We document the build-up of regulatory and market equity capital in large U.S. bank holding compa... more We document the build-up of regulatory and market equity capital in large U.S. bank holding companies between 1986 and 2000. During this time, large banking firms raised their capital ratios to the highest levels in more than 50 years. Since 1995, essentially none of the 100 largest U.S. banking firms have been constrained by de jure regulatory capital standards. Nor do these firms appear to be protecting themselves explicitly against falling below supervisory minimum capital standards. Variation in bank equity ratios reliably reflects portfolio risk, and we attribute the capital increase to enhanced market incentives to monitor and price large banks' default risks.
Many researchers apparently believe that some institutional investors prefer dividend-paying stoc... more Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the "prudent man" (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent "prudent investor" (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.
Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest lev... more Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced bank counterparties' incentives to monitor and price default risk. We find no evidence that a bank holding company's (BHC's) market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk.
Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be imp... more Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be improved to enhance financial stability, primarily in the U.S. context. Some of the Report's recommendations were adopted, but not all. This paper identifies some topics that should be studied in a 21 st-century version of Safe and Soundness Banking.
In an efficient market, spreads will reflect both the issuer's current risk and investors' expect... more In an efficient market, spreads will reflect both the issuer's current risk and investors' expectations about how that risk might change over time. Collin-Dufresne and Goldstein (2001) show analytically that a firm's expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors' expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.
The financial crisis saw local credit losses spread widely because bank capital was insufficient ... more The financial crisis saw local credit losses spread widely because bank capital was insufficient to cope with the accumulated credit risk, maturity mismatch and contingent liquidity risk. Ultimately, short-term liability holders lost faith in some large banks' ability to repay them. The resulting runs forced supervisors to step in with government support. Basel III rules now require higher equity ratios, though banks have been granted a very long time to comply. The financial industry has successfully argued that raising hundreds of billions in capital is at present too difficult.
Book-valued capital ratios and regulatory inertia are some of the causes, write Mark J. Flannery ... more Book-valued capital ratios and regulatory inertia are some of the causes, write Mark J. Flannery and Emanuela Giacomini
We find evidence that the Federal Reserve stress tests (CCAR and DFAST) produce information about... more We find evidence that the Federal Reserve stress tests (CCAR and DFAST) produce information about the stress-tested firms as well as other, non-stress-tested banking companies. Although standard event studies do not always show abnormal returns for the stress-tested sample on average, we argue that such tests are ill-suited for this sort of information event. Using a different empirical approach, we show that around stress test announcement dates, the absolute value of the cumulative abnormal returns (|CAR|) of stress-tested bank holding companies averages almost 3 percent. Cumulative abnormal trading volumes are more than 1 percentage point higher than a market model would predict. Absolute value abnormal returns and volumes are higher for more levered and riskier firms. We explore several theoretical hypotheses outlined in Goldstein and Sapra (2014) but find no evidence of negative welfare costs associated with the disclosure of stress test results.
Using a large sample of European acquisitions, we find that acquired firms substantially close th... more Using a large sample of European acquisitions, we find that acquired firms substantially close the gap between their actual and optimal leverage ratios. The bulk of this adjustment occurs quite rapidlywithin a year of the acquisition. The typical over-levered firm adjusts its debtto-assets ratio from 34.4% in the year before acquisition to 20% in the year after. (The adjustment is smaller, but still quite rapid, for targets that had been under-leveraged.) These adjustments occur primarily through debt issuances or retirements. We also investigate whether target firms' pre-merger leverage contributes to the probability of them being acquired. We find that firms further away from their optimal leverage are more likely to be acquired: for an average firm, an increase in the absolute leverage deviation from 1% to 10% of total assets increases the probability of being acquired by 4.1% to 5.6% (The larger effect applies to overleveraged firms.) Overall, our results provide support for the trade-off theory of capital structure and suggest that financial synergies have a significant role in the typical European acquisition decision.
