Malcolm P. Baker

3 Results


Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly

The instability of banks in the financial crisis of 2008 has stoked the enduring debate about optimal capital requirements. One of the central concerns has long been the possibility that capital requirements affect banks' overall cost of capital, and therefore lending rates and economic activity. In this paper, the authors estimate how leverage affects the risk and cost of bank equity and the overall cost of capital in practice. They are especially motivated by the potential interaction of capital requirements and the "low risk anomaly" within the stock market: That is, while stocks have on average earned higher returns than less risky asset classes like corporate bonds, which in turn have earned more than Treasury bonds, it is less appreciated that the basic risk-return relationship within the stock market has historically been flat-if not inverted. Using a large sample of historical US data, the authors find that the low risk anomaly within banks may represent an unrecognized and possibly substantial downside of heightened capital requirements. However, despite the fact that tightened capital requirements may considerably increase the cost of capital and lending rates, with adverse implications for investment and growth, such requirements may well remain desirable when all other private and social benefits and costs are tallied up. Read More

Dividends as Reference Points: A Behavioral Signaling Approach

While managers appear to view dividends as a signal to investors, managers also argue that standard dividend signaling models are not focused on the correct mechanisms. These standard models posit that executives use dividends to destroy some firm value and thereby signal that plenty remains: The "money burning" typically takes the form of tax-inefficient distributions, foregone profitable investment, or costly external finance. Executives who actually set dividend policy overwhelmingly reject these ideas yet, at the same time, are equally adamant that dividends are a signal to shareholders and that cutting them has negative consequences. In this paper, the authors develop what they believe to be a more realistic signaling approach. Using core features of prospect theory as conceptualized by Daniel Kahneman and Amos Tversky (the fathers of behavioral economics), they create a model in which past dividends are reference points against which future dividends are judged. The theory is consistent with several important aspects of the data. Baker and Wurgler also find support for its broader intuition that dividends are paid in ways that make them memorable and thus serve as stronger reference points and signals. Read More

Behavioral Finance—Benefiting from Irrational Investors

Do investors really behave rationally? Behavioral finance researchers Malcolm Baker and Joshua Coval don't think humans are such cold calculators. One proof: Individual and even institutional investors often give in to inertia and hold on to shares in unwanted stock. And therein lays opportunity for investment managers and firms. Read More