- 30 Sep 2009
- Working Paper Summaries
Breakthrough Inventions and Migrating Clusters of Innovation
In just a short period of time the spatial location of invention can shift substantially. The San Francisco Bay Area grew from 5 percent of U.S. domestic patents in 1975-1984 to over 12 percent in 1995-2004, for example, while the share for New York City declined from 12 percent to 7 percent. Smaller cities like Austin, Texas, and Boise, Idaho, seem to have become clusters of innovation overnight. Despite the prevalence of these movements, we know very little about what drives spatial adjustments in U.S. invention, the speed at which these reallocations occur, and their economic consequences. In this paper, HBS professor William R. Kerr investigates whether breakthrough inventions draw subsequent research efforts for a technology to a local area. Evidence strongly supports the conclusion that centers of breakthrough innovations experience subsequent growth in innovation relative to their peer locations. Key concepts include: Breakthrough inventions spur higher subsequent growth in innovation within a local area and technology compared to peer locations that, for example, have the same overall numbers of patents and similar technologies at the time when the breakthrough occurred. The underlying mobility of the workforce is quite important for the speed at which spatial adjustments occur. Immigrants, and particularly new immigration to the United States, can facilitate faster spatial reallocation. Closed for comment; 0 Comments.
- 24 Sep 2009
- Working Paper Summaries
“I read Playboy for the articles”: Justifying and Rationalizing Questionable Preferences
We want others to find us good, fair, responsible and logical; and we place even more importance on thinking of ourselves this way. Therefore, when people behave in ways that might appear selfish, prejudiced, or perverted, they tend to engage a host of strategies designed to justify questionable behavior with rational excuses: "I hired my son because he's more qualified." "I promoted Ashley because she does a better job than Aisha." Or, "I read Playboy for the articles." In this chapter from a forthcoming book, HBS doctoral student Zoë Chance and professor Michael I. Norton describe various means of coping with one's own questionable behavior: through preemptive actions and concurrent strategies for re-framing uncomfortable situations, forgoing decisions, and forgetting those decisions altogether. Key concepts include: Because people do not want to be perceived as (or feel) unethical or immoral, they make excuses for their shameful behavior—even to themselves. People cope with their own questionable actions in a number of ways, from forgoing certain experiences to rationalizing, justifying, and forgetting—a remarkable range of strategies allowing them to maintain a clear conscience even under dubious circumstances. Closed for comment; 0 Comments.
- 23 Sep 2009
- Working Paper Summaries
Operational Failures and Problem Solving: An Empirical Study of Incident Reporting
Operational failures occur within organizations across all industries, with consequences ranging from minor inconveniences to major catastrophes. How can managers encourage frontline workers to solve problems in response to operational failures? In the health-care industry, the setting for this study, operational failures occur often, and some are reported to voluntary incident reporting systems that are meant to help organizations learn from experience. Using data on nearly 7,500 reported incidents from a single hospital, the researchers found that problem-solving in response to operational failures is influenced by both the risk posed by the incident and the extent to which management demonstrates a commitment to problem-solving. Findings can be used by organizations to increase the contribution of incident reporting systems to operational performance improvement. Key concepts include: Operational failures that trigger more financial and liability risks are associated with more frontline worker problem-solving. By communicating the importance of problem-solving and engaging in problem-solving themselves, line managers can stimulate increased problem-solving among frontline workers. Even without managers' regular engagement in problem-solving, communication about its importance can promote more problem-solving among frontline workers. By explaining some of the variation in responsiveness to operational failures, this study empowers managers to adjust their approach to stimulate more problem-solving among frontline workers. Closed for comment; 0 Comments.
- 17 Sep 2009
- Working Paper Summaries
Input Constraints and the Efficiency of Entry: Lessons from Cardiac Surgery
Many professions rely on highly and variably skilled individuals. If a new firm is looking to enter a specific market, in addition to setting up a physical facility the company needs to hire or contract with specialized labor. In the short term, the supply of these specialists is relatively inelastic. From the point of view of economics, there remains a well-known potential for free entry to be inefficient when firms make entry decisions without internalizing the costs associated with the business they "steal" from incumbent firms. In 1996 Pennsylvania eliminated its certificate-of-need (CON) policy that had restricted entry by hospitals into expensive clinical programs, such as coronary artery bypass graft (CABG) programs—leading to an increase from 43 to 63 in the number of hospitals providing this service. HBS professor Robert Huckman and coauthors examine the welfare implications of entry in the market for cardiac surgery. Key concepts include: Following the introduction of new CABG programs in Pennsylvania, volume shifted from incumbent programs to entrants and from lower- to higher-quality surgeons, thereby improving the overall quality of surgical outcomes. The repeal of CON in Pennsylvania improved the market for cardiac surgery by directing more volume to better doctors and increasing access to treatment. The benefit of reduced mortality from the increased use of high-quality surgeons roughly offset the fixed costs associated with free entry. Closed for comment; 0 Comments.
