10
Jan

The Stock Market and Bank Risk-Taking

The Stock Market and Bank Risk-Taking

by Antonio Falato and David Scharfstein

Executive Summary — It is clear that risk-taking by financial institutions is one of the main causes of financial crises and severe recessions. Yet we know relatively little about what gives rise to such risk-taking in the first place. This paper presents evidence that a focus on short-term stock prices induces publicly-traded banks to increase risk relative to privately-held banks. The findings provide support for the view that compensation schemes should require management to hold stock for longer periods to mitigate their incentives to pump up short-term earnings and the short-term stock price.

Author Abstract

We present evidence that pressure to maximize short-term stock prices and earnings leads banks to increase risk. We start by showing that banks increase risk when they transition from private to public ownership through a public listing or an acquisition. The increase in risk is greater than for a control group of banks that intended but failed to transition from private to public ownership, a result that is robust to using a plausibly exogenous instrument for failed transitions. The increase in risk is also greater than for a control group of banks that were acquired but did not change their listing status. We establish that pressure to maximize short-term stock prices helps to explain these findings by showing that the increase in risk is larger for newly public banks that are more focused on short-term stock prices and performance.

10
Jan

Explaining China’s Crash

Explaining China’s Crash

After a decade of massive growth, China’s stock market began a precipitous summer slide that that hasn’t slowed yet. Dante Roscini explains what’s deflating markets worldwide.

by Christina Pazzanese

After more than a decade of nearly can’t-miss growth, China’s stock market began a precipitous summer slide that has spooked investors worldwide.

In July, the Shanghai composite index dropped 15 percent from June, prompting the People’s Bank of China to devalue the yuan by 1.9 percent in mid-August, the biggest currency adjustment in two decades. But continued trading volatility climaxed on Aug. 23 in what many have called China’s “Black Monday.” Shanghai stocks dropped by 8.5 percent overnight, their steepest single-day decline since 2007. Since June, China’s stock market has fallen 38 percent.

As the world’s second-largest economy, China’s crash ripped through world markets, including Japan, Hong Kong, Europe, and the United States, as uneasy investors instigated historic single-day sell-offs.

Early this week, the Chinese government reportedly arrested nearly 200 people, including corporate executives, government officials, and journalists, for allegedly spreading false rumors online about the market’s stability. And in a turnabout, authorities also announced they will not institute more interventions to rescue the still-shaky economy, as they had pledged.

Dante Roscini (HBS MBA 1988) is a professor of management practice at Harvard Business School. For two decades, he ran equity capital markets for Goldman Sachs, Merrill Lynch, and Morgan Stanley. His casework focuses on international investment, sovereign debt, monetary policy, and central banking. Roscini spoke with the Harvard Gazette about China’s economic woes and how they may affect global markets and investors going forward.

Christina Pazzanese: Why were so many caught off-guard by this crash? Weren’t there warning signs that this might happen?

Dante Roscini: Yes, there were warning signs. Some of the indicators in China’s economy have been slowing for some time. In January, the official data for GDP growth was 7.4 percent, the weakest in 24 years and the first time in a century that growth fell short of the official target, although by only 0.1 percent. There has been continuing softness in data regarding manufacturing activity, exports, and imports. When China made a currency adjustment, market participants took fright, fearing a much bigger slowdown than they expected. The wheels came off an over-exuberant Chinese stock market, which had surged over 150 percent in 12 months and hit a seven-year high. The consequences were felt by financial markets everywhere.

Q: Given how opaque China’s economy is, does anyone accurately know how deep or lasting this slowdown might be?

A: The official numbers must indeed be taken with a grain of salt. There is a debate in the marketplace and among economists as to what the future holds. Are we headed for a “soft landing,” a correction that can be managed so that growth, albeit at a slower pace, will continue to be solid, or are we at an inflection point and we risk a more precipitous deceleration, a “hard landing”?

China has astounded the world for 30 years by growing consistently at 10 percent per year or more, lifting hundreds of millions out of poverty. It has gone from almost nowhere to being the second-biggest economy, contributing 15 percent to the global GDP and 25 percent to its growth.

Exports drove that growth. Over the past two decades, the level of exports to developed markets from China grew on the order of 20 percent per year. And yet, the consumption of goods in those markets was only growing by about 5 percent per year. China was therefore grabbing market share; “Made in China” became ubiquitous. This was driven in large part from massive outsourcing on the part of companies in developed markets. They were moving production to China in droves because labor was cheap, so the economy grew very, very fast.

