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This paper empirically examines the role of soft information in the competitive interaction between relationship and transaction banks. Soft information can be interpreted as a private signal about the quality of a firm that is observable to a relationship bank, but not to a transaction bank. We show that borrowers self-select to relationship banks depending on whether their privately observed soft information is positive or negative. Competition affects the investment in learning the private signal from firms by relationship banks and transaction banks asymmetrically. Relationship banks invest more; transaction banks invest less in soft information, exacerbating the selection effect. Finally, we show that firms where soft information was important in the lending decision were no more likely to default compared to firms where only financial information was used.
This note reviews the legal issues and concerns that are likely to play an important role in the ongoing deliberations of the Federal Constitutional Court of Germany concerning the legality of ECB government bond purchases such as those conducted in the context of its earlier Securities Market Programme or potential future Outright Monetary Transactions.
Credit boom detection methodologies (such as threshold method) lack robustness as they are based on univariate detrending analysis and resort to ratios of credit to real activity. I propose a quantitative indicator to detect atypical behavior of credit from a multivariate system - a monetary VAR. This methodology explicitly accounts for endogenous interactions between credit, asset prices and real activity and detects atypical credit expansions and contractions in the Euro Area, Japan and the U.S. robustly and timely. The analysis also proves useful in real time.
This study investigates the transition from being a listed company with a dispersed ownership structure to being a privately held company with a concentrated ownership structure. We consider a sample of private equity backed portfolio companies to evaluate the consequences of the corporate governance changes on operational performance. Our analysis shows significant positive abnormal growth in several performance ratios for the private period of our sample companies relative to comparable public companies. These performance differences come from the increase in ownership concentration after the leveraged buyout transaction.
We are able to shed light on the black box of restructuring tools private equity investors use to improve the operational performance of their portfolio companies. By building on previous work considering performance evaluation of PE backed companies, we analyze whether private equity improves operating efficiency and which of the typical restructuring tools are the main performance drivers. Using a set of over 300 international leveraged buyout transactions of the last thirty years, we find that while there is vast improvement in operational efficiency, these gains vary considerably. Our top performing transactions are subject to strong equity incentives, frequent asset restructuring and tight control by the investor. Furthermore, investors’ experience has a positive influence while financial leverage has no influence on operational performance.
The paper looks at the determinants of fiscal adjustments as reflected in the primary surplus of countries. Our conjecture is that governments will usually find it more attractive to pursue fiscal adjustments in a situation of relatively high growth, but based on a simple stylized model of government behavior the expectation is that mainly high trust governments will be in a position to defer consolidation to years with higher growth. Overall, our analysis of a panel of European countries provides support for this expectation. The difference in fiscal policies depending on government trust levels may help explaining why better governed countries have been found to have less severe business cycles. It suggests that trust and credibility play an important role not only in monetary policy, but also in fiscal policy.
Homestead exemptions to personal bankruptcy allow households to retain their home equity up to a limit determined at the state level. Households that may experience bankruptcy thus have an incentive to bias their portfolios towards home equity. Using US household data for the period 1996 to 2006, we find that household demand for real estate is relatively high if the marginal investment in home equity is covered by the exemption. The home equity bias is more pronounced for younger households that face more financial uncertainty and therefore have a higher ex ante probability of bankruptcy.
The paper uses fiscal reaction functions for a panel of euro-area countries to investigate whether euro membership has reduced the responsiveness of countries to shocks in the level of inherited debt compared to the period prior to succession to the euro. While we find some evidence for such a loss in prudence, the results are not robust to changes in the specification, such as an exclusion of Greece from the panel. This suggests that the current debt problems may result to a large extent from preexisting debt levels prior to entry or from a larger need for fiscal prudence in a common currency, while an adverse change in the fiscal reaction functions for most countries does not apply.
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on results from the true model. We apply our method to a calibrated affine model and fine that relative wealth equivalent losses are below 1.16% if the jump size is stochastic and below 1% if the jump size is constant and γ ≥ 5. We perform robustness checks for various levels of risk-aversion, expected jump size, and jump intensity.