- 11 Sep 2009
- Working Paper Summaries
Financing Constraints and Entrepreneurship
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. Key concepts include: Promoting entrepreneurship is an important goal of many governments, and researchers need to define for policymakers a more unified perspective for how studies and samples fit together. The "slice" of entrepreneurship examined is very important for the appropriate positioning of research on financing constraints, but studies too often fail to consider this dimension in the conclusions drawn from empirical results. The framework presented here is useful for thinking about the appropriate role of public policy in stimulating entrepreneurship. Closed for comment; 0 Comments.
- 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.
- 10 Sep 2009
- Working Paper Summaries
Feeling Good about Giving: The Benefits (and Costs) of Self-Interested Charitable Behavior
Helping others takes countless forms and springs from countless motivations, from deep-rooted empathy to a more calculated desire for public recognition. Social scientists have identified a host of ways in which charitable behavior can lead to benefits for the giver, whether economically via tax breaks, socially via signaling one's wealth or status, or psychologically via experiencing well-being from helping. Charitable organizations have traditionally capitalized on all of these motivations for giving, with a recently emerging focus on highlighting the mood benefits of giving—the feelings of empowerment, joy, and inspiration that giving engenders. Indeed, if giving feels good, why not advertise the benefits of "self-interested giving," allowing people to experience that good feeling while increasing contributions to charity at the same time? HBS doctoral candidate Lalin Anik, Professor Michael I. Norton, and coauthors explore whether organizations that seek to increase charitable giving by advertising the benefits of giving are making claims supported by empirical research and, most importantly, whether such claims actually increase donations. Key concepts include: Happier people give more and giving makes people happier, such that happiness and giving may operate in a positive feedback loop (with happier people giving more, getting happier, and giving even more). At the same time, charitable organizations should be concerned about the possibility of crowding out their donors' proclivity to donate in the longer term by incentivizing them (via gifts, etc.) in the short term. While offering donors monetary or material incentives for giving may undermine generosity in the long term, preliminary research suggests that advertising the emotional benefits of prosocial behavior may leave these benefits intact and might even encourage individuals to give more. Future research is needed to disentangle the possible costs and benefits of self-interested giving. The authors are actively engaging charitable organizations to conduct these studies. Closed for comment; 0 Comments.
- 09 Sep 2009
- Working Paper Summaries
Perspectives from the Boardroom--2009
Chief executives and regulators have been blamed for the current economic crisis, but in some ways what is surprising is that boards have generally escaped notice. Clearly the experience of corporate boards in the downturn has not been explored. To understand what transpired in the boardrooms of complex companies, and to offer a prescription to improve board effectiveness, eight senior faculty members of the HBS Corporate Governance Initiative talked with 45 prominent directors about what has happened to their companies and why. These directors, who serve on the boards of financial institutions and other complex companies, were asked two broad questions: How well did their boards function before the recession? And, what do they believe should be improved as they look to the future? This white paper [PDF] first explains how the interviewees characterize the strengths of their boards, then examines in depth six areas in which they identified shortcomings or needs for improvement: 1) clarifying the board's role; 2) acquiring better information and deeper knowledge of the company; 3) maintaining a sound relationship with management; 4) providing oversight of company strategy; 5) assuring management development and succession; 6) improving risk management. Finally, the paper discusses two issues that appeared not to trouble the interviewees but that the public feels are important: executive compensation and the relationship between the board and shareholders. This paper was written by Jay Lorsch with the assistance of Joseph Bower, Clayton Rose, and Suraj Srinivasan. The interviews were conducted by Joseph Bower, Srikant Datar, Raymond Gilmartin, Stephen Kaufman, Rakesh Khurana, Jay Lorsch, and Clayton Rose. Key concepts include: Regulations and laws offer little guidance about what specifically boards should do, and, given this lack of specificity, most boards have gradually developed an implicit understanding of what their job should be. Directors expressed strong consensus that the key to improving boards' performance is not government action but action on the part of each board. To improve board effectiveness, each board should achieve clarity about its role in relation to that of management: the extent and nature of the board's involvement in strategy, management succession, risk oversight, and compliance. If, as interviewees insisted, each board's effectiveness is directly attributable to its activities, it follows that boards have a responsibility to define their own roles with clarity, and to decide how to perform those roles in light of the nature of the firm, its industry, and its particular challenges. If boards are to decide on their goals and activities, they must expect to invest extended time in hard-headed discussions of both, leading to concrete and actionable conclusions. Boards need to maintain a delicate balance in their relationship with management. They must be challenging and critical on the one hand and supportive on the other. They have to sustain an open and candid flow of communication in both directions. And they must seek sources of understanding their company beyond just management without offending management. Issues of executive compensation and the relationship between boards and shareholders cannot be ignored, if only because they affect public perceptions of business and therefore its social legitimacy. Paper Information Full Working Paper Text Working Paper Publication Date: September 2009 Faculty Unit: Organizational Behavior 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.