Using a large sample of European acquisitions, we find that acquired firms substantially close th... more Using a large sample of European acquisitions, we find that acquired firms substantially close the gap between their actual and optimal leverage ratios. The bulk of this adjustment occurs quite rapidlywithin a year of the acquisition. The typical over-levered firm adjusts its debtto-assets ratio from 34.4% in the year before acquisition to 20% in the year after. (The adjustment is smaller, but still quite rapid, for targets that had been under-leveraged.) These adjustments occur primarily through debt issuances or retirements. We also investigate whether target firms' pre-merger leverage contributes to the probability of them being acquired. We find that firms further away from their optimal leverage are more likely to be acquired: for an average firm, an increase in the absolute leverage deviation from 1% to 10% of total assets increases the probability of being acquired by 4.1% to 5.6% (The larger effect applies to overleveraged firms.) Overall, our results provide support for the trade-off theory of capital structure and suggest that financial synergies have a significant role in the typical European acquisition decision.
Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be imp... more Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be improved to enhance financial stability, primarily in the U.S. context. Some of the Report’s recommendations were adopted, but not all. This paper identifies some topics that should be studied in a 21 st-century version of Safe and Soundness Banking.
Many researchers apparently believe that some institutional investors prefer dividend-paying stoc... more Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the "prudent man" (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent "prudent investor" (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.
We assemble a sample of 1,558 large investments made by 1,185 firms over the period 1989-1999, an... more We assemble a sample of 1,558 large investments made by 1,185 firms over the period 1989-1999, and study two main issues: How do firms pay for these large investments? And how does the stock market subsequently evaluate them? We find that major investments are mostly externally financed. The pecking order and market timing effects on capital structure are transitory. Firms move toward target leverage ratios. Long-run abnormal stock returns are not generally consistent with the hypothesis that managers tend to overinvest with internal funds. Only firms financing large projects with (newly-raised) external funds exhibit reliably negative abnormal returns over the subsequent 1-3 years.
Eichengreen and Portes (1995) and Dooley (2000) explore similar ideas in the sovereign debt arena... more Eichengreen and Portes (1995) and Dooley (2000) explore similar ideas in the sovereign debt arena, emphasising debt workouts and country liquidity runs respectively.
Hedge funds are significant players in the U.S. capital markets, but differ from other market par... more Hedge funds are significant players in the U.S. capital markets, but differ from other market participants in important ways such as their use of a wide range of complex trading strategies and instruments, leverage, opacity to outsiders, and their compensation structure. The traditional bulwark against financial market disruptions with potential systemic consequences has been the set of counterparty credit risk management (CCRM) practices by the core of regulated institutions. The characteristics of hedge funds make CCRM more difficult as they exacerbate market failures linked to agency problems, externalities, and moral hazard. While various market failures may make CCRM imperfect, it remains the best line of defense against systemic risk.
The deadweight costs of financial distress limit many firms' incentive to include a lot of (taxad... more The deadweight costs of financial distress limit many firms' incentive to include a lot of (taxadvantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. "Reverse convertible debentures" (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.
We document the build-up of regulatory and market equity capital in large U.S. bank holding compa... more We document the build-up of regulatory and market equity capital in large U.S. bank holding companies between 1986 and 2000. During this time, large banking firms raised their capital ratios to the highest levels in more than 50 years. Since 1995, essentially none of the 100 largest U.S. banking firms have been constrained by de jure regulatory capital standards. Nor do these firms appear to be protecting themselves explicitly against falling below supervisory minimum capital standards. Variation in bank equity ratios reliably reflects portfolio risk, and we attribute the capital increase to enhanced market incentives to monitor and price large banks' default risks.
The financial crisis has clearly indicated that government regulators are reluctant to permit a l... more The financial crisis has clearly indicated that government regulators are reluctant to permit a large financial institution to fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions always maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a new security, which converts from debt to equity automatically when the issuer's equity ratio falls too low. "Contingent capital certificates" can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets' poor outcomes.
