Regulatory Pressure and Fire Sales in the Corporate Bond Market
(with Pab Jotikasthira, and Christian T. Lundblad)
Abstract: This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculative-grade bonds. As insurance companies hold over one third of all outstanding investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 2001-2005, we find insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. This forced selling generates elevated selling pressure around the downgrade which causes price pressures and subsequent price reversals that are indicative of significant periods during which transaction prices deviate from fundamental values. Most importantly, bonds widely held by constrained insurance companies experience significantly larger price reversals. Investors providing liquidity to this market appear to earn abnormal returns.
Inheritance Law and Investment in Family Firms
(with Marco Pagano and Fausto Panunzi)
Abstract: We investigate whether inheritance law constrains investment in family firms. Using a model of succession in family firms where the law may constrain the entrepreneur to give a minimal stake to non-controlling heirs, we show that the size of this stake reduces investment in family firms, by reducing the firm's ability to pledge future income streams to external financiers. We take this prediction to the data, by collecting information about inheritance law in 62 countries. Wherever present, these laws effectively constrain the stake that can be given to the controlling and non-controlling heirs. Using a purpose-built indicator of the permissiveness of inheritance law together with measures of investor protection and data for 10,245 firms from 32 countries over the 1990-2006 period,, we find that stricter inheritance law is associated with lower investment in family firms, while it leaves investment unaffected in non-family firms, and that this result survives several robustness checks. Moreover, as predicted by the model, inheritance laws affects investment only in family firms that experience a succession.
Ripples Through Markets: Inter-market Impacts Generated by Large Trades
Abstract: This paper investigates the impacts of very large trades for cross-listed companies where parallel markets suffer from information frictions. We use a sample of large trades executed on London Stock Exchange's SEAQ-I market for European cross-quoted firms and investigate their impact on home market trading and prices. We find that (a) London market makers' strategy produces significant price impacts in home markets even though no information is published by the London market about the large trade execution, (b) price impacts on the home market are not a one-shot phenomena but rather protracted in time and starting some time before the large trade is executed, (c) price impacts are non-linear in trade size and bigger in the home markets, (d) home markets' prices reach their new equilibrium before London publishes the trade information, and (e) the stock's price performance in the days before the large trade is executed is found to influence the magnitude of price impacts.
IPO underpricing and after-market liquidity
(with Marco Pagano)
Abstract: The underpricing of the shares sold through Initial Public Offerings (IPOs) is generally explained with asymmetric information and risk. We complement these traditional explanations with a new theory. Investors who buy IPO shares are also concerned by expected liquidity and by the uncertainty about its level when shares start trading on the after-market. The less liquid shares are expected to be, and the less predictable their liquidity is, the larger will be the amount of “money left on the table” by the issuer. We present a model that integrates such liquidity concerns within a traditional framework with adverse selection and risk. The model’s predictions are supported by evidence from a sample of 337 British IPOs effected between 1998 and 2000. Using various measures of liquidity, we find that expected after-market liquidity and liquidity risk are important determinants of IPO underpricing, after controlling for variables traditionally used to explain underpricing.
Reputation Effects in Trading on the New York Stock Exchange
(with Robert Battalio and Robert Jennings)
Abstract: Theory suggests that reputations, developed through repeated face-to-face interactions, allow non-anonymous, floor-based trading venues to attenuate the adverse selection problem in the trading process. We identify instances when stocks listed on the New York Stock Exchange (NYSE) relocate on the trading floor. Although the specialist follows the stock to its new location, many floor brokers do not. We use this natural experiment to determine whether reputation affects trading costs. We find a discernable increase in the cost of liquidity in the days leading up to and immediately after a stock’s relocation. The increase is more pronounced for stocks with higher adverse selection. Using NYSE audit-trail data, we find that the floor brokers that relocate with the stock obtain lower trading costs than those who do not move. Together, these results suggest the floor of the NYSE plays an important role in the liquidity provision process.
Opening and Closing the Market: Evidence from the London Stock Exchange
(with Hyun Song Shin and Ian Tonks)
Abstract: Various markets, particularly NASDAQ, have been under pressure from regulators and market participants to introduce call auctions for their opening and closing periods. We investigate the performance of call markets at the open and close from a unique natural experiment provided by the institutional structure of the London Stock Exchange. As well as a call auction, there is a parallel "off-exchange" dealership system at both the market's open and close. Although the call market dominates the dealership system in terms of price discovery, we find that the call suffers from a high failure rate to open and close trading, especially on days characterized by difficult trading conditions. In particular, the call's success decreases significantly when (a) asymmetric information is high, (b) trading is expected to be slow, (c) order flow is unbalanced, and (d) uncertainty is high. Furthermore, traders' resort to call auctions is negatively correlated with firm size, implying that the call auction is not the optimal method for opening and closing trading of medium and small sized stocks. We suggest that these results can be explained by thick market externalities.