In the process of becoming the “factory of the world,” the country needed infrastructures: roads, ports, rails, plants, cities for the workers, and so on. Massive investment — rather than consumption — drove the economy. Consumption in China is still only about a third of GDP versus some 70-odd percent in the developed markets. China kept buying all sorts of goods and became the first importer in the world for a number of commodities, in the process benefiting those countries that could supply them.

The issue is that we may be reaching the limits to the outsourcing trend. For example, almost 100 percent of textiles in this country are now outsourced–you can’t go further than that. Between 50 and 60 percent of all manufactured goods in the U.S. are outsourced, and not everything is outsourceable. Furthermore, wage inflation in China has dented its competitiveness and there are other location choices. So, the question is: How much more can this phenomenon continue? Are we at the end of the era of Chinese exceptionalism?

This concept dovetails with the idea that China must change its development model in order to gain long-term economic and social stability. Economists have been saying this for a long time and the Chinese leadership is trying to rebalance growth toward consumption. In other economies where this shift has taken place before — such as the Asian Tigers — it was generally associated with lower growth since relying on endogenous progression of domestic demand is not as powerful as relying on an exogenous inflow of export-driving outsourcing.

Q: Although the U.S. and European markets seem to have stabilized for now, what are the potential ramifications globally of China’s market troubles? Could their problems spill over into other markets?

A: Certainly it was trouble from a stock market perspective. The fall was as bad as we saw here in 2001 after the dot-com bubble. The response by the Chinese authorities was extraordinary. They enacted of series of price-distorting measures that smacked of desperation. They stopped all IPOs; they asked state-owned companies to buy back their shares; they arrested traders and journalists; they banned short selling and channeled pension money into equities, effectively nationalizing a piece of the market.

Fortunately, the stock market is a rather small part of China’s economy. The total market capitalization is less than a third of GDP against the 100 percent or more in developed economies. Also, few people have their money in the stock market. The real money is in the property market; a drop in values of real estate would have more far-reaching consequences.

In terms of global spillovers, the recovery in most developed markets does not depend on exports to China. Of course, if the Chinese deceleration were to lead to a negative shock to global growth, that would be bad news for everyone. I don’t believe this to be the base case unless there is a real hard landing.

Q: Which industries and nations will feel this slowdown most acutely and how are they reacting?

A: China represents between 1 and 3 percent of the exports for the G3 economies [the United States, Germany, and Japan]. But for Australia, Chile, Korea, Singapore, and Peru for example, these numbers are more significant, anywhere from 6 to 17 percent. Some of China’s neighbors are tied to its manufacturing processes; other countries more far afield supply it with oil, gas, metals, and other primary materials. A slowdown in China could impact some of these emerging markets pretty hard. Capital has quickly flown out of them, hitting their currencies and equity markets. Europe is less exposed, though some specific sectors, such as luxury goods, will feel the pinch.

Q: What does it mean for the U.S. economy if this is China’s new normal or things decline even further?

A: The U.S. is growing solidly. This crisis is not going to be too impactful through the trade channel. Exports make up only 13 percent of U.S. GDP and exports to China represent less than 1 percent of U.S. GDP. Some U.S. multinationals might be exposed to a fall in their overseas earnings. GE stock was down 20 percent for a time on Black Monday, though Apple, for example, recently said that business in China continues to be strong. Perhaps the strongest impact would be if, as some people are asking, the [Federal Reserve Bank] were to delay raising U.S. interest rates on the basis that China’s deceleration will induce a global slowdown. That decision would clearly have an effect on this economy.

Q: What are investors most concerned about and what will they look for in the short and medium terms to feel confident again in China’s stability?

A: Investors are prone to panic, as we’ve seen; they tend to rush for the exits. In reality, China is generally in a position to manage the turbulence in its economy. First, it has a service sector that is growing fast and that will be a natural counterbalance to the slowdown in industry. Second, China is in good shape from a fiscal standpoint. They have a budget deficit target of 2.3 percent this year, but are currently in surplus. Third, they still have enormous foreign exchange reserves that will allow them to intervene in the currency market. Finally, the Chinese central bank has room for further monetary stimulus; they can lower the reserve requirement for banks from the current 18 percent of deposits and they can reduce interest rates. For example, the one-year lending rate is at 4.6 percent against practically zero here.

