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Recent Papers

What Purpose do Corporations Purport? Evidence from Letters to Shareholders. (with Pietro Ramella and Luigi Zingales, March 2023)   Presentation

Using natural language processing, we identify corporate goals stated in the shareholder letters of the 150 largest companies in the United States from 1955 to 2020. Corporate goals have proliferated, from less than one on average in 1955 to more than 7 in 2020. While in 1955, profit maximization, market share growth, and customer service were dominant goals, today almost all companies proclaim social and environmental goals as well. We examine why firms announce goals and when. We find goal announcements are associated with management’s responses to the firm’s (possibly changed) circumstances, with the changing power and preferences of key constituencies, as well as from management’s attempts to deflect scrutiny. While executive compensation is still overwhelmingly based on financial performance, we do observe a rise in bonus payments contingent on meeting social and environmental objectives. Firms that announce environmental and social goals tend to implement programs intended to achieve those goals, although their impact on outcomes is unclear. The evidence is consistent with firms focusing on shareholder interests while incorporating stakeholder interests as interim goals. Goals also do seem to be announced opportunistically to deflect attention and alleviate pressure on management.    

Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets (with Viral Acharya, Rahul Chauhan, and Sascha Steffens, March 2023)  Online Appendix

When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits and reduced their average maturity. They also issued lines of credit to corporations. However, when the Fed halted its balance-sheet expansion in 2014 and even reversed it during quantitative tightening (QT) starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the financial sector was left more sensitive to potential liquidity shocks, with weaker-capitalized banks most exposed. This necessitated Fed liquidity provision in September 2019 and again in March 2020. Liquidity-risk-exposed banks suffered the most drawdowns and the largest stock price declines at the onset of the Covid crisis in March 2020. The evidence suggests that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability.

Joined at the hip: Why continued globalization offers us the best chance of addressing climate change (Per Jacobsson Lecture at the IMF, October 2022)

Most policymakers realize the urgency of combating the existential threat of climate change. Yet the same policymakers seem much more sanguine about the ongoing de-globalization, which is occurring through a combination of old fashioned protectionism and emerging geo–political concerns. Some believe we can compartmentalize action on the climate, shielding it from the hostility that increasingly characterizes economic relations between even friendly countries today. This is a pipe dream. Not just politically but also economically, continued growth of cross-border flows of trade, capital, technology, information, and people, which is what I mean by globalization, is essential to tackle climate change. Climate action and continued globalization are joined at the hip.

Liquidity, liquidity everywhere, not a drop to use: Why flooding banks with central bank reserves may not expand liquidity, with Viral Acharya, September 2022. Presentation

Central bank balance sheet expansion is financed by commercial banks. It involves not just a substitution of liquid central bank reserves for other assets held by commercial banks, but also a counterpart increase in commercial bank liabilities, such as short-term deposits issued to finance reserves. Banks typically also write a variety of other claims on reserve holdings. Normally, central bank balance sheet expansion will enhance the net future availability of liquidity to the system. However, in episodes of stress when a large fraction of claims on liquidity are exercised, the demand for liquidity can be significantly greater than the availability of reserves. Furthermore, some liquid commercial banks may hoard reserves to bolster their own prospects, contributing significantly to liquidity shortages. Therefore, because central bank balance sheet expansion operates through commercial bank balance sheets, it need not eliminate future episodes of liquidity stress, it may even exacerbate them. This may also attenuate any positive effects of central bank balance sheet expansion on economic activity.  

When is Debt Odious: A Theory of Repression and Growth Traps (with Viral Acharya and Jack Shim, June 2022)  

We examine the dynamics of a country’s growth, consumption, and sovereign debt, assuming that the government is myopic and wants to maximize short-term, self-interested spending. Surprisingly, government myopia can increase a country’s access to external borrowing. In turn, access to borrowing can extend the government’s effective horizon; the government’s ability to borrow hinges on it convincing creditors they will be repaid, which gives it a stake in generating future revenues. In a high-saving country, the lengthening of the government’s effective horizon can incentivize it to tax less, resulting in a “growth boost", with higher steady-state household consumption than if it could not borrow. However, in a country that saves little, the government may engage in more repressive policies to enhance its debt capacity. This could lead to a “growth trap” where household steady-state consumption is lower than if the government had no access to debt. We discuss the effectiveness of alternative debt policies, including declaring debt odious, debt forgiveness, and debt ceilings. We also analyze the impact of unanticipated shocks on the country’s welfare.

Kill Zone (with Krishna Kamepalli and Luigi Zingales, Revised June 2022)  

Venture capitalists suggest that incumbent internet platforms create a kill zone around themselves, where any competing entrant is acquired quickly. Consequently, financing new startups becomes unprofitable. We construct a simple model that rationalizes the existence of a kill zone. The price at which an acquisition is done depends on the number of customers the entrant platform can attract if it remains independent, which in turn depends on the number of apps that have adapted to the platform. The prospect of a quick acquisition by the incumbent platform, however, reduces the app designers’ benefits from adaptation, making it harder for a technological superior entrant to acquire customers. This reduces the stand-alone price of the new entrant, decreasing the price at which they will be acquired, and thus reducing the incentives of VCs to finance their entry. We discuss the policy implications of this model.     

Secured Credit Spreads and the Issuance of Secured Debt (with Efraim Benmelech and Nitish Kumar, forthcoming, Journal of Financial Economics)

Credit spreads for secured debt are lower than for unsecured debt, especially when a firm’s credit quality deteriorates, the economy slows, or average credit spreads widen. Yet investment grade firms tend to be reluctant to issue secured debt at all times. In contrast, we find that for firms that are rated below-investment grade, the likelihood of secured debt issuance increases as firm’s credit quality deteriorates, the economy slows, or average credit spreads widen. This differential pattern of issue behavior is consistent with highly rated firms seeing unencumbered collateral as a form of insurance, to be used only in extremis.

