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Working Paper
Endogenous Debt Maturity: Liquidity Risk vs. Default Risk
We study the endogenous determination of corporate debt maturity in a setting with default risk. We assume that firms must access the bond market and they issue debt with a flexible structure (coupon, face value, and maturity). Initially, the firm is in a low growth/illiquid state that requires debt refinancing if it matures. Since lenders do not refinance projects with positive but small net present value, firms may be forced to default in the first phase. We call this liquidity risk. The technology is such that earnings can switch to a higher (but riskier) level. In this second phase firms have access to the equity market but they may default if this is the best option. We call this strategic default risk. In the model optimal maturity balances these two risks. We show that firms with poor prospects and firms in more unstable industries will choose shorter maturities even if it is feasible to issue longer debt. The model also offers predictions on how asset maturity, asset salability, and leverage influence maturity. Even though our model is extremely stylized we find that the predictions are roughly consistent with the evidence. Moreover, it offers some insights into the factors that determine the structure of the debt.
AUTHORS: Manuelli, Rodolfo E.; Sanchez, Juan M.
DATE: 2018-10-01

Journal Article
Investment and Bilateral Insurance
Private information may limit insurance possibilities when two agents get together to pool idiosyncratic risk. However, if there is capital accumulation, bilateral insurance possibilities may improve because misreporting distorts investment. We show that if one of the Pareto weights is sufficiently large, that agent does not have incentives to misreport. This implies that, under some conditions, the full information allocation is incentive compatible when agents have equal Pareto weights. In the long run, either one of the agents goes to immiseration, or both agents’ lifetime utilities are approximately equal. The second case is only possible with capital accumulation.
AUTHORS: Sanchez, Juan M.; Kozlowski, Julian; Espino, Emilio
DATE: 2018-07

Working Paper
Investment and Bilateral Insurance
Private information may limit insurance possibilities when two agents get together to pool idiosyncratic risk. However, if there is capital accumulation, bilateral insurance possibilities may improve because misreporting distorts investment. We show that if one of the Pareto weights is sufficiently large, that agent does not have incentives to misreport. This implies that, under some conditions, the full information allocation is incentive compatible when agents have equal Pareto weights. In the long run, either one of the agents goes to immiseration, or both agents’ lifetime utilities are approximately equal. The second case is only possible with capital accumulation.
AUTHORS: Sanchez, Juan M.; Espino, Emilio; Kozlowski, Julian
DATE: 2013-01-02

Journal Article
Stylized Facts on the Organization of Small Business Partnerships
The authors study the internal organization of small business partnerships and focus on the number of owners and ownership structure and the dynamics of these variables. They find that partnerships tend to have a small number of owners with equal distribution of ownership shares. Moreover, while partnerships with equally distributed shares tend to keep this distribution constant, those with unequally distributed shares tend to move toward more equal distribution over time. The authors highlight that these facts are in line with the theory of private information in small business partnerships proposed by Espino, Kozlowski, and Snchez (2014).
AUTHORS: Kozlowski, Julian; Espino, Emilio; Sanchez, Juan M.
DATE: 2016

Working Paper
Financial Frictions and Export Dynamics in Large Devaluations
We study the role of financial frictions and balance-sheet effects in accounting for the dynamics of aggregate exports in large devaluations. We investigate a small open economy with heterogeneous firms and endogenous export decisions in which firms face financing constraints and debt can be denominated in foreign units. Despite the negative impact of these channels on capital accumulation and output at the firm-level, we find that they only explain a modest fraction of the gradual increase of exports observed in these episodes. Exports increase since financially-constrained exporters are able to reallocate sales across markets. We show analytically the role of this mechanism on exports adjustment and document its importance using plant-level data.
AUTHORS: Kohn, David; Leibovici, Fernando; Szkup, Michal
DATE: 2017-05-01

Journal Article
Why bail-in? And how!
All men are created equal, but all liabilities are not. Some liabilities are more equal than others. These "financial liabilities" are products of financial firms. These products shift risk (insurance or derivatives) or provide liquidity (bank deposits or repurchase agreements). Since these liabilities have an independent value as products, they are worth more than their net present value. The value of a financial firm, then, depends on its liability structure. These special liabilities therefore affect insolvency law. Most financial firms are governed by special insolvency law; those that are not receive special treatment in the Bankruptcy Code. These special laws work well for these special firms. However, they do not work for one subset of financial firms: large financial conglomerates. This article draws three major conclusions. First, no established law can succeed with these firms. Second, the "bail-in" process, which is currently under development, should succeed. Finally, policymakers and corporate finance theorists might want to rethink the meaning of capital for financial firms.
AUTHORS: Sommer, Joseph H.
DATE: 2014-12

