate is available here; Lucian Bebchuk’s opening statement is available here; René Stulz’s opening statement is available here; Lucian’s Bebchuk’s response is available here; and René Stulz’s response is available here. Bebchuk’s response refers to two studies on the subject issued by the Harvard Law School Program on Corporate Governance, Regulating Bankers’ Pay and Paying for Long-Term Performance.

In his opening statement, René Stulz relies on the results of the Fahlenbrach-Stulz study (FS study) to reject the view that executive compensation has contributed to the financial crisis. Stulz argues that the evidence in his study is “inconsistent with the view that banks performed poorly because CEOs had poor incentives.” However, as explained below, the FS study does not provide a good basis for rejecting the poor incentives view.

The FS study attempts to test the “poor incentives” hypothesis by examining whether banks whose CEOs had larger equity holdings performed better during the crisis. Failing to find such an association – and indeed finding that such banks performed worse – the FS study rejects the poor incentives hypothesis. But the poor incentives view does not attribute poor risk-taking incentives to relatively low equity holdings, and the analysis in the FS study does not supply an adequate test of this view.

As I explained in my opening statement, the poor incentives view does not regard large equity holdings as the way to ensure good risk-taking incentives and does not view poor incentives as rooted in insufficient equity holdings. Rather, as I explained, poor incentives have resulted from (i) design of equity compensation (as well as bonus compensation) that rewarded executives even for short-term results that were subsequently reversed, and (ii) linking executive payoffs only to payoffs for shareholders and not also to payoffs for other contributors of capital to financial firms (such as bondholders).

…continue reading: Executive Pay and the Financial Crisis: A Response to René Stulz

Executive Pay and the Financial Crisis

Posted by Lucian Bebchuk, Harvard Law School, on Wednesday February 1, 2012 at 10:15 am
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Editor’s Note: Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. This post is the opening statement in an online debate at a World Bank forum between Lucian Bebchuk and René Stulz on the question: Has executive compensation contributed to the financial crisis? The moderator’s introduction to the debate is available here, Lucian Bebchuk’s statement is available here, and René Stulz’s opening statement is available here, with responses by Bebchuk and Stulz expected next week. Bebchuk’s post refers to several studies on the subject issued by the HLS Program on Corporate Governance, including Regulating Bankers’ Pay, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, and Paying for Long-Term Performance.

Yes, there is a good basis for concern that executive pay arrangements have contributed to excessive risk-taking during the run-up to the financial crisis. To be sure, other factors were clearly at work: the environment within which firms operated grew riskier due to asset bubbles generated by macro policies and global factors, and regulatory constraints on risk-taking and capital requirements were too lax. As financial economists generally recognize, however, for any given environment and outside constraints, the performance and risk choices of firms depend substantially on the incentives of firms’ executives. Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.

Of course, despite incentives to take excessive risks, some executives might have avoided doing so due to professional integrity, reputational concerns, or fiduciary duty norms. And some executives taking excessive risks might have done so due to their under-estimation of the risks taken. But economics and finance teach us that incentives often matter. Thus, to the extent that pay arrangements provided significant incentives to take excessive risks, the possibility that such incentives in fact contributed materially to the excessive risks taken in the run-up to the crisis should be seriously considered.

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

…continue reading: Executive Pay and the Financial Crisis

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