Are large shareholders good monitors of management? A public firm's shareholders have extensive legal control rights in the corporation, but in practice much of this control is delegated to managers. In companies with small, dispersed shareholders, owners may find it costly to coordinate and exercise monitoring and control, leaving management with considerable discretion. Large shareholders, however—by concentrating a block of shares in the hands of a single decision-maker—may play a beneficial role in facilitating effective owner control. Yet large shareholders are not without their costs. HBS professor Bo Becker and coauthors develop and test a framework to quantify the impact of large owners (individual non-managerial blockholders, not mutual funds or other institutions) on several key aspects of firm behavior. They show that such shareholders play an important role for corporate governance in sizable U.S. public firms, and can affect several firm policies.
Does the composition of ownership of a financial asset influence future returns and risk? Previous economic research has documented significant price effects of investor demand in numerous settings, including retail demand for options, investor demand for bonds, and mutual funds' flow-driven demand for stocks. This paper provides a methodology to identify assets that are vulnerable to such investor demand shocks. The central idea is that assets are risky if the current owners of the asset face correlated liquidity shocks—i.e., they buy and sell at the same time. We call assets with a high concentration of owners who trade in the same direction "fragile." A related concept is "co-fragility." Two assets are "co-fragile" if their owners have correlated trading needs, even if the holdings of these owners do not directly overlap. The authors build measures of fragility for U.S. stocks between 1990 and 2007. Consistent with their predictions, more fragile stocks are more volatile, and two co-fragile stocks exhibit high correlations among their stock returns.
Performance measurement is one of the critical factors that determine how individuals in an organization behave. It includes subjective as well as objective assessments of the performance of both individuals and subunits of an organization such as divisions or departments. Besides the choice of the performance measures themselves, performance evaluation involves the process of attaching value weights to the different measures to represent the importance of achievement on each dimension. This paper examines five common divisional performance measurement methods: cost centers, revenue centers, profit centers, investment centers, and expense centers. The authors furnish the outlines of a theory that attempts to explain when each of these five methods is likely to be the most efficient.
During periods of rising house prices, falling interest rates, and increasingly competitive and efficient refinancing markets, cash-out refinancing is like a ratchet, incrementally increasing homeowner debt as real-estate values appreciate without the ability to symmetrically decrease debt by increments as real-estate values decline. This paper suggests that systemic risk in the housing and mortgage markets can arise quite naturally from the confluence of these three apparently salutary economic trends. Using a numerical simulation of the U.S. mortgage market, the researchers show that the ratchet effect is capable of generating the magnitude of losses suffered by mortgage lenders during the financial crisis of 2007-2008. These observations have important implications for risk management practices and regulatory reform.
Financing constraints are one of the biggest concerns impacting potential entrepreneurs around the world. Given the important role that entrepreneurship is believed to play in the process of economic growth, alleviating financing constraints for would-be entrepreneurs is also an important goal for policymakers worldwide. In this paper HBS professors William R. Kerr and Ramana Nanda review two major streams of research examining the relevance of financing constraints for entrepreneurship. They then introduce a framework that provides a unified perspective on these research streams, thereby highlighting some important areas for future research and policy analysis in entrepreneurial finance.
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.
The notion of levying higher taxes on tall people—an idea offered largely tongue in cheek—presents an ideal way to highlight the shortcomings of current tax policy and how to make it better. Harvard Business School professor Matthew C. Weinzierl looks at modern trends in taxation.
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.
Competition usually creates better products and services. But when competition increased among credit rating agencies, the result was less accurate ratings, according to a study by HBS professor Bo Becker and finance professor Todd Milbourn of Washington University in St Louis. In our Q&A, Becker discusses why users of ratings should exercise a little caution.
