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

The recent financial crisis has rekindled interest in the relationship between the structure of the financial network and systemic risk. Two polar views on this relationship have been suggested in the academic literature and the policy world. The first maintains that the “incompleteness” of the financial network can be a source of instability, as individual banks are overly exposed to the liabilities of a handful of financial institutions. Thus, according to this argument, a more complete financial network, which limits the exposure of the banks to any one counterparty would be less prone to systemic failures. The second view, in stark contrast, hypothesizes that it is the highly interconnected nature of the financial system that contributes to its fragility, as it facilitates the spread of financial distress and solvency problems from one bank to the rest in an epidemic-like fashion.

In our recent NBER working paper, Systemic Risk and Stability in Financial Networks, my co-authors (Asuman Ozdaglar of MIT and Alireza Tahbaz-Salehi of Columbia Business School) and I provide a tractable theoretical framework for the study of the economic forces shaping the relationship between the structure of the financial network and systemic risk. We show that as long as the magnitude (or the number) of negative shocks is below a critical threshold, a more equal distribution of interbank obligations leads to less fragility. In particular, all else equal, the sparsely connected ring financial network (corresponding to a credit chain) is the most fragile of all configurations, whereas the highly interconnected complete financial network is the configuration least prone to contagion. In line with the observations made by Allen and Gale (2000), our results establish that, in the more complete networks, the losses of a distressed bank are passed to a larger number of counterparties, guaranteeing a more efficient use of the excess liquidity in the system in forestalling defaults.

…continue reading: Systemic Risk and Stability in Financial Networks

In the paper, Governance in Executive Suites, which was recently made publicly available on SSRN, my co-author (Yao Lu) and I analyze the interplay between governance in executive suites and board monitoring. We find an exogenous shock increasing board independence weakens governance in executive suites. The empirical proxy for the strength of governance in executive suites is based on the governance mechanism identified by Landier et al. (2009), wherein dissenting executives steer CEOs towards more shareholder friendly decisions through “an efficient implementation constraint that disciplines the decision-making process.”

…continue reading: Governance in Executive Suites

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

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 our paper Does Corporate Transparency Contribute to Efficient Resource Allocation? which was recently accepted for publication in the Journal of Accounting Research, we examine whether the country-level information environment positively affects the timely reallocation of resources in response to growth shocks (or changes in growth opportunities) by improving the transfer of resources from industries which experience negative growth shocks to those that experience positive growth shocks.

We hypothesize that if a pair of countries has a high level of corporate transparency in each country, then investors are better able to recognize and direct resources towards industries which experience positive growth shocks and away from industries which experience negative growth shocks, irrespective of financial development. Our sample consists of calculated correlations in industry growth rates for 666 country pairs based on 37 unique countries and 37 manufacturing industries for the period 1980-1990 using industry-level data from a United Nations Industrial Development Organization (2000) database. We merge these correlations with country-level measures of corporate transparency that capture the quality of the financial reporting regime, the intensity of private information collection, the quality of information dissemination structures, the level of earnings opacity and stock price synchronicity.

We find transparency is positively associated with the correlation in industry-specific growth rates across country pairs. This positive association is consistent with the notion that corporate transparency helps to channel resources to those particular industries with good growth opportunities and hence contributes to more effective inter-sector allocation of resources. These results generally hold across alternative measures of transparency. In addition, we find that the impact of corporate transparency on the co-movement in growth rates is greater for country pairs with similar levels of economic development. Third, we find that the residual transparency metrics positively explain co-movements in industry-specific growth rates among country pairs, which indicates that transparency over and above that predicted by the underlying institutions facilitates resource allocation. Finally, we measure a country’s level of ex ante growth opportunities using the price-earnings ratio of global industry portfolios weighted by a country’s industrial mix and find that it is only countries with high transparency where there is an association between ex ante global growth opportunities of firms (within a country) and the country’s realized ex post growth in real GDP per capita. This result is consistent with the argument that firms in more transparent settings are better able to exploit global growth shocks and thus achieve higher realized growth rates.

The full paper is available for download here.

In our paper Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock, which was recently updated after I presented it at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Catherine Schrand and I exploit the Enron debacle as an exogenous shock for other U.S. firms and relate cost of capital shocks to subsequent disclosure responses in an attempt to understand the critical link between disclosure and cost of capital. This approach is different from existing research, which has examined the relation cross-sectionally , relating disclosure levels to the cost of capital. Even though this research has found that firms with more extensive voluntary disclosure exhibit less information asymmetry and have a lower cost of capital, a causal interpretation of such findings has proved problematic due to endogeneity concerns for which valid instruments are very difficult to find. Our approach tackles the endogeneity concern in a different way, exploiting the Enron collapse acts as a natural experiment. In addition, there are a number of features of the Enron collapse that make this a powerful setting to address the broad question of the relation between disclosure and cost of capital. First, the shock led to investor concerns about a systematic lack of transparency in financial reporting. Hence, it seems reasonable to expect firms to consider disclosure responses. Second, the shock occurred during a relatively short window. Finally, it occurred during the fourth quarter of 2001. Thus, firms had the opportunity to respond in their annual financial reporting.

Our sample comprises 1,868 U.S. firms with December fiscal-year ends and the required financial data from 1999 to 2001. Using this sample, we document that the cost of capital shocks are associated with an increase in the firms’ disclosures in their subsequent annual 10-K filings. Firms extend the number of pages in their 10-K filings, notably the sections containing the management discussion & analysis, related-party transactions, financial statements and footnotes. This link between cost of capital shocks and 10-K disclosure responses is robust to a broad set of alternative specifications. The increase in disclosure is particularly pronounced for firms that experience positive beta shocks and are likely to be more sensitive to their cost of capital because they have larger external financing needs and more growth opportunities. We also find that Arthur Anderson clients increase their 10-K pages and the section on related-party transactions more than firms that have other auditors, consistent with the idea that the disclosures are a response to the transparency concerns created by the Enron scandal.

We do not find a significant relation between the beta shocks and changes in the length of firms’ annual earnings announcements. However, an analysis of firms’ interim disclosures after the shock suggests that firms increase the number of 8-K filings in response to the crisis. We show that the 8-K disclosures mitigate the effects of the shock but such interim disclosures do not eliminate the relation between the cost of capital shocks and disclosure in the 10-K, consistent with the idea that firms’ 10-K filings and interim disclosures are complementary activities to reduce the transparency problems during this time period. The latter finding is important because it suggests that the annual 10-K filing contains relevant information that can alleviate investor concerns, despite its lack of timeliness. Finally, we show that firms’ disclosure responses subsequently reduce firms’ costs of capital and hence mitigate the impact of the transparency crisis.

The full paper is available for download here.