Banking →
- 11 Sep 2009
- Working Paper Summaries
Banking Deregulations, Financing Constraints and Firm Entry Size
How do financing constraints on new start-ups affect the initial size of these new firms? Since bank debt comprises the majority of U.S. firm borrowings, new ventures are especially sensitive to local bank conditions due to their limited options for external finance. Liberalization in the banking sector can thus have important effects on entrepreneurship in product markets. As HBS professors William Kerr and Ramana Nanda explain, the 1970s through the mid-1990s was a period of significant liberalization in the ability of banks to establish branches and to expand across state borders, either through new branches or through acquisitions. Using a database of annual employment data for every U.S. establishment from 1976 onward, Kerr and Nanda examine how U.S. branch banking deregulations impacted the entry size of new start-ups in the non-financial sector. This paper is closely related to their prior work examining how the deregulations impacted the rates of startup entry and exit in the non-financial sector. Key concepts include: The average entry size for start-ups did not change following the bank deregulations. However, this result masks the differences in entry size among startups that failed within three years of entry and those that survived for four years or more. Start-ups that survived for four years or longer entered at 2% larger sizes after the deregulations compared to earlier periods. Entrants that failed within three years did not enter at larger firm sizes. It is a challenge to measure accurately changes in the initial size of new firms even using micro-data such as that from the U.S. Census Bureau. Carefully characterizing effects of financing constraints on the initial size of new firms theoretically and empirically is an important research topic for entrepreneurial finance. Closed for comment; 0 Comments.
- 02 Sep 2009
- Working Paper Summaries
Information Risk and Fair Value: An Examination of Equity Betas and Bid-Ask Spreads
What is the role of fair values in the current economic crisis? The interplay between information risk—that is, uncertainty regarding valuation parameters for an underlying asset—and the reporting of financial instruments at fair value has been a subject of high-level policy debate. Finance theory suggests that information risk is reflected in firms' equity betas and the information asymmetry component of bid-ask spreads. HBS professor Edward Riedl and doctoral candidate George Serafeim test predictions for a sample of large U.S. banks, exploiting recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3, which indicate progressively more illiquid and opaque financial instruments. Overall, banks with higher exposures to level 3 financial assets have both higher equity betas and higher bid-ask spreads. Both results are consistent with higher levels of information risk, and thus cost of capital, for these firms. Key concepts include: Banks with higher exposure to level 3 (or more illiquid) financial assets reflect higher information risk, revealed both in higher equity betas and higher bid-ask spreads. This is suggestive that current disclosures surrounding level 3 financial instruments are insufficient to mitigate investor perceptions of greater information risk for highly opaque financial assets. The regulatory implications may include enhancements to the disclosures (particularly for level 3 financial instruments), as well as increased movement towards risk-weighted regulatory capital. Closed for comment; 0 Comments.
- 22 Jun 2009
- Research & Ideas
“Too Big To Fail”: Reining In Large Financial Firms
Four little words have cost U.S. taxpayers dearly in government bailouts of once-mighty Wall Street firms. Congress can put an end to such costly rescues, says HBS professor David A. Moss, and the Federal Reserve could be a super regulator, adds senior lecturer Robert C. Pozen. But will Congress enact the regulatory cure that is required? From the HBS Alumni Bulletin. Key concepts include: No firm should be too big to fail. The federal government should slap tough new regulations on all firms that pose "systemic risk"—the risk that a failure of one institution could wreak havoc across the entire financial system. The majority of financial firms that pose no systemic risk should face relatively light regulation, ensuring their continued dynamism and innovation. Not everyone on the politically divided Congressional Oversight Panel agrees with Moss's analysis and recommendations. The general concept of regulating systemic risk has gained broad support from a wide range of influential economists, lawmakers, and interest groups. Closed for comment; 0 Comments.
- 01 Jun 2009
- Lessons from the Classroom
The Challenges of Investing in Science-Based Innovation
Smart science-based businesses view today's economic turmoil as an opportunity to stoke up research and innovation for long-term competitive advantage, says professor Vicki L. Sato. How about your business? Key concepts include: Companies with highly differentiated products will be able to weather this storm, and come out the other side stronger. Innovation management challenges fall across several key areas, including strategy, organizational design, decision-making, and resource allocation. Different situations will require different business decisions—investing in R&D isn't always the right path to take. Closed for comment; 0 Comments.