Although private firms are important components of the U.S. economy, their tax practices remains largely unknown due to the lack of publicly available financial information. In recent years, private equity (PE) firms have been broadly criticized based on the substantial tax benefits enjoyed by their owners and managers. Editorials have inflamed public opinion by accusing PE firm owners and managers as having excessively low tax rates, and pointing out that the substantial wealth generated by PE firms can "pay for sophisticated tax planning," including the use of offshore investment companies based in tax havens. More generally, critics contend that PE firms aggressively manage their tax liabilities and those of their portfolio companies. This study investigates the latter contention. In particular, the authors look at whether private companies that are majority-owned by PE firms ("majority PE-backed firms") engage in more tax avoidance than other publicly traded and privately held firms. This may be the first study to compare the tax practices of firms with different private ownership structures.
Are developments in the theory of taxation improving tax policies around the world? The optimal design of a tax system is a topic that has long fascinated economic theorists and flummoxed economic policymakers. This paper explores the interplay between tax theory and tax policy. It identifies key lessons policymakers might take from the academic literature on how taxes ought to be designed, and it discusses the extent to which these lessons are reflected in actual tax policy. The authors find that there has been considerable change in the theory and practice of taxation over the past several decades—although the two paths have been far from parallel. Overall, tax policy has moved in the directions suggested by theory along a few dimensions, even though the recommendations of theory along these dimensions are not always definitive.
A tax on height follows inexorably from a well-established empirical regularity and the standard approach to the optimal design of tax policy. Many readers of this paper, however, will not so quickly embrace the idea of levying higher taxes on tall taxpayers. Indeed, when first hearing the proposal, most people either recoil from it or are amused by it. That reaction is precisely what makes tax policy so intriguing, according to N. Gregory Mankiw of Harvard University and Matthew Weinzierl of HBS. This paper addresses a classic problem: the optimal redistribution of income. A Utilitarian social planner would like to transfer resources from high-ability individuals to low-ability individuals, but is constrained by the fact that he cannot directly observe ability. Taxing height helps the planner achieve redistribution efficiently because height, the data show, is an indicator of income-earning ability. Although readers might take this paper in one of two ways—some seeing it as a small, quirky contribution aimed to clarify the literature on optimal income taxation, others as a broader effort to challenge the entire literature—the authors' results raise a fundamental question about the framework for optimal taxation for which William Vickrey and James Mirrlees won the 1996 Nobel Prize in Economics and which remains a centerpiece of modern public finance.
Do insiders strategically sell their stock holdings prior to the accounting disclosure of goodwill impairment losses? While a number of recent studies provide evidence of insider trading prior to the announcement of earnings performance measures, a remaining puzzle is what types of information aggregated into reported earnings constitute the source of insiders' private information. This study provides evidence of a specific reporting item, goodwill impairments, about which insiders are able to strategically trade before its full discovery by the equity market and its recognition within the financial statements. Goodwill impairments represent likely sources of information for insiders to trade on for two reasons. First, they tend to be economically large, averaging 11.9 percent of the market value of equity during the sample period of 2002-2007. Second, managers likely have material private information regarding future cash flow estimates through their internal budgeting processes; and managers' private information advantage may be relatively long-lived due to goodwill impairment testing rules that may delay the accounting recognition of economic goodwill impairments.
Insurance markets are growing rapidly in developing countries. Despite the promise of these markets, however, adoption to date has been relatively slow. Yet households often remain exposed to movements in local weather; regional house prices; prices of commodities like rice, heating oil, and gasoline; and local, regional, and national income fluctuations. In many cases, financial contracts simply do not exist to hedge these exposures, and when contracts do exist their use is not widespread. Why don't financial markets develop to help households hedge these risks? Why don't more households participate when formal markets are available? HBS professor Shawn Cole and coauthors attempt to shed light on these questions by studying participation in rural India in a rainfall risk-management product that provides a payoff based on monsoon rainfall. The results suggest that it may take a significant amount of time—and substantial marketing efforts—to increase adoption of risk-management tools at the household level.