- 28 Aug 2009
- Working Paper Summaries
The Impact of Private Equity Ownership on Portfolio Firms’ Corporate Tax Planning
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. Key concepts include: While majority PE-backed private firms significantly benefit from the tax shield generated by leverage, they otherwise appear less tax aggressive than public firms. In contrast, private firms that are majority-owned by PE firms engage in more tax avoidance than both management-owned and minority PE-backed private firms. On average, majority PE-backed firms pay 15 cents less income tax per dollar of pretax income than other privately held firms, even after controlling for losses and debt tax shields. Closed for comment; 0 Comments.
- 27 Aug 2009
- Working Paper Summaries
Measuring and Understanding Hierarchy as an Architectural Element in Industry Sectors
In an industry setting, classic supply chains display strict hierarchy, whereas clusters of firms have linkages going in many different directions. Previous theory has often assumed the existence of the hierarchical relationships among firms, and empirical industry studies tend to focus on a single-layer industry, or a two-layer structure comprising buyers and suppliers. And yet, some industries have a multilayer structure with a multistep supply chain. Others comprise a cluster of complementary firms producing different parts of a large system. HBS professor Carliss Y. Baldwin and colleagues use network analysis to study multilayer industries both empirically (in the case of Japan) and theoretically and to explore how industries are organized at the sector level in an attempt to reveal the underlying rules that determine how industry architectures form and change. Key concepts include: Empirical analysis shows that the automotive sector in Japan exhibits a significantly higher degree of hierarchy and higher transaction breadth (average number of customers per firm) than the electronics sector. The degree of hierarchy in an industry sector may be traced back to fundamental properties of the underlying technologies. This research helps points the way to new approaches for understanding industry architectures and the factors that influence the architecture of industry sectors. Closed for comment; 0 Comments.
- 20 Aug 2009
- Working Paper Summaries
A Decision-Making Perspective to Negotiation: A Review of the Past and a Look into the Future
The art and science of negotiation has evolved greatly over the past three decades, thanks to advances in the social sciences in collaboration with other disciplines and in tandem with the practical application of new ideas. In this paper, HBS doctoral student Chia-Jung Tsay and professor Max H. Bazerman review the recent past and highlight promising trends for the future of negotiation research. In the early 1980s, Cambridge, Massachusetts, was a hot spot on the negotiations front, as scholars from different disciplines began interacting in the exploration of exciting new concepts. The field took a big leap forward with the creation of the Program on Negotiation, an interdisciplinary, multicollege research center based at Harvard University. At the same time, Roger Fisher and William Ury's popular book Getting to Yes (1981) had a pronounced impact on how practitioners think about negotiations. On a more scholarly front, a related, yet profoundly different change began with the publication of HBS professor emeritus Howard Raiffa's book The Art and Science of Negotiation (1982), which for years to come transformed how researchers would think about and conduct empirical research. Key concepts include: Even as it has transitioned from decision analysis to behavioral decision research to social psychology, the decision perspective to negotiation has remained central to practitioners and academics alike, offering both practical relevance and the foundation for exciting new lines of research. Some of the most recent directions being pursued are surprises that early contributors to the decision perspective could have never predicted, as negotiation scholars engage with other disciplines and draw insights from diverse fields ranging from philosophy to neurobiology. Such collaboration is a healthy sign for an ongoing line of negotiation research. Closed for comment; 0 Comments.