A Comprehensive Test of Order Choice Theory: Recent Evidence from the NYSE
(with Craig W. Holden, Pankaj Jain and Robert Jennings)
Abstract: We perform a comprehensive test of order choice theory from a sample period when the NYSE trades in decimals and allows automatic executions. We analyze the decision to submit or cancel an order or to take no action. For submitted orders we distinguish order type (market vs. limit), order side (buy vs. sell), execution method (floor vs. automatic), and order pricing aggressiveness. We use a multinomial logit specification and a new statistical test. We find a negative autocorrelation in changes in order flow exists over five-minute intervals supporting dynamic limit order book theory, despite a positive first-order autocorrelation in order type. Orders routed to the NYSE’s floor are sensitive to market conditions (e.g., spread, depth, volume, volatility, market and individual-stock returns, and private information), but those using the automatic execution system (Direct+) are insensitive to market conditions. When the quoted depth is large, traders are more likely to “jump the queue” by submitting limit orders with limit prices bettering existing quotes. Aggressively-priced limit orders are more likely late in the trading day providing evidence in support of prior experimental results.
Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading
(with Pab Jotikasthira, Christian T. Lundblad and Yihui Wang)
Abstract: This paper explores the trading incentives of financial institutions induced by the interaction between regulatory accounting rules and capital requirements by investigating insurance companies’ trading behavior during the recent financial crisis. According to insurance regulation, life insurers have a greater degree of flexibility to hold downgraded instruments at historical cost, whereas property and casualty insurers are forced to re-mark many of their downgraded securities to market prices. Using firm-level insurance company transaction and position data, we study the implications of this accounting difference, and document direct evidence of ‘gains trading’ associated with historical cost accounting during the financial crisis. When faced with severe downgrades among their holdings in asset-backed securities (ABS), life insurers largely continue to hold the downgraded securities at historical cost and instead selectively sell their corporate bond holdings with the highest unrealized gains. This is particularly true for insurers facing regulatory capital constraints and with high ABS exposures. This behavior is largely absent among property and casualty insurers; they instead disproportionately sell their re-marked ABS holdings. Finally, we find that the gains trading among life companies induces significant price declines in the otherwise unrelated corporate bonds that happen to exhibit high unrealized gains.
Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies
(with Vijay Yerramilli)
Abstract: In this paper, we investigate whether U.S. bank holding companies (BHCs) with strong and independent risk management functions had lower aggregate risk and downside risk. We hand-collect information on the organization structure of the 75 largest publicly-listed BHCs, and use this information to construct a Risk Management Index (RMI) that measures the strength of organizational risk controls at these institutions. We find that BHCs with a high RMI in the year 2006, i.e., before the onset of the financial crisis, had lower exposures to mortgage-backed securities and risky trading assets, were less active in trading off-balance sheet derivatives, and generally fared better in terms of operating performance and lower downside risk during the crisis years (2007 and 2008). In a panel spanning 8 years, we find that BHCs with higher RMIs had lower aggregate risk and downside risk, and higher stock returns, after controlling for size, profitability, a variety of risk characteristics, corporate governance, executive compensation, and BHC fixed effects. This result holds even after controlling for any simultaneity bias. Overall, these results suggest that strong internal risk controls are effective in lowering risk at banking institutions.
Investors’ Horizons and the Amplification of Market Shocks
(with Cristina Cella and Mariassunta Giannetti)
Abstract: During episodes of market turmoil, institutional investors with short trading horizons are inclined or forced to sell their holdings to a larger extent than investors with longer trading horizons. This may amplify the effects of market-wide shocks on the prices of stocks held by short horizon investors. We test the relevance of this mechanism by exploiting the negative shock caused by Lehman Brothers’ bankruptcy in September 2008. Consistent with our conjecture, short-term investors sell significantly more than long-term investors around and after the Lehman Brothers’ bankruptcy. Most importantly, stocks held by short-term investors experience more severe price drops and larger price reversals than those held by long-term investors. Since they are obtained after controlling for contemporaneous net flows, the stocks’ exposure to innovations in implied volatility and aggregate liquidity, various firms’ and investors’ characteristics, including the momentum effect and the propensity of institutional investors to follow an index, our results cannot be explained by characteristics of the institutions’ investment strategy other than their investment horizons. We also show that the effect of investor trading horizon emerges during other episodes of severe market turmoil, such as the October 1987 market crash. Overall, the empirical evidence strongly indicates that investors’ short horizons amplify the effects of market-wide negative shocks.
Transparency, Tax Pressure and Access to Finance
(with Tullio Jappelli, Marco Pagano and Fausto Panunzi)
In choosing transparency, firms must trade off the benefits from access to more abundant and cheaper capital against the cost of a greater tax burden. The paper studies this trade-off in a model with distortionary taxes and endogenous rationing of external finance, and tests its predictions using two different data sets with listed and privately-held firms. The predictions of the model are borne out by the evidence from both data sets. First, investment and access to finance are positively correlated with accounting transparency and negatively with tax pressure, controlling for firm-level characteristics, sector and country effects. Second, transparency is negatively correlated with tax pressure, particularly in sectors where firms are less dependent on external finance, and is positively correlated with tax enforcement. Finally, financial development enhances the positive effect of transparency on investment, and encourages transparency by firms that depend more on external finance.
