Research projects 2012

Finance, banking, and the macroeconomy 

Efficiency of financial markets 

Corporate governance

Finance, banking, and the macroeconomy

Determining Banks' Participation in Central Bank Bailouts (Vladimir Sokolov)

During severe shocks to the financial system, monetary authorities often bailout banks which are dependent on external financing and are considered to be central to economic activity. When government-managed capital reallocations benefiting a particular group of firms occur, academics and policy makers often raise concerns about the necessity and consequences of such interventions. Among others, Faccio et al. (2006), Igan et al. (2010), Duchin and Sosyura (2011a) have dealt with this issue. They have demonstrated that political connections of firms play a role in the distribution of bailout funding and the subsequent performance of firms. This paper seeks to explore this issue further and addresses the following question: After controlling for the type of ownership what financial factors matter for government-orchestrated bailouts of banks? In particular I am going to exploit the exogenous nature of the shock to the Russian economy caused by the collapse of the Lehman Brothers and investigate to what extent the distribution of the bailout funding by the central bank was influenced by the recipients’ pre-crisis financial characteristics and by their crisis-period operating performance.  

The proposed study will investigate massive government assistance to banks experiencing credit constrains due to heavy reliance on external financing, and is related to the growing literature that explores the impact of the Troubled Asset Relief Program (TARP) implemented by the US government for strengthening its financial sector during the recent liquidity crisis. (e.g., Duchin and Sosyura (2011b), Black and Hazelwood (2011), Brunnermeier et al. (2011)).

After the beginning of the Global financial crisis in August 2007, the Central Bank of Russia (CBR) similarly to other central banks set-up new anti-crisis credit facilities, on which it heavily relied after the collapse of the Lehman Brothers in September 2008. These new credit facilities were organized by the CBR as American-style auctions for the commercial banks where banks could willingly participate and choose the amount of liquidity they were going to obtain from the CBR. Using a detailed balance-sheet and income data on a rich sample of over 1000 Russian banks I am going to investigate what bank's characteristics influence the bank's choice to obtain the CBR funding during the crisis period through the newly established credit facilities.

The task of empirically identifying factors that are important for distribution of the bailout funding is often complicated by endogeneity problems. For example, an economic crisis can trigger a relatively stronger decline in the demand for products of certain industrial sectors, which would induce government to subsidize those sectors. Another simultaneity problem is related to the fact that some industrial sectors are a priori more dependent on external financing and are more vulnerable to cuts in lending by banks (e.g., Dell'Ariccia et al. (2008) and Kroszner et al. (2007)). In case of the financial crisis government assistance could be tilted towards such industrial sectors and monetary authority could allocate bailout funding to banks which are affiliated with such sectors.

The endogeneity concerns could be address in several ways. First, in order to identify financially constrained banks from the balance sheet data I will pursue a strategy used by Duchin et al. (2010) which relies on an assumption that lending and borrowing decisions made by banks in a pre-crisis period are not positively correlated with unobserved bank-specific shocks during the crisis. Secondly, besides the CBR data on banks I’m going to use the data on more 7 mln. Russian companies compiled by Bureau van Dijk, which includes information on firms’ banks. The firm-bank level data should allow me to absorb the firm-specific changes in credit demand during the crisis period and presumably identify the variation of banks’ characteristics which determine their choice to apply for bailout funding. All in all, this environment presents an ideal experiment for studying the banks’ decision making process during the crisis with regard to participation in the central bank’s credit auctions.

The perspective results of the study should be important to academics and policy makers. Because banks' management chooses the degree of participation in the auction the expected results could reveal what banks’ characteristics are considered to be most important by their management for obtaining the bailout funding. Monitory authorities could use these results for designing the future anti-crises credit facilities.