- 19 Aug 2009
- Working Paper Summaries
Optimal Taxation in Theory and Practice
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. Key concepts include: Where large gaps between theory and policy remain, the harder question is whether policymakers need to learn more from theorists, or the other way around. Both possibilities have historical precedents. Given the worldwide trend toward tax systems with flatter tax rates, it is at least arguable that the movement toward flatter taxes is consistent with prescriptions from theory. Among OECD countries, top marginal rates have declined, marginal income tax schedules have flattened, and commodity taxes are more uniform and are typically assessed on final goods. On the other hand, some results from optimal tax theory cannot be easily identified in actual policy and seem unlikely to be found there anytime soon. Trends in capital taxation are mixed, and rates are still well above the zero level recommended by theory. Some of theory's more subtle prescriptions, such as taxes that involve personal characteristics, asset testing, and history dependence, remain rare. Closed for comment; 0 Comments.
- 19 Aug 2009
- Working Paper Summaries
The Optimal Taxation of Height: A Case Study of Utilitarian Income Redistribution
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. Key concepts include: We must either advocate a tax on height or reject, or at least significantly amend, the conventional Utilitarian approach to optimal taxation. Such choices cannot be avoided. Calculations show that a Utilitarian social planner should levy a sizable tax on height. A tall person making $50,000 should pay about $4,500 more in taxes than a short person making the same income. Height is, of course, only one of many possible personal characteristics that are correlated with a person's opportunities to produce income. In this paper, the authors have avoided these other variables, such as race and gender, because they are intertwined with a long history of discrimination. Any discussion of using these variables in tax policy would raise various political and philosophical issues that go beyond the scope of this paper. Some might fear that a height tax would potentially become a "gateway" tax for the government, making taxes based on demographic characteristics more natural and dangerously expanding the scope for government information collection and policy personalization. Yet modern tax systems already condition on much personal information, such as number of children, marital status, and personal disabilities. A height tax is qualitatively similar, so it is difficult to see why it would trigger a sudden descent down a slippery slope. Closed for comment; 0 Comments.
- 14 Aug 2009
- Working Paper Summaries
Insider Trading Preceding Goodwill Impairments
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. Key concepts include: Up to 24 months preceding the announcement of goodwill impairment, insiders exhibit higher net selling behavior relative to firms not reporting such losses. In addition, among firms reporting goodwill impairments, those with net selling among insiders exhibit significantly more negative abnormal stock returns relative to those not reporting net selling among insiders. Overall, these results build on prior research investigating managers' discretion over goodwill impairments by providing evidence of a managerial incentive to delay the accounting recognition of goodwill impairments. Closed for comment; 0 Comments.
- 13 Aug 2009
- Working Paper Summaries
In Favor of Clear Thinking: Incorporating Moral Rules into a Wise Cost-Benefit Analysis
Policy decisions may be the most important set of decisions we make as a society. In this realm, moral rules often play an active and dysfunctional role. The typical way in which we make decisions—by weighing them individually—leads us to overuse moral rules in a manner that is inconsistent with the more reflective set of preferences we would identify through joint consideration of options. In their response to a companion article in Perspectives on Psychological Science, Max Bazerman, of HBS, and Joshua D. Greene, of Harvard University, argue that cost-benefit analysis (CBA) is unfairly stereotyped. The critique of CBA in the companion article could be better framed as a set of considerations that can contribute to more careful CBAs. Key concepts include: Good decision analysts pay attention to potential misapplications of cost-benefit analysis. CBA is not perfect, for many reasons. But CBA needs to be compared against an alternative, and the development of that alternative thus far is limited. Closed for comment; 0 Comments.