- 04 May 2009
- Working Paper Summaries
An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System
The present financial crisis should remind us that private financial institutions and markets cannot always be counted upon to manage risk optimally on their own. Almost everyone now recognizes that the government has a critical role to play—as the lender, insurer, and spender of last resort—in times of crisis. But effective public risk management is also needed in normal times to protect consumers and investors and to help prevent financial crises from starting in the first place. According to HBS professor David Moss, the biggest threat to our financial system today is posed not by commercial banks (as in 1933), but rather by systemically significant institutions (outside of commercial banking) that have the potential to trigger financial avalanches. The threat posed by these financial institutions is only compounded by the unprecedented federal guarantees introduced in response to the current crisis and the pervasive moral hazard they spawn. Under the system that Moss proposes, no financial institution would be too big to fail. Key concepts include: Ensure financial stability in the future by identifying and regulating systemically significant institutions on an ongoing basis, before crisis strikes. The biggest risk management problem we face today in the financial sector is not commercial banks, but rather systemically significant institutions that pose a threat to the broader financial system (because of their size and interconnectedness) and, as a result, carry implicit federal guarantees. The fifty years of relative financial calm that followed the Glass-Steagall Act of 1933, the Securities Exchange Act of 1934, and the Banking Act of 1935 strongly suggest that sound public risk management can make a positive difference. To the extent that systematically significant financial institutions will receive federal support in the event of a general financial crisis, such support should be formalized (and paid for) in advance. Although all government guarantees can generate moral hazard, implicit guarantees are often the worst kind. Closed for comment; 0 Comments.
- 04 May 2009
- Research & Ideas
What’s Next for the Big Financial Brands
Some of the great financial brands such as Merrill Lynch built trust with customers over decades—but lost it in a matter of months. Harvard Business School marketing professor John Quelch explains where they went wrong, and what comes next. Key concepts include: Turmoil and distrust in the financial services sector is an open invitation to non-financial companies to exploit the brand vacuum created by the demise of the likes of Merrill Lynch and the Royal Bank of Scotland. Financial brands today must address the most basic of consumer concerns: Will my money be safe with this company? Financial brands should continue to advertise but with messages that help customers with recession-relevant product and service offerings. Closed for comment; 0 Comments.
- 01 Apr 2009
- Working Paper Summaries
The Contingent Nature of Public Policy and Growth Strategies in the Early Twentieth-Century U.S. Banking Industry
The effects of public policy on organizations and economic activities have been widely observed. This line of research has contributed to organizational theory by showing the importance of state action for constructing economic systems, as well as firm structures and strategies. But there are a number of reasons why this perspective may in fact overemphasize the importance of public policy. This working paper, forthcoming as an article in the Academy of Management Journal, more fully investigates the contingent nature of the effects of policy on organizations, with the orienting premise that policy is just one of the external conditions that organizations face, and policy effects are more or less powerful to the extent that they are interactive with other elements of the environment. Specifically, the authors focus on how policy that regulated bank branching and other environmental factors affected—independently as well as interactively—the emergence and growth of large-scale firms in U.S. commercial banking from 1896 to 1978. Key concepts include: The histories of firms' external environments may be essential to an understanding of their structure and current success, with implications for organizational theory. Closed for comment; 0 Comments.
- 26 Feb 2009
- Research & Ideas
Podcast: Preventing Future Financial Failures
Professor David Moss says we need ongoing federal regulation of the few "systemically significant" institutions whose demise could threaten financial stability. Closed for comment; 0 Comments.
- 20 Jan 2009
- Research & Ideas
Risky Business with Structured Finance
How did the process of securitization transform trillions of dollars of risky assets into securities that many considered to be a safe bet? HBS professors Joshua D. Coval and Erik Stafford, with Princeton colleague Jakub Jurek, authors of a new paper, have ideas. Key concepts include: Over the past decade, risks have been repackaged to create triple-A-rated securities. Even modest imprecision in estimating underlying risks is magnified disproportionately when securities are pooled and tranched, as shown in a modeling exercise. Ratings of structured finance products, which make no distinction between the different sources of default risk, are particularly useless for determining prices and fair rates of compensation for these risks. Going forward, it would be best to eliminate any sanction of ratings as a guide to investment policy and capital requirements. It is important to focus on measuring and judging the system's aggregate amount of leverage and to understand the exposures that financial institutions actually have. Closed for comment; 0 Comments.