We show that the optimal consumption of an individual over the life cycle can have the hump shape (inverted U-shape) observed empirically if the preferences of the individual exhibit internal habit formation. In the absence of habit formation, an impatient individual would prefer a decreasing consumption path over life. However, because of habit formation, a high initial consumption would lead to high required consumption in the future. To cover the future required consumption, wealth is set aside, but the necessary amount decreases with age which allows consumption to increase in the early part of life. At some age, the impatience outweighs the habit concerns so that consumption starts to decrease. We derive the optimal consumption strategy in closed form, deduce sufficient conditions for the presence of a consumption hump, and characterize the age at which the hump occurs. Numerical examples illustrate our findings. We show that our model calibrates well to U.S. consumption data from the Consumer Expenditure Survey.
SAFE Newsletter : 2013, Q2
(2013)
An analyst who works in Germany is more likely to publish a high (low) price target regarding a DAX30 stock if other Germany based analysts are also optimistic (pessimistic) about the same stock. This finding is not biased by the fact that DAX30 companies are headquartered in Germany. In times of bull markets, price targets of analysts who regularly exchange their opinion are higher correlated compared to other analysts. This effect vanishes in a bearish market environment. This suggests that communication among analysts indeed plays an important role. However, analysts’ incentives induce them not to deviate too much from the overall average during an economic downturn.
With this paper, I propose a simple asset pricing model that accounts for the influence from social interaction. Investors are assumed to make up their mind about an asset's price based on a forecasting strategy and its past profitability as well as on the contemporaneous expectations of other market participants. Empirically analysing stocks in the DAX30 index, I provide evidence that social interaction rather destabilises financial markets. At least, it does not have a stabilising effect.
In this paper, I analyse the reciprocal social influence on investment decisions within an international group of roughly 2,000 mutual fund managers who invested in companies in the DAX30. Using a robust estimation procedure, I provide empirical evidence that the average fund manager puts 0.69% more portfolio weight on a particular stock, if his peers on average assign a weight to the corresponding position which is 1% higher compared to other stocks in the portfolio. The dynamics of this influence on the choice of portfolio weights suggest that fund managers adjust their behaviour according to the prevailing market situation and are more strongly influenced by others in times of an economic downturn. Analysing the working locations of the fund managers, I conclude that more than 90% of the magnitude of influence stems from the social learning. While this form of influence varies much over time, the magnitude of influence resulting from the exchange of opinion is more or less constant.
The recent wave of randomized trials in development economics has provoked criticisms regarding external validity. We investigate two concerns—heterogeneity across beneficiaries and implementers—in a randomized trial of contract teachers in Kenyan schools. The intervention, previously shown to raise test scores in NGO- led trials in Western Kenya and parts of India, was replicated across all Kenyan provinces by an NGO and the government. Strong effects of shortterm contracts produced in controlled experimental settings are lost in weak public institutions: NGO implementation produces a positive effect on test scores across diverse contexts, while government implementation yields zero effect. The data suggests that the stark contrast in success between the government and NGO arm can be traced back to implementation constraints and political economy forces put in motion as the program went to scale.
Ziel meiner Dissertation ist die empirische Analyse von Auswirkungen der sozialen Interaktion zwischen Akteuren auf Finanzmärkten. Die folgenden Aufsätze sind Bestandteil dieser kumulativen Dissertation:
