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Annual Review of Financial Economics - Volume 5, 2013
Volume 5, 2013
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Introduction to Volume 5 of the Annual Review of Financial Economics
Vol. 5 (2013), pp. 1–7More LessIn Volume 5 of the Annual Review of Financial Economics, we continue focusing on the role of banks and credit in the recent financial crisis with articles on too big to fail, credit-rating agencies, corporate governance for banks, bank leverage and real interest rates, and financial contagion in the banking sector. More traditional topics such as dynamic capital-structure models, cross-sectional asset pricing tests, trends in firm-specific volatility, short selling, and conglomerates and the theory of the firm are also included. In addition, we have two contributions that fall outside the mainstream of financial economics, one involving capital allocation in the insurance industry and the other involving tax issues at the intersection of law and finance. But we begin this volume with a commemoration of the 40th anniversary of the publications of Black & Scholes (1973) and Merton (1973b) on pricing options and other derivative securities, two articles that forever changed the theory and practice of financial economics.
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Fischer Black
Vol. 5 (2013), pp. 9–19More LessReprintThis article was originally published by Wiley for the American Finance Association (Merton RC, Scholes MS. 1995. Fischer Black. J. Finance 50(5):1359–70). It is reprinted with permission from John Wiley and Sons © 1995.
Reference formatting was updated to facilitate linking.
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A Review of Merton’s Model of the Firm’s Capital Structure with Its Wide Applications
Vol. 5 (2013), pp. 21–41More LessSince its publication, the seminal structural model of default by Merton (1974) has become the workhorse for gaining insights about how firms choose their capital structure, a “bread and butter” topic for financial economists. Capital structure theory is inevitably linked to several important empirical issues such as (a) the term structure of credit spreads, (b) the level of credit spreads implied by structural models in relation to the ones that we observe in the data, (c) the cross-sectional variations in leverage ratios, (d) the types of defaults and renegotiations that one observes in real life, (e) the manner in which investment and financial structure decisions interact, (f) the link between corporate liquidity and corporate capital structure, (g) the design of capital structure of banks [contingent capital (CC)], (h) linkages between business cycles and capital structure, etc. The literature, building on Merton’s insights, has attempted to tackle these issues by significantly enhancing the original framework proposed in his model to make the theoretical framework richer (by modeling frictions such as agency costs, moral hazard, bankruptcy codes, renegotiations, investments, state of the macroeconomy, etc.) and in greater accordance with stylized facts. In this review, I summarize these developments.
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Too Big to Fail: Causes, Consequences, and Policy Responses
Vol. 5 (2013), pp. 43–61More LessGovernments cannot credibly commit to eschew bailouts of creditors when large financial institutions become distressed. This too-big-to-fail (TBTF) problem distorts how markets price securities issued by TBTF firms, thus encouraging them to borrow too much and take too much risk. TBTF also encourages financial firms to grow, leading to competitive inequity and potential misallocation of credit. This review discusses evidence that such distortions are empirically relevant and also discusses the policy efforts to limit them. In the wake of the Financial Crisis of 2007–2008, it seems increased concentration in the financial industry has worsened the TBTF problem. Nevertheless, markets price the risks of large financial firms more now than before the Financial Crisis.
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Corporate Governance: What’s Special About Banks?
Vol. 5 (2013), pp. 63–92More LessThis review surveys the literature on the corporate governance of banks. Traditional corporate governance mechanisms, such as concentrated ownership and takeover threats, in principle, also apply to banks. However, banks have special traits and are heavily regulated, preventing natural forms of governance to arise and rendering many of these governance mechanisms ineffective. Financial regulation can in principle compensate for weaknesses in corporate governance but in practice has had limited effectiveness in protecting the interests of banks’ stakeholders, because of, for instance, unproductive interactions between regulatory restraints and existing governance arrangements. The review concludes with a discussion of corporate governance and regulatory reforms to enhance the safety and soundness of banks. These proposals range from placing more emphasis on value creation for bank stakeholders other than shareholders to reducing risk-shifting incentives for bank managers and shareholders.
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Credit Rating Agencies: An Overview
Vol. 5 (2013), pp. 93–122More LessCredit rating agencies (CRAs) play a central role in the debt (bond) markets of many countries. CRAs have also attracted a considerable amount of public and policy attention during the past decade, especially with respect to their role in the financial crisis of 2008–2009 and their role in the more recent Eurozone difficulties. This article provides an overview of the CRAs: who they are, what they do, how their centrality to the financial markets came about, what their role in the financial crisis was, and the important aspects of the policy measures that have affected the CRAs.
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Interest Rates and the Bank Risk-Taking Channel
Vol. 5 (2013), pp. 123–141More LessThe recent global financial crisis has brought the debate on how interest rates affect bank risk-taking to center stage. Proponents of this new risk-taking channel of monetary policy have argued that the low interest–rate environment in the run-up to the crisis may have created incentives for banks to take on excessive leverage and lower their lending standard, thus weakening bank portfolios. There is growing empirical evidence supporting this view. In contrast, this link has been little studied from a theoretical standpoint, leaving somewhat of a hole in our understanding of why (and how) banks’ decisions concerning the overall risk of their portfolios, and their capital structures, may be influenced by changes in the interest rate environment and, by extension, policy choices (e.g., monetary policy) that affect it. We summarize some of the emerging literature on this topic (both empirical and theoretical), as well as some of the more classical work on related topics. We also present a simple model that illustrates various channels through which bank risk-taking is affected by the interest rate environment in which banks operate. We use that model to analyze the likely effect of various other forces. Given the wealth of evidence that interest rates may have a real effect through banks’ portfolio decisions, it is important for policymakers to better understand the channel through which real interest rates operate on banks’ decision-making.
