Posts Tagged ‘Shocks’

The Functional Regulation of Finance

Posted by Steven L. Schwarcz, Duke University, on Monday June 16, 2014 at 9:21 am
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Editor’s Note: Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law.

How should we think about regulating our dynamically changing financial system? Existing regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature, is that financial regulation is overly reactive to past crises. The Dodd-Frank Act, for example, puts much weight on reforming mortgage financing.

There is, however, a less obvious flaw: that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. This type of grounded regulation can have value as long as it is monitored and updated as needed to adapt to changes in the financial architecture. Yet without that monitoring and updating, it can quickly become outmoded—such as occurred in 2008 when the pre-crisis financial regulatory framework, based on the dominance of bank-intermediated funding, failed to address a collapsing financial system in which the majority of funding had become non-bank intermediated.

…continue reading: The Functional Regulation of Finance

Labor Representation in Governance as an Insurance Mechanism

Posted by E. Han Kim, University of Michigan, Ross School of Business, on Tuesday May 27, 2014 at 9:12 am
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Editor’s Note: E. Han Kim is Professor of Finance at the University of Michigan.

Worker participation in corporate governance varies across countries. While employees are rarely represented on corporate boards in most countries, Botero et al. (2004) state “workers, or unions, or both have a right to appoint members to the Board of Directors” in Austria, China, Czech Republic, Denmark, Egypt, Germany, Norway, Slovenia, and Sweden. Such board representation gives labor a means to influence corporate policies, which may affect productivity, risk sharing, and how the economic pie is shared between providers of capital and labor.

…continue reading: Labor Representation in Governance as an Insurance Mechanism

Shock-Based Causal Inference in Corporate Finance

Posted by Bernard Black, Northwestern University School of Law, on Friday April 11, 2014 at 9:03 am
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Editor’s Note: Bernard Black is the Nicholas D. Chabraja Professor at Northwestern University School of Law and Kellogg School of Management. The following post is based on a paper co-authored by Professor Black and Vladimir Atanasov at the Mason School of Business, College of William and Mary.

Much corporate finance research is concerned with causation—does a change in some input cause a change in some output? Does corporate governance affect firm performance? Does capital structure affect firm investments? How do corporate acquisitions affect the value of the acquirer, or the acquirer and target together? Without a causal link, we lack a strong basis for recommending that firms change their behavior or that governments adopt specific reforms. Consider, for example, corporate governance research. Decisionmakers—corporate boards, investors, and regulators—need to know whether governance causes value, before they decide to change the governance of a firm (or all firms in a country) with the goal of increasing firm value or improving other firm or market outcomes. If researchers provide evidence only on association between governance and outcomes, decisionmakers may adopt changes based on flawed data that may lead to adverse consequences for particular firms.

…continue reading: Shock-Based Causal Inference in Corporate Finance

Distracted Directors

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 5, 2014 at 9:12 am
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Editor’s Note: The following post comes to us from Antonio Falato, Economist at Federal Reserve Board; Dalida Kadyrzhanova of the Department of Finance at the University of Maryland; and Ugur Lel of the Department of Finance at Virginia Tech.

In our paper, Distracted Directors: Does Board Busyness Hurt Shareholder Value?, which was recently accepted for publication in the Journal of Financial Economics, we examine the impact of independent director busyness on firm value in a setting that addresses a key challenge that the board of directors is an endogenously determined institution. A large number of publicly-traded firms in the U.S. have recently limited the number of multiple directorships held by their board members. For example, a recent survey shows that 74 percent of S&P 500 firms impose restrictions on the number of corporate directorships held by their independent directors, up from 27 percent in 2006, and the Institutional Shareholder Services recommends restrictions on the number of multiple directorships. Although such shareholder initiatives are consistent with standard theoretical considerations (e.g., Holmstrom and Milgrom, 1992), the empirical evidence on whether director busyness has any effect on the firm is thus far mixed. While several studies find that busy directors are associated with lower firm valuations and less effective monitoring (e.g., Fich and Shivdasani, 2006; Core, Holthausen and Larcker, 1999) others either do not, or provide mixed evidence (e.g., Ferris, Jagannathan and Pritchard, 2003; Field, Lowry, and Mkrtchyan, 2013).