Key words: bailouts, banks, government 

Efficiency of financial markets

Market Transparency and Informed liquidity provision (Alexey Boulatov)

In the classic models of securities trading with asymmetric information, informed traders submit market orders to liquidity providers who are uninformed and perfectly competitive. For example, the market makers in Glosten and Milgrom (1985), Kyle (1985) and Easley and O’Hara (1987) have no private information, and they set prices to break even in expectation. They provide liquidity to one or more informed traders who demand liquidity. Similarly, in Glosten (1994) liquidity is provided by a book of limit orders submitted by perfectly competitive uninformed agents. Informed traders then demand liquidity by submitting market orders that execute against the book of (uninformed) limit orders. Dennert (1993) and Bernhardt and Hughson (1997) relax the assumption of perfect competition among liquidity providers and model oligopolistic competition among dealers. Liquidity providers are uninformed in their models as well. Kyle (1989) considers a model in which strategic, privately informed traders provide liquidity and build an order book that is hit by uninformed liquidity demanders. Bernhardt and Taub (2006) compare the equilibrium of Kyle (1989) with that of Kyle (1985). They do not consider settings in which informed liquidity demanders trade with liquidity providers who are also informed,however.

The proposed analysis is intended to relax the assumption that liquidity providers are uninformed.  We also relax the assumption that they are perfectly competitive. We model a security market in which informed agents trade as liquidity demanders as in Kyle (1985) and as liquidity providers as in Kyle (1989). Numerous studies have extended Kyle’s models, but none consider the situation where informed agents coexist as liquidity demanders and liquidity providers.

The specific questions we ask are whether hidden liquidity enhances the quality of the market in terms of execution costs to uninformed traders and the informational efficiency of prices. The case in favor of hiding liquidity is that doing so attracts traders who would not provide liquidity in displayed markets, thus increasing competition among liquidity providers. The case against is that hidden liquidity enhances the advantage of informed traders over the uninformed. Informed traders typically profit by camouflaging their orders among those of the uninformed, and hidden liquidity enables the informed explicitly to conceal their orders. This could result in higher execution costs for the uninformed and less efficient prices. These forces create the basic tension in our model.

Key words: liquidity, execution costs, market, informed/ uninformed traders

Option Pricing with Scheduled Jumps in the Underlying Asset (Sergey Gelman)

This paper introduces a new model of continuous time option pricing, which explicitly accounts for scheduled jumps caused by quarterly earnings announcements in the underlying stock. We present the stock price process as the product of a geometric brownian motion and scheduled jump process with a uniform jump size. This simple specification allows for obtaining a closed-form analytical solution for the European call option price. Empirical tests using a vast number of options with different strikes and maturities on several US stocks during 1999-2008 provide some evidence of superiority of our model over Black-Scholes in terms of fitting option prices. Moreover, the suggested model turns out to be no less precise as the Merton (1976) model with unscheduled jumps. Furthermore, the model allows to derive implications for delta hedging strategies prior to the announcement date. In particular, one should take a larger position in stock and intensify rebalancing for portfolios with out-of-the-money options compared to the Black-Scholes (1973) setup.

Key words: merger and acquisition deals, political affinity, bid, investment, premium

Corporate governance

Nationalization in Russia 2004-2008: Effects on performance and corporate governance (Carsten Sprenger)

In this research project I plan to analyze empirically the performance of Russian companies that have been acquired by the Russian government from private owners. This is done by comparing different performance indicators of these companies to those of a sample of comparable firms that remained privately owned. In recent years, there has been a tendency to more state control over companies in certain sectors in Russia. To our knowledge, no systematic analysis of the relative performance of SOEs in Russia has been carried out. This question is however of great importance for the government policy towards privatization vs. nationalization. The aim of this research project is to provide evidence on the performance effect of a increase of state ownership to a majority (this is our definition of nationalization).

In 2010-11 I have assembled a database of nationalization deals in the years 2004-2007 and collected financial statements and information on corporate governance of target companies for up to three years before and after the date of nationalization. I plan to extend the data to the year 2008 where a number of further nationalizations occurred.