One thing to watch for will be how China ensures the stability of its financial system since total debt has reached 250 percent of GDP, credit has been abundant, and the size of the shadow banking system has exploded.

More, investors will judge how China is going to manage its reforms for the longer term. Are they going to foster the rule of law and give domestic and foreign entrepreneurs more confidence to invest? Are they going to allow private companies to better compete with state-owned ones? Are they going to change the system of residence permits so that people can move more freely? Will they liberalize the capital account and let the currency float? In short, markets will assess how credibly the country’s policies are evolving.

Q: How does China’s political leadership affect their economy and their ability to correctly identify and fix the shortcomings? And have these emergency interventions damaged the market’s credibility?

A: I believe that the bigger question is if the political leadership will have the courage to move from a command economy to something that looks more like a market economy. Their heavy-handed remedial actions against the drop in the stock market have damaged their credibility. This was discouraging for those investors who were hoping that Beijing was making its markets more free. A fake marketplace creates distrust and is counterproductive in the long term.

This interview has been edited for length and clarity.

Christina Pazzanese is a Harvard Staff Writer. This article first appeared in the Harvard Gazette under the title China Syndrome.

10
Jan

Catering to Investors Through Product Complexity

Catering to Investors Through Product Complexity

by Boris Vallee & Claire Célérier

Executive Summary — This paper investigates the rationale for issuing complex securities to retail investors.

Author Abstract

This paper investigates the rationale for issuing complex securities to retail investors. We focus on a large market of investment products targeted exclusively at households: retail structured products in Europe. We hypothesize that banks strategically use product complexity to cater to yield-seeking households by making product returns more salient and shrouding risk. We find four empirical results consistent with this view. First, we show that structured products with complex payoff formulas offer higher headline rates, and that they more frequently expose investors to a complete loss of their investment. We then document that banks are more inclined to issue high-headline-rate and more complex products in low-rate environments. Finally, we find that high-headline-rate and more complex products are more profitable for banks, and that their ex post performance is lower.

10
Jan

Forward Guidance in the Yield Curve: Short Rates versus Bond Supply

Forward Guidance in the Yield Curve: Short Rates versus Bond Supply

by Robin Greenwood, Samuel G. Hanson, and Dimitri Vayanos

Executive Summary — Since late 2008, central banks have been conducting monetary policy through two primary instruments: quantitative easing (QE), in which they buy long-term government bonds and other long-term securities, and “forward guidance,” in which they guide market expectations about the path of future short rates. This paper analyzes the effects of forward guidance on both short rates and QE. Results show that forward guidance on QE tends to impact longer maturities than forward guidance on short rates, even when expectations about bond purchases by the central bank concern a shorter horizon than expectations about future short rates.

Author Abstract

We present a model of the yield curve in which the central bank can provide market participants with forward guidance on both future short rates and on future Quantitative Easing (QE) operations, which affect bond supply. Forward guidance on short rates works through the expectations hypothesis, while forward guidance on QE works through expected future bond risk premia. If a QE operation is expected to be undone in the near term, then its announcement will have a hump-shaped effect on the yield and forward-rate curves; otherwise the effect may be increasing with maturity. Humps associated to QE announcements typically occur at maturities longer than those associated to short-rate announcements, even when the effects of the former are expected to last over a shorter horizon. We use our model to re-examine the empirical evidence on QE announcements in the United States.

10
Jan

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

by Erik Stafford

Executive Summary — This paper studies the asset selection of private equity investors and the risk and return properties of passive portfolios with similarly selected investments in publicly traded securities. Results indicate that sophisticated institutional investors appear to significantly overpay for the portfolio management services associated with private equity investments.

Author Abstract

Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.

10
Jan

Economic Uncertainty and Earnings Management

Economic Uncertainty and Earnings Management

by Luke C.D. Stein and Charles C.Y. Wang

Executive Summary — This paper provides the first evidence on how market participants’ uncertainty about firms’ future prospects affects managerial decisions in financial reporting. Firms are more likely to manage earnings downward during times of elevated uncertainty, particularly when managers face greater incentives or enjoy greater ability to do so.