1. Frederik König (2012): Does Social Interaction destabilise Financial Markets?
2. Frederik König (2012) : Analyst Behaviour: the Geography of Social Interaction
3. Frederik König (2012) : Fluctuations of Social Influence: Evidence from the Behaviour of Mutual Fund Managers during the Economic Crisis 2008/09
In meinem ersten Aufsatz stelle ich ein Marktpreismodell vor, welches dem Einfluss durch soziale Interaktion Rechnung trägt. Mit Hilfe dieses Modells gehe ich der Fragestellung nach, ob soziale Interaktion zwischen Marktteilnehmern eine stabilisierende oder eine destabilisierende Wirkung auf Finanzmärkte hat. Mit meinem zweiten Aufsatz untersuche ich das Verhalten von Aktienanalysten, die als wesentlicher Impulsgeber für Finanzmärkte gelten. Konkret stelle ich heraus, ob Analysten stärker von anderen Analysten beeinflusst werden, wenn diese im gleichen Land bzw. in der gleichen Stadt arbeiten oder wenn sogar ein regelmäßiger Meinungsaustausch erfolgt. Beides setzte ich ins Verhältnis zum vorherrschenden Marktumfeld. In meinem dritten Aufsatz beschäftige ich mich mit der sozialen Interaktion zwischen Fondsmanagern. Diese verwalten in etwa ein Drittel des frei handelbaren Aktienvermögens und haben folglich einen nennenswerten Einfluss auf Finanzmärkte. Mit Hilfe einer neuartigen Schätzmethode bestimme ich die Größe des sozialen Einflusses und untersuche auch hier temporale Variationen im Verhältnis zum zu Grunde liegenden Marktumfeld. Des Weiteren zerlege ich die Gesamtgröße des sozialen Einflusses in zwei Komponenten, die zum einen den Einfluss im Rahmen der reinen Beobachtung und zum anderen den Einfluss durch Kommunikation reflektieren.
The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model.
This paper investigates risk-taking in the liquid portfolios held by a large panel of Swedish twins. We document that the portfolio share invested in risky assets is an increasing and concave function of financial wealth, leading to different risk sensitivities across investors. Human capital, which we estimate directly from individual labor income, also drives risk-taking positively, while internal habit and expenditure commitments tend to reduce it. Our micro findings lend strong support to decreasing relative risk aversion and habit formation preferences. Furthermore, heterogeneous risk sensitivities across investors help reconcile individual preferences with representative-agent models.
We develop a dynamic network model whose links are governed by banks' optmizing decisions and by an endogenous tâtonnement market adjustment. Banks in our model can default and engage in firesales: risk is transmitted through direct and cascading counterparty defaults as well as through indirect pecuniary externalities triggered by firesales. We use the model to assess the evolution of the network configuration under various prudential policy regimes, to measure banks' contribution to systemic risk (through Shapley values) in response to shocks and to analyze the effects of systemic risk charges. We complement the analysis by introducing the possibility of central bank liquidity provision.
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
This paper presents a theory that explains why it is beneficial for banks to engage in circular lending activities on the interbank market. Using a simple network structure, it shows that if there is a non-zero bailout probability, banks can significantly increase the expected repayment of uninsured creditors by entering into cyclical liabilities on the interbank market before investing in loan portfolios. Therefore, banks are better able to attract funds from uninsured creditors. Our results show that implicit government guarantees incentivize banks to have large interbank exposures, to be highly interconnected, and to invest in highly correlated, risky portfolios. This can serve as an explanation for the observed high interconnectedness between banks and their investment behavior in the run-up to the subprime mortgage crisis.
Basel III and CEO compensation in banks: pay structures as a regulatory signal : [March 6, 2013]
(2013)
This paper proposes a new regulatory approach that implements capital requirements contingent on managerial compensation. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea of the proposed regulation is to utilize the compensation scheme to drive a wedge between the interests of top management and shareholders to counteract shareholder risk-shifting incentives. The decisive advantage of this approach compared to existing regulation is that the regulator does not need to be able to properly measure the bank investment risk, which has been shown to be a difficult task during the 2008-2009 financial crisis.
We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel - monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and tends to concentrate on the bank funding side. Then, to rationalize this evidence we build a macro model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.
Euro area data show a positive connection between sovereign and bank risk, which increases with banks’ and sovereign long run fragility. We build a macro model with banks subject to incentive problems and liquidity risk (in the form of liquidity based banks’ runs) which provides a link between endogenous bank capital and macro and policy risk. Our banks also invest in risky government bonds used as capital buffer to self-insure against liquidity risk. The model can replicate the positive connection between sovereign and bank risk observed in the data. Central bank liquidity policy, through full allotment policy, is successful in stabilizing the spiraling feedback loops between bank and sovereign risk.
This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. However, the significance mainly comes from R&D firms, which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we also document that only idiosyncratic volatility (ivol) has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting according to the size of idiosyncratic volatility, we only find a significant ivol anomaly for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To simultaneously control for several explanatory variables, we also run panel regressions of portfolio alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses.