…continue reading: Distracted Directors

CEO Compensation and Corporate Risk

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday November 7, 2013 at 9:07 am
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Editor’s Note: The following post comes to us from Todd Gormley of the Department of Finance at the University of Pennsylvania, David Matsa of the Department of Finance at Northwestern University, and Todd Milbourn, Professor of Finance at Washington University in St. Louis.

Every firm is exposed to business risks, including the possibilities of large, adverse shocks to cash flows. Potential sources for such shocks abound—examples include disruptive product innovations, the relaxation of international trade barriers, and changes in government regulations. In our paper, CEO Compensation and Corporate Risk: Evidence from a Natural Experiment, forthcoming in the Journal of Accounting and Economics, we examine (1) how boards adjust CEOs’ exposure to their firms’ risk after the risk of such shocks increase and (2) how incentives given by the CEOs’ pre-existing portfolios of stock and options affect their firms’ response to this risk. Specifically, we study what happens when a firm learns that it is exposing workers to carcinogens, which increase the risks of significant corporate legal liability and costly workplace regulations.

The results presented in this paper suggest that corporate boards respond quickly to changes in their firms’ business risk by adjusting the structure of CEOs’ compensation, but that the changes only slowly impact the overall portfolio incentives CEOs face. After the unexpected increase in left-tail risk, corporate boards reduce CEOs exposure to their firms’ risk; the sensitivities of the flow of managers’ annual compensation to stock price movements and to return volatility decrease. Various factors likely contribute to the board’s decision, including CEOs’ reduced willingness to accept a large exposure to their firms’ risk and the decline in shareholders’ desired investment after left-tail risk increases. Indeed, managers act to further reduce their exposure to the firm’s risk by exercising more options than do managers of unexposed firms. These changes, however, only slowly move CEOs’ overall exposure to their firm’s risk because the magnitude of their pre-existing portfolios continues to influence their financial exposure to the firm.

…continue reading: CEO Compensation and Corporate Risk

Exit as Governance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday August 20, 2013 at 9:15 am
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Editor’s Note: The following paper comes to us from Sreedhar Bharath of the Department of Finance at Arizona State University, Sudarshan Jayaraman of the Accounting Area at Washington University in Saint Louis, and Venky Nagar of the Department of Accounting at the University of Michigan.

Traditional theories of blockholder governance have focused primarily on blockholder intervention in management decisions. However, recent theories posit that blockholders can govern firms even when they have no intervention power. These theories view blockholders as informed traders who control management through “exit,” i.e., selling a firm’s stock based on private information (Admati and Pfleiderer 2009, Edmans 2009, Edmans and Manso 2011). Blockholder exit in these models exerts downward pressure on the stock price, which hurts management through its equity interest in the firm. Management therefore wants to make sure its actions are such that blockholders are willing to stay with the firm.

When blockholders are informed traders, management undertakes productive effort and investment in order to improve firm value and dissuade blockholders from exiting. The true governance force therefore comes from the threat of blockholder exit, not actual exit. Even if no exit is observed, blockholders could be governing effectively because their exit threat is sufficient to discipline management.

In our paper, Exit as Governance: An Empirical Analysis, forthcoming in the Journal of Finance, we empirically test the governance impact of blockholder exit threats. Since threats cannot be directly observed, this study focuses instead on a key mechanism that facilitates exit threats, namely stock liquidity. The exit threat models suggest that stock liquidity enhances the power of exit threats and improves firm value. For example, in Edmans (2009), the manager is compensated on the stock price and can take fundamental actions to improve firm value. Stock liquidity encourages strategic traders to acquire more information on firm fundamentals and trade on it in larger volumes (or blocks). The manager is sensitive to the resulting stock price, and therefore takes actions to increase firm value and induce (informed) blockholders to stay. Liquidity thus enhances the power of blockholder exit threats and improves firm value. This theoretical prediction forms the basis of our empirical tests.

…continue reading: Exit as Governance

Optimal CEO Compensation with Search: Theory and Empirical Evidence

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday July 15, 2013 at 9:08 am
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Editor’s Note: The following post comes to us from Melanie Cao of the Finance Area at York University and Rong Wang of the Finance Group at Singapore Management University.