Author Abstract

In the presence of managerial short-termism and asymmetric information about skill and effort provision, firms may opportunistically shift earnings from uncertain to more certain times. We document that firms report more negative discretionary accruals when financial markets are less certain about their future prospects. Stock-price responses to earnings surprises are moderated when firm-level uncertainty is high, consistent with performance being attributed more to luck rather than skill and effort, which can create incentives to shift earnings toward lower-uncertainty periods. We show that the resulting opportunistic earnings management is concentrated in CEOs, firms, and periods where such incentives are likely to be strongest: (1) where CEO wealth is sensitive to change in the share price, (2) where announced earnings are particularly likely to be an important source of information about managerial ability and effort, and (3) before implementation of Sarbanes-Oxley made opportunistic earnings management more challenging. Our evidence highlights a novel channel through which uncertainty affects managerial decision making in the presence of agency conflicts.

10
Jan

What Do Measures of Real-Time Corporate Sales Tell Us About Earnings Surprises and Post-announcement Returns?

What Do Measures of Real-Time Corporate Sales Tell Us About Earnings Surprises and Post-announcement Returns?

by Kenneth A. Froot, Namho Kang, Gideon Ozik, and Ronnie Sadka

Executive Summary — This study by Kenneth A. Froot and colleagues show that managers’ departures from the Timely Disclosure Hypothesis—the notion that managers release through available announcement channels all of their then-current private information—may be sensitive to post-quarter private information managers have obtained. Managers may act through their stock trading to benefit from these departures.

Author Abstract

: We develop real-time proxies of retail corporate sales from multiple sources, including approximately 50 million mobile devices. These measures contain information from both the earnings quarter (within quarter) and the period between that quarter’s end and the earnings announcement date (post quarter). Our within-quarter measure is powerful in explaining quarterly sales growth, revenue surprises, and earnings surprises, generating average excess returns at announcement of 3.4%. However, surprisingly, our post-quarter measure is related negatively to announcement returns and positively to post-announcement returns. When post-quarter private information is directionally strong, managers, at announcement, provide guidance and use language that points statistically in the opposite direction. This effect is more pronounced when, post-announcement, management insiders trade. We conclude managers do not fully disclose their private information and instead message to shareholders and analysts something of opposite sign. The data suggest they may be motivated in part by subsequent personal stock-trading opportunities.

10
Jan

Retail Execs Underplay Current Performance to Investors–but Why?

Retail Execs Underplay Current Performance to Investors–but Why?

In quarterly earnings calls with investors and analysts, some retail managers may underplay how their companies are actually performing, according to recent research by Kenneth Froot and colleagues.

by Dina Gerdeman

Retail executives aren’t always giving stockholders the straight scoop about the financial standing of their companies in comments around earnings announcements—and some may be providing misleading information, potentially for their own benefit.

That’s the upshot of new research by retired Harvard Business School finance professor Kenneth A. Froot in the April working paper What Do Measures of Real-Time Corporate Sales Tell Us about Earnings Surprises and Post-Announcement Returns?

“It’s startling to find that managers are not even neutral; they’re somewhat negative”

Froot co-authored the study with University of Connecticut Assistant Professor Namho Kang; EDHEC Business School Research Associate and Affiliated Professor Gideon Ozik; and Boston College Professor Ronnie Sadka, chairperson of the finance department, Carroll School of Management.

Quarterly earnings announcements, which typically are presented four to six weeks after the close of a quarter, often involve a conference call by company executives with shareholders and stock analysts. Part of those sessions may include executives giving soft “guidance” or other information about business prospects for the recently begun current quarter. But are they painting an accurate picture of a company’s current performance?

The researchers discovered something they didn’t expect: When a strong showing seemed to be under way for a company, managers at announcement often hinted at just the opposite—that the news was not so great.

“We thought if the company was continuing to do well, we’d see managers finding ways to convey that—wink, wink,” says Froot, who held the André R. Jakurski Chair before retiring from HBS in 2013. “That’s when we found this surprising result in direct opposition to what recent reported and unreported numbers said. It’s startling to find that managers are not even neutral; they’re somewhat negative.”

RESEARCHERS CREATE FORECASTING MODEL

To test their ideas, the researchers studied 50 big-box retailers in the United States, including Costco, CVS, The Home Depot, Kroger, Target, and Walmart. One of their biggest research challenges was how to determine whether a manager’s guidance was on target or misleading. They did so by constructing their own estimates of how a company was doing in real time by using data collected from a variety of consumer devices, including tens of millions of mobile phones, tablets, as well as desktop computers.