- 10 Dec 2008
- Working Paper Summaries
Market Reaction to the Adoption of IFRS in Europe
How do investors in European firms react to a change in financial reporting? Prior to 2005, most European firms applied domestic accounting standards. The adoption of International Financial Reporting Standards (IFRS) would result in the application of a common set of financial reporting standards within Europe, and between Europe and the many other countries that require or permit application of IFRS. However, modification of IFRS by European regulators would result in European standards differing from those used in other countries, thereby eliminating some potential convergence benefits. This study investigates the equity market reaction to 16 events associated with the adoption of IFRS in Europe. Overall, the researchers' findings are consistent with investors expecting the benefits associated with IFRS adoption in Europe to exceed the expected costs. Key concepts include: Overall, investors reacted positively to the increased likelihood of IFRS adoption. Investors expected net benefits associated with increases in information quality, decreases in information asymmetry, more rigorous enforcement of the standards, and convergence. The reaction for firms domiciled in code law countries is less positive, consistent with investors' concerns over enforcement of IFRS in those countries. Closed for comment; 0 Comments.
- 06 Aug 2008
- Working Paper Summaries
Fixing Market Failures or Fixing Elections? Agricultural Credit in India
There are strong theoretical reasons to believe that politicians manipulate resources under their control to achieve electoral success. Yet, compelling examples of this manipulation are heretofore rarely documented in scholarly literature. Cole's paper presents evidence that government-owned banks in India serve the electoral interests of politicians. It also analyzes how resources are strategically distributed. Key concepts include: Findings show that the costs of redistribution are considerable: The estimated effect of 5 to 10 percent higher levels of credit in election years is substantially larger than the average annual growth rate of credit. Efforts to isolate government banks from political pressure, as is done with many central banks, may reduce these effects. Agricultural credit lent by public banks is substantially higher in election years. More loans are made in "swing" districts in which the ruling state party had a narrow margin of victory (or a narrow loss) than in less competitive districts. This targeting is not observed in nonelection years or in private bank lending. Closed for comment; 0 Comments.
- 22 Jul 2008
- Working Paper Summaries
Financial Development, Bank Ownership, and Growth. Or, Does Quantity Imply Quality?
Government ownership of banks, a common phenomenon, is among the most important policy tools used to influence financial development. But what is the actual effect of such ownership on the financial development of a country? This paper uses a policy experiment in India to evaluate the effect of government ownership of banks on development. Key concepts include: Had the Indian government required bank expansion into rural areas and set lending targets, without nationalizing banks, rural areas might have achieved the same, or better, outcomes. Despite a substantial increase in agricultural credit, there is no evidence of improved agricultural outcomes in markets with nationalized banks. Bank nationalization may have slowed the growth of employment in the more developed sectors of trade and services. Closed for comment; 0 Comments.
- 30 Jun 2008
- Research & Ideas
Rethinking Retirement Planning
Many of us are relying on defined contribution plans to help fund retirement. But Harvard Business School professor Robert C. Merton believes today's plans are not sustainable. So what's next? A new way to look at the problem. Key concepts include: Defined contribution plans currently offered by the majority of employers place an undue burden on workers who don't have the interest, time, or expertise to manage their finances. A new pension program focuses on an inflation-protected annuity rather than an endpoint with a lump sum of accumulated wealth. The program requires few interactions from users: "set it and forget it." Closed for comment; 0 Comments.
- 24 Jun 2008
- Working Paper Summaries
Bank Structure and the Terms of Lending to Small Businesses
Access to "soft information" and the greater sensitivity of decentralized banks to the local institutional environment can have both positive and negative consequences for small firms. Hence there may be a dark side to decentralized bank lending in certain instances. This paper argues that the same ability of decentralized banks to act on soft information also makes them more responsive to the local environment when setting terms of their loans. While this can be beneficial for small businesses in competitive markets, it also implies that the organizational structure of decentralized banks might allow them to better exploit their market power in concentrated banking markets by restricting credit or charging higher interest rates from small businesses. Key concepts include: According to the findings, small firms and those with greater "soft information" were more likely to get larger loans from decentralized banks, particularly in environments where the legal enforcements of financial contracts were relatively weak. On the other hand, decentralized banks were also more likely than centralized banks to cherry-pick the best firms, give smaller loans, and charge higher interest rates in concentrated banking markets. The relative benefit of decentralized bank structures for small business lending may therefore depend critically on the institutional and competitive environment in which banks are located. Public policy should consider promoting competition between decentralized banks in order to truly achieve the benefits associated with credit access for small businesses or those with more "soft information." Closed for comment; 0 Comments.
