Recent Articles, Books, and Papers
See my blog for recent articles/comments: http://blogs.chicagobooth.edu/faultlines
Why are downturns following episodes of high asset values so detrimental to growth? A traditional explanation is “debt overhang” – the debt built up during the boom serves to restrict borrowing and investment during the bust. But why is the debt not renegotiated? In this paper, we attempt a different explanation of the causes and consequences of debt overhang. In doing so, we also differentiate between the control rights over assets, which are sufficient to enforce external claims only in a boom, and control rights over cash flows that enable the enforcement of external claims in a downturn. It is the change in the relevant control rights that makes it so hard to renegotiate debt efficiently, and causes the debt build up to have long-drawn adverse effects in the downturn.
Local Financial Capacity and Asset Values: Evidence from Bank Failures (with Rodney Ramcharan), Journal of Financial Economics , forthcoming
Using differences in regulation as a means of identification, we find that a reduction in local financial intermediation capacity reduces the recovery rates on assets of failing banks. It also depresses local land prices and is associated with subsequent distress in nearby banks. Fire sales appear to be one channel through which lower local intermediation capacity reduces the recovery rates on failed banks’ assets. The paper provides a rationale for why bank failures are contagious, and why the value of specialized financial assets may depend on the size of the intermediary market that is available to buy it.
The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s (with Rodney Ramcharan), forthcoming, American Economic Review
How important is the role of credit availability in inflating asset prices? And does greater credit availability make the economy more sensitive to changes in sentiment or fundamentals? In this paper we address 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. We find that credit availability likely had a direct effect on inflating land prices. Credit availability may have also amplified the relationship between the perceived improvement in fundamentals and land prices. When fundamentals turned down, however, areas with higher ex ante credit availability suffered a greater fall in land prices, and experienced higher bank failure rates. We draw lessons for regulatory policy.
Constituencies and Legislation: The Fight over the McFadden Act of 1927 (with Rodney Ramcharan), Management Science , forthcoming
The McFadden Act of 1927 was one of the most hotly contested pieces of legislation in U.S. banking history, and its influence was felt over half a century later. This paper studies the Congressional voting behavior surrounding the Act’s passage. We find congressmen in districts in which landholdings were concentrated, and credit costlier were significantly more likely to oppose the act. The evidence suggests that while the law and the overall regulatory structure can shape the financial system far into the future, they themselves are likely to be shaped by elites, even in countries with benign political institutions.
Sovereign debt, government myopia, and the financial sector (with Viral Acharya) Review of Financial Studies, Volume: 26 Issue: 6 Pages: 1526-1560 DOI: 10.1093/rfs/hht011 Published: JUN 2013
What determines the sustainability of sovereign debt? We develop a model where myopic
governments seek popularity but can nevertheless commit credibly to service external debt.
They do not default when debt is low because they would lose access to debt markets
and be forced to reduce spending; they do not default as debt builds up and net new
borrowing becomes difficult, because of the adverse consequences from default to the
domestic financial sector. More myopic governments default less often, but tax in a more
distortionary way and increase the vulnerability of the domestic financial sector to future
government debt default.
The Corporation in Finance: Paper behind my presidential speech to the American Finance Association, Journal of Finance Volume: 67 Issue: 4 Pages: 1173-1217 DOI: 10.1111/j.1540-6261.2012.01745.x Published: AUG 2012
The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.
The True Lessons of the Recession: The West Cannot Borrow and Spend its Way to Recovery, Foreign Affairs (May/June 2012)
Trade Credit Contracts (with Leora Klapper and Luc Laeven), Review of Financial Studies, March 2012, 25(3), pp. 838-867, DOI: 10.1093/rfs/hhr122
We employ a novel dataset on almost 30,000 trade credit contracts to describe the broad characteristics of the parties that contract together and the key contractual terms of these contracts. Whereas prior work has typically used information on only one side of the buyer-seller transaction, this paper utilizes information on both, allowing for the first analysis of buyer-seller pairs. An equally important distinction is that we have multiple contracts for the same buyer or supplier firms, rather than a firm-average response, allowing for the correction of time-invariant firm characteristics that might determine the choice of credit terms. We find that the largest and most creditworthy buyers receive contracts with the longest maturities from smaller suppliers, and that discounts for early payment tend to be offered to riskier buyers.
Illiquid Banks, Financial Stability, and Interest Rate Policy (with Douglas Diamond),Journal of Political Economy Volume: 120 Issue: 3 Pages: 552-591 DOI: 10.1086/666669 Published: JUN 2012
Do low interest rates alleviate banking fragility? Banks finance illiquid assets with demandable deposits, which discipline bankers but expose them to damaging runs. Authorities may choose to bail out banks being run. Unconstrained bailouts undermine the disciplinary role of deposits. Moreover, competition forces banks to promise depositors more, increasing intervention and making the system worse off. By contrast, constrained intervention to lower rates maintains private discipline, while offsetting contractual rigidity. It may still lead banks to make excessive liquidity promises. Anticipating this, central banks can reduce financial fragility by raising rates in normal times to offset their propensity to reduce rates in adverse times.
Fear of Fire Sales, Illiquidity Seeking, and the Credit Freeze (with Douglas Diamond), Quarterly Journal of Economics, May 2011, 126(2), pp. 557-591
Is there any need to “clean” up a banking system in the midst of a crisis, for instance, by closing some weak banks and forcing others to sell bad assets, or can one wait till the crisis is over? We argue that an “overhang” of impaired banks that may be forced to sell assets in the future can increase the private returns to holding illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits.
Land and Credit: A Study of the Political Economy of Banking in the United States in the Early 20th Century (with Rodney Ramcharan), Journal of Finance, December 2011, 66(6), pp. 1895-1931, DOI: 10.1111/j.1540-6261.2011.01694.x
We find that in the early 20th century, counties in the United States where the agricultural elite had disproportionately large land holdings had significantly fewer banks per capita, even correcting for state level effects. Moreover, credit appears to have been costlier, and access to it more limited, in these counties. The evidence is suggestive that elites may restrict financial development in order to limit access to finance, and they may be able to do so even in countries with well developed political institutions. (Web Appendix)
The Internal Governance of Firms (with Viral Acharya and Stewart Myers), Journal of Finance , June 2011, 66(3), pp. 689-720
We develop a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. Internal governance can mitigate agency problems and ensure that firms have substantial value, even with little or no external governance by investors. Internal governance works best when both top management and subordinates are important in generating cash flow. External governance, even if crude and uninformed, can complement internal governance and improve efficiency. This leads to a theory of investment and dividend policy, where dividends are paid by self-interested CEOs to maintain a balance between internal and external control. Our paper can explain why firms with limited external oversight, and firms in countries with poor external governance, can have substantial value. (Web Appendix)
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