- 12 Aug 2009
- Working Paper Summaries
Culture Clash: The Costs and Benefits of Homogeneity
Culture clash is often considered a major cause for the failing of mergers and acquisitions, and for this reason it is an important consideration for corporate strategy. Although less publicized, culture clash has also plagued alliances and long-term market relationships. It provides a unique lens on the performance effects of corporate culture itself, and thus culture's potential to generate a competitive advantage. This paper develops an economic theory of the costs and benefits of corporate culture—in the sense of shared beliefs and values—in order to study the effects of culture clash in mergers and acquisitions. Key concepts include: Culture is the degree to which members have similar beliefs about the best way of doing things. In mergers and acquisitions, the costs of culture clash will typically show up immediately and affect mainly the operational efficiency of the merged firms. The benefits of culture clash will take more time to emerge and will affect more the fit with the environment. Closed for comment; 0 Comments.
- 06 Aug 2009
- Working Paper Summaries
Buy Local? The Geography of Successful and Unsuccessful Venture Capital Expansion
From Silicon Valley to Herzliya, Israel, venture capital firms are concentrated in very few locations. More than half of the 1,000 venture capital offices listed in Pratt's Guide to Private Equity and Venture Capital Sources are located in just three metropolitan areas: San Francisco, Boston, and New York. More than 49 percent of the U.S.-based companies financed by venture capital firms are located in these three cities. This paper examines the location decisions of venture capital firms and the impact that venture capital firm geography has on investments and outcomes. Findings are informative both to researchers in economic geography and to policymakers who seek to attract venture capital. Key concepts include: The success rate of venture capital investments in a region is an important determinant of venture capital firms' decisions to open new branches. While venture capital firms in San Francisco, Boston, and New York City outperform, their outperformance is not driven by local investments. While their performance in investments everywhere is better than that of their peers based in different cities, the outperformance is particularly striking outside the cities where they have offices. Interestingly, some of the performance disparity between local and nonlocal investments disappears when a venture firm does more than one investment in a region, suggesting that as the marginal monitoring cost falls, venture capital firms may reduce their expected success rate for investment in a distant geography. Closed for comment; 0 Comments.
- 05 Aug 2009
- Working Paper Summaries
Authority versus Persuasion
In directing employees, managers often face a choice between invoking authority and persuasion. In particular, since a firm's formal and relational contracts and its culture and norms are quite rigid in the short term, a manager who needs to prevent an employee from undertaking the wrong action has the choice of either trying to persuade the employee or relying on interpersonal authority. In choosing between persuasion and authority the manager makes a cost-benefit trade-off. This paper studies that trade-off, focusing in particular on conflicts that originate in open disagreement. Key concepts include: Persuasion and authority can be both substitutes and complements. In particular, authority and persuasion are substitutes when authority is highly effective but complements when authority is not very effective. Persuasion is attractive on projects where effort or motivation is more important. The reason is that (under the assumption that executing a good project is more valuable than executing a bad project) the employee will exert extra effort if he or she believes more in the project. The manager also relies more on persuasion (without authority) when employees have higher pay-for-performance incentives. Closed for comment; 0 Comments.
Systemic Risk and the Refinancing Ratchet Effect
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. Key concepts include: Consider the hypothetical scenario in which all homeowners decide to refinance and extract cash from any accumulated house equity so that their loan-to-value ratio is kept the same as the one for a new purchaser of that house. Suppose that the refinancing market is so competitive, i.e., refinancing costs are so low and capital is so plentiful, that homeowners can implement this refinancing each month. In this extreme case, during periods of rising home prices and falling interest rates, cash-out refinancing has the same risk effect "as if" all houses had been purchased and their mortgages originated at the peak of the housing market, thereby creating a large systemic risk exposure. Then, when home prices fall, the refinancing ratchet "locks,'' causing a systemic event with widespread correlated defaults and large losses for mortgage lenders. While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, the simulations show that even if all homeowners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises can still occur. The fact that the refinancing ratchet effect arises only when three market conditions are simultaneously satisfied demonstrates that the current financial crisis is subtle, and may not be attributable to a single cause. There may be no easy legislative or regulatory solutions: Lower interest rates, higher home prices, and easier access to mortgage loans have appeared separately in various political platforms and government policy objectives over the years. Their role in fostering economic growth makes it virtually impossible to address the refinancing ratchet effect within the current regulatory framework. We need an independent organization devoted solely to the study, measurement, and public notification of systemic risk, not unlike the role that the National Transportation Safety Board plays with respect to airplane crashes, train wrecks, and highway accidents. The subtle and multifaceted nature of the refinancing ratchet effect is just one example of the much broader challenge of defining, measuring, and managing systemic risk in the financial system. Closed for comment; 0 Comments.