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R2 and the Economy
Vol. 5 (2013), pp. 143–166More LessThe characterization of firm-specific return volatility as the intensity with which firm-specific events occur reconciles many seemingly discordant results. A functionally efficient stock market allocates capital to its highest value uses, which often amounts to financing Schumpeterian creative destruction, wherein creative winner firms outpace destroyed losers, who could be the previous year’s winners. This rise in firm-specific fundamentals volatility elevates firm-specific return volatility in a sufficiently informationally efficient stock market. These linkages are interconnected feedback loops rather than unidirectional chains of causality.
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Empirical Cross-Sectional Asset Pricing
Vol. 5 (2013), pp. 167–199More LessI review recent research efforts in the area of empirical cross-sectional asset pricing. I start by summarizing the evidence on cross-sectional return predictability and the failure of standard (consumption) capital asset pricing models (CAPMs) and their conditional versions to explain these predictability patterns. Part of the recent literature focuses on ad hoc factor models, which summarize the cross section of expected returns in parsimonious form, or on production-based approaches, which suggest links between firm characteristics and expected returns. Without imposing restrictions on investor preferences and beliefs, neither one of these two approaches can answer the question of why investors price assets the way they do. Within the rational expectations paradigm, recent research that imposes such restrictions has focused on the intertemporal CAPM (ICAPM), long-run risks models, as well as frictions and liquidity risk. Approaches based on investor sentiment have focused on the development of empirical proxies for sentiment and for the limits to arbitrage that allow sentiment to affect prices. Empirical work that considers learning and adaptation of investors has worked with out-of-sample tests of cross-sectional predictability.
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Insurance Risk, Risk Measures, and Capital Allocation: Navigating a Copernican Shift
Vol. 5 (2013), pp. 201–223More LessWe pursue two interrelated lines of thought. The first is a conceptual arc from (a) consideration of the unique characteristics of insurance risk, to (b) the quantification of this risk through risk measures, to (c) the application of these concepts to problems of allocating capital within an insurance company. The second is the identification and analysis of a dichotomy between prescriptive and descriptive approaches that appears in the study of each of the three previous components. In this way, we demonstrate the need for a Copernican shift from prescriptive solutions emphasizing the intrinsic characteristics of insurance loss random variables, to descriptive solutions accounting for both the properties of loss distributions and the economic and regulatory realities faced by insurance companies.
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Conglomerate Firms, Internal Capital Markets, and the Theory of the Firm
Vol. 5 (2013), pp. 225–244More LessThis article reviews the conglomerate literature, with a focus on recent papers that have cast strong doubt on the hypothesis that conglomerate firms destroy value on average when compared to similar stand-alone firms. Recent work has shown that investment decisions by conglomerate firms are consistent with value maximization; conglomerate firms trade at an average premium relative to single-segment firms when value weighting; and the valuation premia and discounts, both for conglomerates and single-segment firms, are driven by differences in the production of unique differentiated products. A profit-maximizing theory of the firm that considers how firms select their organizational structure can explain these recent findings and much of the large variation in findings in the conglomerate literature. We also review the literature showing how market imperfections create additional benefits and costs for internal capital markets and a potential for managerial distortions.
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Short Selling
Vol. 5 (2013), pp. 245–258More LessShort selling plays a unique role in financial markets. Short selling’s institutional structure is distinct from other types of trades, and short sellers have been shown to be more informed than other types of traders. This review discusses short sellers’ motivation, the institutional mechanics of short selling, the empirical findings on short selling, the regulation of short selling, the connection between corporate events and short selling, and the equity lending market. The review assesses the current direction of research as well as summarizes the current state of knowledge about the subject.
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Law and Finance: The Case of Constructive Sales
Vol. 5 (2013), pp. 259–276More LessThis review illustrates the interaction between law and finance in the particular case of the taxation of constructive sales. The focus is on the treatment of variable prepaid forward contracts and the rules regarding these instruments articulated by Revenue Ruling 2003-7 and the recent case involving Philip Anschutz (Anschutz Co. et al. v. Commissioner of Internal Revenue 2011). Simple models are used to show how the tests established by the law fail to reflect important financial considerations, such as the volatility of asset returns and the riskiness of dividend payments. These models provide examples that form the basis for a critique of the current rules and also indicate a possible path for future reform and improvement of the law, namely the addition of a delta-based test to the existing rules. The analysis presented here aims to encourage future work that applies financial theory to critique and improve legal rules in a wide range of other situations.
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Financial Contagion and Network Analysis
Vol. 5 (2013), pp. 277–297More LessNetwork models of interbank exposures allow the mapping of the complex web of financial linkages among many institutions and address issues of system stability and contagion risk. Although existing models cover a fair amount of ground in explaining how network structure can lead to default cascades and in quantifying the likelihood and the impact of default cascades through balance-sheet mechanics, the literature has shortcomings in explaining how shocks are potentially amplified through the network of exposures. These amplification mechanisms seem to be very important in financial crises. This review discusses the main conceptual ideas behind network models of contagion, the major findings of this literature, as well as some limitations of existing models.
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