- 24 Apr 2008
- Working Paper Summaries
Bank Accounting Standards in Mexico: A Layman’s Guide to Changes 10 Years after the 1995 Bank Crisis
Mexico was the first emerging market compelled to reformulate the financial reporting of its banks as a result of a financial crisis. In the last decade, Mexico has undergone a process of internationalization of its banking industry. Today, more than 80 percent of the equity of Mexican banks belongs to internationally active bank corporations. This internationalization demands more transparent regulation, including standardized accounting rules and better disclosure of information. The case of Mexico can therefore serve as an example of the relevance of these changes, as well as of their scope and limitations. This paper attempts to clarify the nature and structure of the new accounting standards, and explains how they have affected financial statements and their interpretation. Key concepts include: Mexican bank accounting standards enjoyed special treatment during most of the 20th century because banking was an industry protected from foreign competition in a relatively closed economy. More transparent bank accounts and stricter accounting processes in Mexico are especially crucial today, in light of the predominantly foreign ownership of the Mexican banking system. The classification of financial operations still varies from country to country. National differences emerge despite the fact that financial instruments, products, and transactions are either very similar or the same worldwide. Legal and regulatory stipulations, accounting history, tax structure, and local business practices create differences in the way financial transactions are recorded in the financial statements. Closed for comment; 0 Comments.
- 23 Apr 2008
- Op-Ed
The Gap in the U.S. Treasury Recommendations
U.S. Treasury recommendations for strengthening the regulation of the financial system are a good start but fall short, says Harvard Business School professor emeritus Dwight B. Crane. Here's his suggestion for bringing regulation into the 21st century. Key concepts include: The Treasury proposal recognizes that fundamental change in the regulatory structure is required for managing risk in the financial system. The difficulty with the approach is that the risk in the financial system will not disappear—it will simply move to the non-prudentially regulated firms. The United States should include all financial service firms under the regulatory authority of the new prudential regulator. Closed for comment; 0 Comments.
- 23 Jan 2008
- Op-Ed
A House Divided: Investment or Shelter?
For decades Americans viewed their homes as a safe harbor, a place to put down roots. But the last decade saw the rise of housing as an investment opportunity. What comes next? asks Harvard Business School professor Nicolas P. Retsinas, director of Harvard's Joint Center for Housing Studies. Closed for comment; 0 Comments.
- 12 Sep 2007
- Op-Ed
Building Sandcastles: The Subprime Adventure
The early days of the subprime industry seemed to fulfill a market need—and millions of renters became homeowners as a result. But rapidly escalating home prices masked cracks in the subprime foundation. HBS professor Nicolas P. Retsinas, who is also director of Harvard University's Joint Center for Housing Studies, lays out what went wrong and why. Closed for comment; 0 Comments.
- 20 Aug 2007
- Working Paper Summaries
Hedge Fund Investor Activism and Takeovers
Are hedge funds better than large institutional investors at identifying undervalued companies, locating potential acquirers for them, and removing opposition to a takeover? Are they best equipped to monitor management? While blockholding by large institutional investors—pension funds and mutual fund investment companies—is widespread, there is virtually no evidence that these institutional shareholders are effective monitors of management or that their presence in the capital structure increases firm value. When institutional blockholders make formal demands on management, there is no evidence of their success. This working paper outlines the advantages and limits of hedge funds to manage these tasks. Greenwood and Schor's characterization differs markedly from previous work on investor activism, which tends to attribute high announcement returns to improvements in operational performance. Key concepts include: While recent popular accounts suggest that we are in an era of the "imperial shareholder," the results in this working paper indicate that activism tends to be most successful when there is a high probability of a takeover. Where improvements may take several quarters or even years to realize, the investment horizon of hedge funds makes them unsuitable overseers of management. Firms that would benefit from modest changes in operating policy or governance, or for which a reduction in CEO pay is to be desired, are not likely to hit the radar screen of hedge funds. While hedge funds do occasionally succeed in changing the board, initiating or increasing dividends, repurchasing shares, or cutting executive pay, it is not clear that these changes increase shareholder value relative to getting the target acquired. Closed for comment; 0 Comments.
Good Banks, Bad Banks, and Government’s Role as Fixer
Government action to stem collapse of the U.S. financial system was certainly warranted, agrees professor Robert Pozen. But results include less competition and increased risk to taxpayers. A Q&A from the HBS Alumni Bulletin and book excerpt from Too Big to Save? Key concepts include: Most of the 600 institutions recapitalized by the federal government over the last year do not satisfy basic bailout criterion. The U.S. needs to get loan securitization going because that's what drives loan volume. The Fed should not be the primary risk regulator. Splitting troubled institutions into two banks is a better approach than creating heavily subsidized public-private partnerships to try to buy toxic assets. Closed for comment; 0 Comments.