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Recent Papers

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

What Purpose do Corporations Purport? Evidence from Letters to Shareholders. (with Pietro Ramella and Luigi Zingales, February 2022)   Presentation

Using natural language processing, we identify and categorize the corporate goals in the shareholder letters of the 150 largest companies in the United States, from 1955 to 2020. Corporate goals have proliferated during this period from an average of two in 1955 to almost 10 in 2020. We find a variety of factors are associated with a corporation stating a specific goal including advertising a firm’s strengths, promising improved performance, signaling a commitment to specific constituencies, building societal legitimacy, and conforming to the behavior of other corporations. In spite of the proliferation of corporate goals, executive compensation is still overwhelmingly based on shareholder value, as measured by stock prices and financial performance. Yet, we do observe a rise in bonus payments made contingent on social and environmental objectives, especially among the signatories of the 2019 Business Roundtable statement on corporate purpose. 

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, December 2021)

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, December 2021

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, forthcoming, Review of Financial Studies)  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,  forthcoming, Journal of Finance)  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.

Kill Zone (with Krishna Kamepalli and Luigi Zingales, Revised February 2021)  Presentation

We study why acquisitions of entrant firms by an incumbent can deter innovation and entry in the digital platform industry, where there are strong network externalities and some customers face switching costs. A high probability of an acquisition induces some potential early adopters to wait for the entrant's product to be integrated into the incumbent's product instead of switching to the entrant. Because of this, the incumbent is able to acquire the entrant for a lower price. Even if the incumbent platform does not undertake any traditional anti-competitive action, the reduction in prospective payoffs to entrants creates a “kill zone” in the space of startups, as described by venture capitalists, where entry is hard to finance. The drop-off in venture capital investment in startups in sectors where Facebook and Google make major acquisitions suggests this is more than just a theoretical possibility.       

Liquidity, Pledgeability, and the Nature of Lending (with Douglas Diamond and Yunzhi Hu, forthcoming, Journal of Financial Economics)

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)

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

When is Debt Odious: A Theory of Repression and Growth Traps (with Viral Acharya and Jack Shim, March 2020)  Presentation

How is a developing country affected by its government's ability to borrow in international markets? We examine the dynamics of a country's growth, consumption, and sovereign debt, assuming that the government's objective is to maximize short-term, typically wasteful, expenditures. Sovereign debt can extend the government's effective horizon; the government's ability to borrow hinges on its convincing investors they will be repaid, which gives it a stake in the future. The lengthening of the government's effective horizon can incentivize it to adopt policies that result in higher steady-state household consumption than if it could not borrow. However, access to borrowing does not always improve government behavior. In a developing country that saves little, the government may engage in repressive policies to enhance its debt capacity, which only ensures that successor governments repress as well. This leads to a ``growth trap'' where household steady-state consumption is lower than if the government had no access to debt. We argue that such a model can explain the well-known negative correlation between a developing economy's reliance on external financing and its economic growth. We also analyze the effects of instruments such as debt relief, a debt ceiling, and fiscal transfers in helping a developing economy emerge out of a growth trap, even when governed by a myopic, possibly rapacious, government.

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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