So far the comparison was done by comparing financial performance indicators of nationalized firms before and after nationalization relative to the industry mean and median. In a next step, I want to do a more careful job in matching nationalized firms to most comparable private firms using propensity score matching. I also would like to distinguish near-bankrupt firms (close to the date of nationalization) that might have been bailed out by the government from solvent companies.

Furthermore, I am interested in the corporate governance mechanisms behind performance changes: changes of CEO and changes in the composition of the board of directors, subsidies and access to credit from state-owned banks, departing from a private or joining a state-owned business group.

Key words : nationalization, performance effect (indicators)

Short vs Long-Term CEO Incentives (Stanimir Morfov)

This project will expand our understanding of moral hazard models with frictions by formally analyzing the provision of incentives in a principal-agent framework with effort persistence and contract terminations. The decomposition of incentives into long-term and short-term is of particular interest. We expect to see how changes in the degree of effort substitutability affect the duration of the contract and the strength of the provided incentives. The contractual framework (different contractual arrangements based on long term contract enforceability) should also have a significant impact on incentives. We will consider both short-term and long-term contracts where the principal can or cannot commit to keeping the agent in the long run. The model will be calibrated to US CEO compensation data and used to evaluate the efficiency cost related to short-term contracting. We will also produce benchmarks for pay-performance sensitivity and relative performance evaluation, and recommendations regarding the level and structure of executive pay which will be even more relevant in the aftermath of the financial crisis.

Key words: short and long-term contracts, incentives, executive pay

Getting by with a little help from my friends: does political affinity lead to lower premiums in M&A deals? (Marie-Ann Betschinger, Alex Settles (with Olivier Bertrand)

At major investment and press conferences across the developed and emerging market world government officials take credit for the formation of new joint ventures, bless merger and acquisition deals, and stake claims to job creation. The visits of foreign dignitaries have become a vital part of the investment road show for multinational corporations. One constant of cross-border and even domestic merger and acquisition deals has been shown in the involvement of the political system (e.g., Baker 2006). The interaction between government and the private sector can therefore be vital to the creation of business deals.

However, while a substantial amount of papers have focused on the relevance of legal regime and investor protection (Bris et al., 2008, Rossi and Volpin, 2004) and takeover law (Comment and Schwert, 1995, Cotter et al., 1997, Eckbo and Langohr, 1989, Marshall and Anderson, 2009, Nenova, 2003) for M&A, only a limited amount of papers have empirically analyzed the role of geopolitics for M&A outcomes. Bid abandonment has been found to be significantly positively influenced by a large difference in the institutional setting of the countries where the acquirer and target are located (Dikova et al., 2010) and nationalist tendencies in the target country (Dinc and Erel, 2010). However, to our knowledge no paper has investigated the importance of political affinity between countries for M&A deals.

In this project, we argue that being a political friend matters for M&A negotiation and results. We examine the role of political affinity for the size of the bid premium as the bid premium is one or even the most important element characterizing a bidding strategy (Eckbo, 2009). In this context we focus on the moderating effect of the domestic political system in the target country. Does better governance lead to a lower influence of politics? We also check if political affinity matters for bid abandonment.

Our sample of M&A deals we obtain from the Deals module of ThomsonONE.com Investment Banking. In particular, this gives us information on the deal premium. For measures of political affinity and the domestic political system we rely on publically available databases, e.g. PolityIV, PolconV (Henisz 2002), Database of Political Institutions (DPI) (Keefer, 2001). We analyse the data using both linear regression analysis and 2 SLS estimations, instrumenting political affinity.

This project hence explores the relevance of geopolitics in M&A decision making. By combining insights from the international relations literature with the one in financial economics and strategy, we want to show that a little help from friends can matter for M&A outcomes. But the national political system is expected to moderate the effect. In more democratic nations and countries with a larger number of checks and balances political affinity is expected to matter less.

Key words : disciplining effects of the media, corporate managers