We study whether prices of traded options contain information about future extreme market events. Our option-implied conditional expectation of market loss due to tail events, or tail loss measure, predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-specific tail loss measure predicts individual expected returns and magnitude of realized stock-specific crashes in the cross-section of stocks. An investor that cares about the left tail of her wealth distribution benefits from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index.
Recently, we evaluated a fiscal consolidation strategy for the United States that would bring the government budget into balance by gradually reducing government spending relative to GDP to the ratio that prevailed prior to the crisis (Cogan et al, JEDC 2013). Specifically, we published an analysis of the macroeconomic consequences of the 2013 Budget Resolution that was passed by the U.S. House of Representatives in March 2012. In this note, we provide an update of our research that evaluates this year’s budget reform proposal that is to be discussed and voted on in the House of Representative in March 2013. Contrary to the views voiced by critics of fiscal consolidation, we show that such a reduction in government purchases and transfer payments can increase GDP immediately and permanently relative to a policy without spending restraint. Our research makes use of a modern structural model of the economy that incorporates the long-standing essential features of economics: opportunity costs, efficiency, foresight and incentives. GDP rises because households take into account that spending restraint helps avoid future increases in tax rates. Lower taxes imply less distorted incentives for work, investment and production relative to a scenario without fiscal consolidation and lead to higher growth.
We use unique data from financial advisers’ professional exam scores and combine it with other variables to create an index of financial sophistication. Using this index to explain long-term stock return expectations, we find that more sophisticated financial advisers tend to have lower return expectations. A one standard deviation increase in the sophistication index reduces expected returns by 1.1 percentage points. The effect is stronger for emerging market stocks (2.3 percentage points). The sophistication effect contributes 60% to the model fit, while employer fixed effects combined contribute less than 30%. These results help understand the formation of potentially excessively optimistic expectations.
A natural experiment in which customer-owned mutual companies converted to publicly listed firms created a plausibly exogenous shock to the stock market participation status of tens of thousands of people. We find the shock changed the way people vote in the affected areas, with a 10% increase in share-ownership rate being followed by a 1.3%–3.1% increase in right-of-center vote share. The institutional details and additional tests suggest that wealth, liquidity, and tax-related incentives cannot fully explain the results. A plausible explanation is that the associated increase in the salience of stock ownership causes a shift in voters’ attention.
SAFE Newsletter : 2013, Q1
(2013)
SAFE Newsletter
(2013)
The Center of Excellence SAFE – “Sustainable Architecture for Finance in Europe” – is a cooperation of the Center for Financial Studies and Goethe University Frankfurt. It is funded by the LOEWE initiative of the State of Hessen (Landes-Offensive zur Entwicklung wissenschaftlich-ökonomischer Exzellenz). SAFE brings together more than 40 professors and just as many junior researchers who are all dedicated to conducting research in support of a sustainable financial architecture. The Center has two main pillars: excellent research on all important topics related to finance; and policy advice, including the dissemination of relevant research findings to European decision makers from the realms of politics, regulation and administration.
In order to promote a fruitful exchange with interested parties from politics, academia, business and the media, SAFE issues a newsletter on a quarterly basis. This aims to provide an overview of the Center‘s ongoing research and policy activities. The SAFE Newsletter succeeds the House of Finance Newsletter, which was published between 2009 and 2012.
SAFE is based at Goethe University’s House of Finance however extends beyond by drawing on scholars from other parts of Goethe University as well as from fellow research institutions. The Center builds on the reputation of the House of Finance institutions, serving as an interdisciplinary think tank on the issue of finance.
Debt-induced crises, including the subprime, are usually attributed exclusively to supply-side factors. We uncover an additional factor contributing to debt culture, namely social influences emanating from the perceived average income of peers. Using unique information from a representative household survey of the Dutch population that circumvents the need to define the social circle, we consider collateralized, consumer, and informal loans. We find robust social effects on borrowing – especially among those who consider themselves poorer than their peers – and on indebtedness, suggesting a link to financial distress. We check the robustness of our results using several approaches to rule out spurious associations and handle correlated effects.