We document the build-up of regulatory and market equity capital in large U.S. bank holding compa... more We document the build-up of regulatory and market equity capital in large U.S. bank holding companies between 1986 and 2000. During this time, large banking firms raised their capital ratios to the highest levels in more than 50 years. Since 1995, essentially none of the 100 largest U.S. banking firms have been constrained by de jure regulatory capital standards. Nor do these firms appear to be protecting themselves explicitly against falling below supervisory minimum capital standards. Variation in bank equity ratios reliably reflects portfolio risk, and we attribute the capital increase to enhanced market incentives to monitor and price large banks' default risks.
Many researchers apparently believe that some institutional investors prefer dividend-paying stoc... more Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the "prudent man" (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent "prudent investor" (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.
Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest lev... more Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced bank counterparties' incentives to monitor and price default risk. We find no evidence that a bank holding company's (BHC's) market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk.
Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be imp... more Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be improved to enhance financial stability, primarily in the U.S. context. Some of the Report's recommendations were adopted, but not all. This paper identifies some topics that should be studied in a 21 st-century version of Safe and Soundness Banking.
In an efficient market, spreads will reflect both the issuer's current risk and investors' expect... more In an efficient market, spreads will reflect both the issuer's current risk and investors' expectations about how that risk might change over time. Collin-Dufresne and Goldstein (2001) show analytically that a firm's expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors' expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.
The financial crisis saw local credit losses spread widely because bank capital was insufficient ... more The financial crisis saw local credit losses spread widely because bank capital was insufficient to cope with the accumulated credit risk, maturity mismatch and contingent liquidity risk. Ultimately, short-term liability holders lost faith in some large banks' ability to repay them. The resulting runs forced supervisors to step in with government support. Basel III rules now require higher equity ratios, though banks have been granted a very long time to comply. The financial industry has successfully argued that raising hundreds of billions in capital is at present too difficult.
Book-valued capital ratios and regulatory inertia are some of the causes, write Mark J. Flannery ... more Book-valued capital ratios and regulatory inertia are some of the causes, write Mark J. Flannery and Emanuela Giacomini
We find evidence that the Federal Reserve stress tests (CCAR and DFAST) produce information about... more We find evidence that the Federal Reserve stress tests (CCAR and DFAST) produce information about the stress-tested firms as well as other, non-stress-tested banking companies. Although standard event studies do not always show abnormal returns for the stress-tested sample on average, we argue that such tests are ill-suited for this sort of information event. Using a different empirical approach, we show that around stress test announcement dates, the absolute value of the cumulative abnormal returns (|CAR|) of stress-tested bank holding companies averages almost 3 percent. Cumulative abnormal trading volumes are more than 1 percentage point higher than a market model would predict. Absolute value abnormal returns and volumes are higher for more levered and riskier firms. We explore several theoretical hypotheses outlined in Goldstein and Sapra (2014) but find no evidence of negative welfare costs associated with the disclosure of stress test results.
Using a large sample of European acquisitions, we find that acquired firms substantially close th... more Using a large sample of European acquisitions, we find that acquired firms substantially close the gap between their actual and optimal leverage ratios. The bulk of this adjustment occurs quite rapidlywithin a year of the acquisition. The typical over-levered firm adjusts its debtto-assets ratio from 34.4% in the year before acquisition to 20% in the year after. (The adjustment is smaller, but still quite rapid, for targets that had been under-leveraged.) These adjustments occur primarily through debt issuances or retirements. We also investigate whether target firms' pre-merger leverage contributes to the probability of them being acquired. We find that firms further away from their optimal leverage are more likely to be acquired: for an average firm, an increase in the absolute leverage deviation from 1% to 10% of total assets increases the probability of being acquired by 4.1% to 5.6% (The larger effect applies to overleveraged firms.) Overall, our results provide support for the trade-off theory of capital structure and suggest that financial synergies have a significant role in the typical European acquisition decision.