The Decline of Secured Debt (with Efraim Benmelech and Nitish Kumar, forthcoming, Journal of Finance)

The share of secured debt issued (as a fraction of total corporate debt) declined steadily in the United States over the twentieth century. This stems partly from financial development giving creditors greater confidence that high quality borrowers will respect their claims even if creditors do not obtain security up front. Consequently, such borrowers prefer retaining financial flexibility by not giving security up front. Instead, security is given contingently – when a firm approaches distress. This also explains why superimposed on the secular decline, the share of secured debt issued is countercyclical.

Central banks, political pressure, and its unintended consequences, 2022,  published in James A. Dorn (editor), Populism and the Future of the Fed, Cato Institute, Washington DC.

The proper role of central banks, the frameworks they use, and the range of tools they believe they can legitimately employ, have changed considerably over the last two decades. Interestingly, this has come after perhaps their greatest triumph, taming inflation. What led to this rethinking? And what are its consequences, some possibly unintended. What have been the effects on financial stability? These are the questions this article examines.

The Relationship Dilemma: Organizational Culture and the Adoption of Credit Scoring Technology in Indian Banking (with Prachi Mishra and Nagpurnanand Prabhala, Review of Financial Studies, June 2022, vol 35, 7, pp 3418-3466.)  Presentation

India introduced credit scoring technology in 2007. We study its adoption by the two main types of banks operating there, new private banks (NPBs) and state-owned public sector banks (PSBs). NPBs start checking the credit scores of most borrowers before lending soon after the technology is introduced. PSBs do so equally quickly for new borrowers but very slowly for prior clients, although lending without checking scores is reliably associated with more delinquencies. We show that an important factor explaining the difference in adoption is the stickiness of past bank structures and associated managerial practices. Past practices hold back better practices today.

Going the Extra Mile: Distant Lending and the Credit Cycle (with Joao Granja and Christian Leuz,  Journal of Finance, Apr 2022, |77 (2) , pp.1259-1324)  Presentation

The average distance of U.S. banks from their small corporate borrowers increased before the global financial crisis, especially for banks in competitive counties. Small distant loans are harder to make, so loan quality deteriorated. Surprisingly, such lending intensified as the Fed raised interest rates from 2004. Why? We show banks’ responses to higher rates led to bank deposits shifting into competitive counties. Short-horizon bank management recycled these inflows into risky loans to distant uncompetitive counties. Thus, rate hikes, competition, and managerial short-termism explain why inflows ‘burned a hole’ in banks’ pockets and, more generally, increased risky lending.

Communities, the State, and Markets: The Case for Inclusive LocalismOxford Review of Economic Policy, Volume 37, Number 4, 2021, pp 811-823.

Liquidity, Pledgeability, and the Nature of Lending (with Douglas Diamond and Yunzhi Hu, Journal of Financial Economics, Mar 2022 143 (3), pp.1275-1294)

We develop a theory of how corporate lending and financial intermediation change based on the fundamentals of the firm and its environment. We focus on the interaction between the prospective net worth or liquidity of an industry and the firm’s internal governance or pledgeability. Variations in prospective liquidity can induce changes in the nature, covenants, and quantity of loans that are made, the identity of the lender, and the extent to which the lender is leveraged. We offer predictions on how these might vary over the financial cycle.  

Indian Banking: A Time to Reform? (with Viral Acharya, September 2020) published in Essays in Honor of Isher Ahluwalia, Ashok Gulati and Radhicka Kapoor ed. ICRIER.

This paper examines what holds Indian banking back and suggests a variety of implementable reforms that could allow banking activity to grow significantly without the periodic boom-bust cycles it has been subject to. Apart from regulatory and market reforms, we propose reforms to bank governance and ownership, especially for public sector banks. With the current enormous strains on government finances, there may be a window of opportunity in which these reforms may be possible since the status quo is untenable

The Spillovers from Easy Liquidity and the Implications for Multilateralism (with Douglas Diamond and Yunzhi Hu -- The Mundell Fleming Lecture) IMF Economic Review, January 2020, 68(1),4-34

Anticipated exchange rate appreciation in capital-receiving countries, induced by easy monetary policy in source funding countries, increases the expected net worth of firms in receiving countries and their ability to buy assets. Anticipating this higher liquidity for corporate assets, corporations in capital-receiving countries lever up, and neglect alternative sources of debt capacity such as maintaining the pledgeability of their cash flows. When monetary policy in source countries tightens, receiving-country exchange rates depreciate, and liquidity dries up in their corporate sector even if country prospects are sound. Since pledgeability has been neglected, debt capacity plummets, leading to a sudden stop in funding and subsequent financial distress. To avoid such booms and busts, authorities in receiving countries often try to smooth exchange rate volatility (actions consistent with a “fear of floating”) by leaning against abrupt appreciations and depreciations. Exchange rate intervention in this view is not an attempt by receiving countries to gain competitive advantage but a macro-prudential tool to mitigate adverse monetary policy spillovers from source countries. We discuss the potential for multilateralism to improve on outcomes.

Pledgeability, Industry Liquidity, and Financing Cycles (with Douglas Diamond and Yunzhi Hu) Journal of Finance VOL. LXXV, NO. 1 • FEBRUARY 2020

Why are downturns following high valuations of firms long and severe? Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. Firms take on more debt when they anticipate higher future industry liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract around, higher anticipated liquidity can also reduce a firm’s current access to finance.

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