Why is there apparently limited demand for financial services in emerging markets? On the one hand, low-income individuals may not want formal services when informal savings, credit, and insurance markets function reasonably well, and the benefits of formal financial market participation may not exceed the costs. On the other hand, limited financial literacy could be the barrier: If people are not familiar or comfortable with products, they will not demand them. These two views carry significantly different implications for the development of financial markets around the world, and would suggest quite different policy decisions by governments and international organizations seeking to promote "financial deepening." HBS professor Shawn Cole and coauthors found that financial literacy education has no effect on the probability of opening a bank savings account for the full population, although it does significantly increase the probability among those with low initial levels of financial literacy and low levels of education. In contrast, modest financial subsidies significantly increase the share of households that open a bank savings account within the subsequent two months.
Although 99 percent of the companies operating in the United States are private, according to the American Institute of Certified Public Accountants, their accounting practices remain largely unknown due mainly to the lack of publicly available financial statements. In this study, HBS professor Sharon P. Katz used a unique database of firms with privately held equity and publicly held debt to examine how two different ownership structures-private equity sponsorship and non-private equity sponsorship-affect firms' financial reporting practices, financial performance, and stock returns in the years preceding and following the initial public offering (IPO).
The quality of accounting information is influenced by an array of factors, most of which stem from the demand for such information for use in contractual arrangements and from the incentives and opportunities of management to manage the reported numbers. Both the demand for quality accounting information for contractual purposes and management incentives to adjust the reported earnings are likely to be influenced by whether the equity of the company is privately held or publicly traded. This study examines the differential earnings quality of private equity and public equity firms in order to shed light on how public ownership of equity affects the quality of firms' earnings. The research highlights how the presence of public equity investors affects management's reporting behavior.
This paper examines the politics of corporate governance at the world's largest appropriations committee, the World Bank's Board of Executive Directors, and exposes a weakness in the design of the World Bank's decision-making structure. Any large public organization faces a challenge of representation and management. Since all decisions cannot be made by all members, founders often grant a more nimble body with decision-making powers. But representatives on the decision-making body may face a temptation to govern in the interests of their own wallet or narrow constituency rather than in the interests of the larger body. In 2008, the Bank's two primary component institutions—the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA)—committed nearly $25 billion in loans and grants through some 300 development projects around the globe. Where did it go? By exploring the political dynamics and corporate governance of an international appropriations committee, we not only learn about international organizations but also the nature of the international system itself.
The role of sovereign wealth funds (SWFs) in the global financial system has been increasingly recognized in recent years, and many reports suggest that SWFs are often employed to further the geopolitical and strategic economic interests of their governments. The resources controlled by these funds—estimated to be $3.5 trillion in 2008—have grown sharply over the past decade. Projections, while inherently tentative due to the uncertainties about the future path of economic growth and commodity prices, suggest that they will be increasingly important actors in the years to come. Despite this significant and growing role, financial economists have devoted remarkably little attention to these funds. The lack of scrutiny must be largely attributed to the deliberately low profile adopted by many SWFs, which makes systematic analysis challenging. Bernstein, Lerner, and Schoar analyze how SWFs vary in their investment styles and performance across various geographies and governance structures. Taken as a whole, results suggest that high levels of home investments by SWFs, particularly those with the active involvement of political leaders, are associated with trend chasing and worse performance.
Can patterns of corporate net stock issuance help identify times when particular characteristics, such as industry, size, or book-to-market ratio, are mispriced? The authors of this study argue that differences between the characteristics of issuers and repurchasers can shed light on characteristic related stock returns. Consider the case in which analysts were interested in forecasting the returns of Google. The standard approach would be to collect Google's characteristics (e.g., large, technology, non-dividend paying, etc) and associate these characteristics with an average return in the cross-section. The authors argue that if other stocks with these characteristics are issuing stock, this bodes poorly for Google's future returns, even if Google is itself not issuing. This research by HBS professor Robin Greenwood and Harvard doctoral student Samuel Hanson has implications for studying the stock market performance of seasoned equity offerings (SEOs), initial public offerings (IPOs), and recent acquirers.