Using a large sample of European acquisitions, we find that acquired firms substantially close th... more Using a large sample of European acquisitions, we find that acquired firms substantially close the gap between their actual and optimal leverage ratios. The bulk of this adjustment occurs quite rapidlywithin a year of the acquisition. The typical over-levered firm adjusts its debtto-assets ratio from 34.4% in the year before acquisition to 20% in the year after. (The adjustment is smaller, but still quite rapid, for targets that had been under-leveraged.) These adjustments occur primarily through debt issuances or retirements. We also investigate whether target firms' pre-merger leverage contributes to the probability of them being acquired. We find that firms further away from their optimal leverage are more likely to be acquired: for an average firm, an increase in the absolute leverage deviation from 1% to 10% of total assets increases the probability of being acquired by 4.1% to 5.6% (The larger effect applies to overleveraged firms.) Overall, our results provide support for the trade-off theory of capital structure and suggest that financial synergies have a significant role in the typical European acquisition decision.
Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be imp... more Twenty years ago, Safe and Soundness Banking studied how the supervisory environment could be improved to enhance financial stability, primarily in the U.S. context. Some of the Report’s recommendations were adopted, but not all. This paper identifies some topics that should be studied in a 21 st-century version of Safe and Soundness Banking.
Many researchers apparently believe that some institutional investors prefer dividend-paying stoc... more Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the "prudent man" (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent "prudent investor" (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.
We assemble a sample of 1,558 large investments made by 1,185 firms over the period 1989-1999, an... more We assemble a sample of 1,558 large investments made by 1,185 firms over the period 1989-1999, and study two main issues: How do firms pay for these large investments? And how does the stock market subsequently evaluate them? We find that major investments are mostly externally financed. The pecking order and market timing effects on capital structure are transitory. Firms move toward target leverage ratios. Long-run abnormal stock returns are not generally consistent with the hypothesis that managers tend to overinvest with internal funds. Only firms financing large projects with (newly-raised) external funds exhibit reliably negative abnormal returns over the subsequent 1-3 years.
Eichengreen and Portes (1995) and Dooley (2000) explore similar ideas in the sovereign debt arena... more Eichengreen and Portes (1995) and Dooley (2000) explore similar ideas in the sovereign debt arena, emphasising debt workouts and country liquidity runs respectively.
Hedge funds are significant players in the U.S. capital markets, but differ from other market par... more Hedge funds are significant players in the U.S. capital markets, but differ from other market participants in important ways such as their use of a wide range of complex trading strategies and instruments, leverage, opacity to outsiders, and their compensation structure. The traditional bulwark against financial market disruptions with potential systemic consequences has been the set of counterparty credit risk management (CCRM) practices by the core of regulated institutions. The characteristics of hedge funds make CCRM more difficult as they exacerbate market failures linked to agency problems, externalities, and moral hazard. While various market failures may make CCRM imperfect, it remains the best line of defense against systemic risk.
The deadweight costs of financial distress limit many firms' incentive to include a lot of (taxad... more The deadweight costs of financial distress limit many firms' incentive to include a lot of (taxadvantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. "Reverse convertible debentures" (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.
We document the build-up of regulatory and market equity capital in large U.S. bank holding compa... more We document the build-up of regulatory and market equity capital in large U.S. bank holding companies between 1986 and 2000. During this time, large banking firms raised their capital ratios to the highest levels in more than 50 years. Since 1995, essentially none of the 100 largest U.S. banking firms have been constrained by de jure regulatory capital standards. Nor do these firms appear to be protecting themselves explicitly against falling below supervisory minimum capital standards. Variation in bank equity ratios reliably reflects portfolio risk, and we attribute the capital increase to enhanced market incentives to monitor and price large banks' default risks.
The financial crisis has clearly indicated that government regulators are reluctant to permit a l... more The financial crisis has clearly indicated that government regulators are reluctant to permit a large financial institution to fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions always maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a new security, which converts from debt to equity automatically when the issuer's equity ratio falls too low. "Contingent capital certificates" can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets' poor outcomes.
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