Do Financial Analysts Restrain Insiders' Informational Advantage?
(with Marios Panayides)
Abstract: We investigate the competitive relationship between financial analysts and firm insiders for price-sensitive information and its influence on liquidity and price discovery. Without the presence of analysts, insiders have complete monopoly over information, influencing market equilibrium and liquidity. If analysts really compete for information (as in Fishman and Hagerty (1992)) they can reduce insiders' informational advantage with a consequent improvement of traders' welfare (as in Holden and Subrahmanyam (1992)). We empirically investigate this hitherto ignored role of analysts by using a sample of stocks that lost all analyst coverage, thus giving insiders complete monopoly over price-sensitive information. The departure of analysts, which is a highly publicized event, leads to important changes in liquidity and market equilibrium. Using a matching-firm methodology to address possible endogeneity, we find that liquidity decreases significantly, price efficiency deteriorates rapidly, information asymmetries increase, and institutional shareholders and liquidity-motivated traders leave the stock. The impact of insiders' trading on adverse selection costs and price efficiency becomes larger and their trades become more profitable. We also find that an important role of analysts is their ability to make price-sensitive information available to the market and this information gets reflected quicker in prices, suggesting that analysts make a significant contribution to market quality by competing with insiders for information.
Control Motivations and Capital Structure Decisions
This paper investigates the impact of corporate control motives on the firm’s capital structure decision. We investigate the impact of family blockholders because they are the best example of a shareholder that values corporate control most. We also look at the impact of institutional blockholders on the capital structure decision. Blockholders with high control motivations face a trade-off between getting external finance and losing or diluting their control over the firm’s decisions. Debt offers a solution to this dilemma while external equity does not. Hence, we hypothesize that firms with blockholders that value control should have higher debt-equity ratios. Furthermore, we also hypothesize that debt is more used where control is valued most: in countries where minority shareholders rights are not well-protected and where losing control would cost the most. The competing hypothesis is provided by risk reduction motivations. In this case, undiversified blockholders – such as families – may want to decrease leverage to reduce firm specific risk in their undiversified portfolios. We use 3,608 firms from 36 different countries to investigate this issue and we find that, after controlling for variables that have been found to influence capital structure, control motives do influence capital structure decisions. Family firms have higher leverage relative to non-family firms and they have even higher leverage in countries where minority shareholders are least protected. Families are found to use leverage in a strategic way: they use it less when they possess control-enhancing mechanisms, such as pyramids, that can allow them to have control anyway.
Blockholders, Debt Agency Costs and Legal Protection
(with Levant Guntay and Ugur Lel)
Abstract: International evidence has found that most companies around the world have concentrated ownership and the founding family is the most common type of blockholding. In this paper we investigate the impact of a founding family on debt agency costs under different investors’ protection environments. On one hand, founding families - through their undiversified investments, inter-generation presence, and reputation concerns - could mitigate debt agency costs of debt because they provide stability in the ownership structure. On the other hand, families – through their unique power position which can lead to expropriation concerns – could end up exacerbating debt agency costs. Using international bond issues from 1988 to 2002 for companies originating from 45 different countries we find evidence that family firms’ debt costs vary with investors’ protection. Family firms originating from an environment with low investors’ protection suffer from higher debt costs while firms originating from high investors’ protection environments benefit from lower debt costs. The results are robust to the inclusion of various measures of internal and external governance mechanisms.
The Market Maker Rides Again: Volatility and Order Flow Dynamics in a Hybrid Market
This paper investigates whether voluntary market makers provide a higher level of price stabilization than limit order traders even if they do not have any obligation to keep orderly markets. I analyze these issues using high frequency data from the London Stock Exchange which has adopted a hybrid market microstructure. Unlike what happens on the NYSE, market makers on the London Stock Exchange have no obligation to maintain orderly markets. I find that prices on the dealership system track the security's true value more efficiently. Compared to the pure limit order book system, the dealership system can transact higher volumes with significantly lower price volatility. This evidence suggests that market makers provide price stabilization even if they have no binding obligation to do so. The benefit market makers obtain from doing so is that they attract orders with the highest information content which is an important advantage in an environment characterized by information asymmetries. The results provide a useful insight into the contribution made by market makers to the trading process at a time when exchanges around the world are competing on the dimensions offered by different trading systems.
Work in Progress
- Workers’ Rights in Bankruptcy, with Marco Pagano (University of Naples and CEPR)
- Insurance Within Family Firms, with Marco Pagano (University of Naples and CEPR) and Fabiano Schivardi (EIEF)
Leverage and Dividends in Family Firms Around Successions, with Fausto Panunzi (Bocconi University and CEPR) and Marco Pagano (University of Naples and CEPR)
Succession and Corporate Governance in Family Firms, with Fausto Panunzi (Bocconi University and CEPR) and Marco Pagano (University of Naples and CEPR)
Voting With the Feet or Using Their Voice? The Behaviour of Institutional Investors in Underperforming Firms, with Noah Stoffman (Indiana University)