Two issues concerning executive compensation deserve particular attention. The first is how a firm’s risk affects the executive’s pay-to-performance sensitivity (hereafter PPS), i.e., the ratio of incentive pay to firm performance. Standard agency models predict that the PPS does not change with the firm’s risk if the agent is risk neutral and decreases with the firm’s risk if the agent is risk averse. Notable examples are Bolton and Dewatripont (2005), Holmstrom (1982), and Murphy (1999). In contrast to this theoretical prediction, the empirical evidence on the effect of the firm’s risk on the PPS is ambiguous. For example, Core and Guay (1999) and Oyer and Shaefer (2005) find a positive relationship while Aggarwal and Samwick (1999) document a negative relationship.

The second issue is the large increase in CEO compensation along with the increase in firm size in the past three decades. This large increase has generated an intense debate in the public and the academia on whether CEOs are over-compensated. Although the increase in firm value contributed partly to the increase in CEO pay, a closer look at the data reveals two notable features (see section IV for a detailed description of the data). First, incentive pay, which is the predominant component of CEO pay, has increased more rapidly than the increase in firm value. From 1994 to 2009, median incentive pay increased by 244% in real terms, compared with a 40% increase in median firm value, and its share in total pay increased from 41% to 78.8%. Second, and related to the first feature, total CEO pay outpaced firm value. The ratio between CEO pay and firm value increased from $1.59 in 1994 to $1.73 in 2009 per a thousand dollars. These features suggest that the key to understanding the increase in CEO compensation is to understand what factors determine the PPS.

…continue reading: Optimal CEO Compensation with Search: Theory and Empirical Evidence

Evidence of CEO Adaptability to Industry Shocks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday July 8, 2013 at 9:30 am
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Editor’s Note: The following post comes to us from Wayne Guay, Daniel Taylor, and Jason Xiao, all of the Department of Accounting at the University of Pennsylvania.

Prior turnover literature documents various signals of poor performance, such as stock returns and earnings, that lead a board of directors to terminate the CEO, but does not explore the underlying causes of the CEO’s poor performance. In many cases, terminated CEOs have been successful earlier in their tenure as CEO. At some point, however, the board decides that the existing CEO’s skills do not fit with the current leadership needs of the firm, and so switches to a new CEO. The question of why these previously successful CEOs are released (apart from retirements or voluntary departures) remains largely unanswered.

In our paper, Adapt or Perish: Evidence of CEO Adaptability to Strategic Industry Shocks, which was recently made publicly available on SSRN, we conjecture that a previously successful CEO may not be able to adapt when the firms within her industry change their business strategy, or more precisely, that strategic shocks within the industry increase the probability that the CEO will suffer from an adaptability problem. If strategic industry shocks alter a firm’s leadership needs, and the board perceives the CEO cannot adapt their skills to fit those needs, then the CEO is more likely to be terminated. For example, assume a CEO has a set of skills that leads them to prefer to conduct manufacturing activities domestically. When faced with competitive forces that dictate a different strategy, some CEOs may be able to adapt successfully to manage foreign manufacturing operations. Other CEOs, however, may have difficulty adjusting their skills to fit the current strategic needs of the firm. If this is the case, the latter type of CEO will face a higher probability of being terminated when the firm’s industry competitors change their strategies. We note that it is certainly the case that all CEOs can adapt to some degree to changing business conditions. The interesting question then, is whether one can identify the types of shocks, if any, that cause CEO adaptability problems.

…continue reading: Evidence of CEO Adaptability to Industry Shocks

Resource Allocation within Firms and Financial Market Dislocation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday May 1, 2013 at 9:12 am
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Editor’s Note: The following post comes to us from Gregor Matvos and Amit Seru, both of the Booth School of Business at the University of Chicago.

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

Systemic Risk and Stability in Financial Networks

Posted by Daron Acemoglu, Massachusetts Institute of Technology, on Friday April 5, 2013 at 9:29 am
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Editor’s Note: Daron Acemoglu is a Professor of Economics at Massachusetts Institute of Technology.

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

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