Journal Article
Cash holdings and bank compensation
The experience of the 2007-09 financial crisis has prompted much consideration of the link between the structure of compensation in financial firms and excessive risk taking by their employees. A key concern has been that compensation design rewards managers for pursuing risky strategies but fails to exact penalties for decision making that leads to bank failures, financial system disruption, government bailouts, and taxpayer losses. As a way to better align management's interests with those of other stakeholders such as creditors and taxpayers, the authors propose a cash holding requirement designed to induce financial firms to adopt a conservative approach to risk taking. Firms meet the requirement by deferring employee compensation in an escrowed cash reserve account. The cash accrues to the earners on a vesting schedule, but is transferred to the firm in times of stress so that it can pay down its debt or otherwise bolster its assets. The cash requirement increases with the leverage of the firm and with the firm's vulnerability to aggregate stress; the authors provide illustrative calculations sizing the proposed cash requirement for many U.S. financial firms over the 2000-13 period. The analysis also compares the role of deferred cash compensation in promoting financial stability with that of other instruments, such as inside debt, deferred equity, and contingent capital.
AUTHORS: Mehran, Hamid; Acharya, Viral V.; Sundaram, Rangarajan K.
DATE: 2016-08

Journal Article
Deferred cash compensation: enhancing stability in the financial services industry
Employees in financial firms are compensated for creating value for the firm, but firms themselves also serve a public interest. This tension can lead to issues that could impose a significant risk to the firm and the public. The authors describe three channels through which deferred cash compensation can mitigate such risk: by promoting a conservative approach to risk, by inducing internal monitoring, and by creating a liquidity buffer. Ultimately, the net contribution of deferred cash pay to financial stability is the sum of the effects of the three channels. The authors argue that a deferred cash program can be designed to limit interference with labor mobility. Further, they underscore that such a scheme for banks is not punitive, particularly in a world of no bailouts. They offer a baseline conservative estimate for the size of the buffer for the largest U.S. banks. Finally, they discuss the potential effects of deferred cash pay on information production and sharing with regulators, and the intersection of deferred cash and enforcement.
AUTHORS: Mehran, Hamid; Tracy, Joseph
DATE: 2016-08

Journal Article
Transparency, accounting discretion, and bank stability
This article examines the consequences of accounting policy choices for individual banks? downside tail risk, for the codependence of such risk among banks, and for regulatory forbearance, or the decision by a regulator not to intervene. The author synthesizes recent research that provides robust empirical evidence for two effects of discretionary accounting policy choices by banks. First, these choices degrade transparency, an outcome that increases financing frictions, inhibits market discipline of bank risk taking, and allows regulatory forbearance. Second, they exacerbate capital adequacy concerns during economic downturns by compromising the ability of loan loss reserves to cover both unexpected recessionary loan losses and the buildup of unrecognized expected loss overhangs from previous periods. The article cautions that bank stability can be undermined by powerful interactions between low transparency and the capital adequacy concerns that stem from accounting discretion.
AUTHORS: Bushman, Robert M.
DATE: 2016-08

Journal Article
Public disclosure and risk-adjusted performance at bank holding companies
This article examines the relationship between the amount of information disclosed by bank holding companies (BHCs) and the BHCs? subsequent risk-adjusted performance. Using data from the annual reports of BHCs with large trading operations, the author constructs an index that quantifies the BHCs? public disclosure of forward-looking estimates of market risk exposure in their trading and market-making activities. She then examines the relationship between this index and subsequent risk-adjusted returns in the BHCs? trading activities and for the firm overall. The key finding is that more disclosure is associated with higher risk-adjusted returns. This result is strongest for BHCs whose trading represents a large share of overall firm activity. More disclosure does not appear to be associated with higher risk-adjusted performance during the financial crisis, however, implying that the findings are a ?business as usual? phenomenon. These findings suggest that greater disclosure is associated with more efficient risk taking and thus improved risk-return trade-offs, a channel for market discipline that has not been emphasized previously in the literature.
AUTHORS: Hirtle, Beverly
DATE: 2016-08

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