Do some retail executives mislead investors to win in the stock market? Source: Rawpixel Ltd

Consumer activity data included counts of specific events that appeared to involve a consumer’s intention to visit a particular retail store. For example, a search for driving directions to a Walmart was counted toward Walmart’s consumer activity for the week.

The researchers’ within-quarter measure accurately tracked current-period revenue growth and predicted announcement surprises and analyst forecast errors. Then they looked at post-quarter corporate information and studied three ways that managers disclose information: discretionary accruals, management forecasts, and conference call tone. In addition, they took a peek at managers’ private discretionary trades during the post-announcement trading window.

The researchers were trying to determine whether firms followed what they call the “timely disclosure hypothesis,” the idea that managers accurately release their private post-quarter information at announcement time.

What they found instead was that managers were “leaning against the wind,” communicating in a way that understated positive real-time post-quarter corporate sales information and withholding certain information as a “surprise for the future.”

Discretionary accruals—non-mandatory expenses or assets, such as a management bonus, that has yet to be realized but is recorded in the accounting books—didn’t point to managers “leaning against the wind.”

But in looking at basic stock return data, it became clear that managers understated their post-quarter private information. And in studying management guidance issued around earnings announcement dates, results suggested that managers gave more pessimistic forecasts when they had more positive post-quarter sales information.

WHAT’S THE MOTIVATION?

The same outcome was found when they studied managers’ voice tone during announcement conference calls using natural language testing that measures the number of positive and negative words used.

Although Froot, Kang, Ozik, and Sadka stop short of assigning a definitive explanation for this distortion of information, their research indicates that managers may provide misleading information for self-serving reasons: “The data suggest they may be motivated in part by subsequent personal stock-trading opportunities,” the paper says.

With some evidence that “a few are behaving badly,” Froot says the findings might prompt the US Securities and Exchange Commission to scrutinize weaknesses in the announcement process.

“We definitely think this merits further research and perhaps some examination by the appropriate authorities,” he says. “It’s likely that the SEC will want to have a look at this.”

10
Jan

Financial Regulation in a Quantitative Model of the Modern Banking System

Financial Regulation in a Quantitative Model of the Modern Banking System

by Juliane Begenau and Tim Landvoigt

Executive Summary — This study at the intersection of macroeconomics and banking explores the optimal regulation of banks. Studying and quantifying the effects of capital requirements in a model that features regulated (commercial) and unregulated (shadow) banks, the authors find that a higher capital requirement makes regulated banks safer, but does not affect the riskiness of shadow banks. The net benefit of such a policy would depend on the level of fragility of the unregulated banks.

Author Abstract

How does the shadow banking system respond to changes in the capital regulation of commercial banks? This paper builds a quantitative general equilibrium model with commercial banks and shadow banks to study the unintended consequences of capital requirements. A key feature of our model is defaultable bank liabilities that provide liquidity services to households. The quality of the liquidity services provided by bank liabilities depends on their safety in case of default. Commercial bank debt is fully insured and thus provides full liquidity. However, commercial banks do not internalize the social costs of higher leverage in the form of greater bankruptcy losses (moral hazard) and are subject to a regulatory capital requirement. In contrast, shadow bank liabilities are subject to runs and credit risk and thus typically less liquid compared to commercial banks. Shadow banks endogenously limit their leverage as they internalize the costs. Tightening the commercial banks’ capital requirement from the status quo leads to safer commercial banks and more shadow banking activity in the economy. While the safety of the financial system increases, it provides less liquidity. Calibrating the model to data from the Financial Accounts of the U.S., the optimal capital requirement is around 20%.

10
Jan

Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds

Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds

by Sergey Chernenko and Adi Sunderam

Executive Summary — A key function of many financial intermediaries is liquidity transformation: creating liquid claims backed by illiquid assets. To date it has been difficult to measure liquidity transformation for asset managers. The study proposes a novel measure of liquidity transformation: funds’ cash management strategies. The study validates the measure and shows that liquidity transformation by asset managers is highly dependent on the traditional and shadow banking sectors.

Author Abstract

We study liquidity transformation in mutual funds using a novel dataset on their cash holdings. To provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. We provide evidence suggesting that mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in.