College of Behavioral & Social Sciences

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ESSAYS ON LINKAGES BETWEEN CAPITAL FLOWS, LEVERAGE, AND THE REAL ECONOMY
(2021) Kwak, Jun Hee HEE; Kalemli-Ozcan, Sebnem; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Europe experienced a sovereign debt crisis starting in 2010, in which perceived default risk and interest rates on government bonds soared in many countries, leading to recessions. This episode was preceded by a steady rise in the ratio of corporate debt to GDP, suggesting that private sector leverage may be a contributing factor to rising sovereign risk. In the main essay, I find that corporate debt causally affects sovereign default risk and show that this corporate-sovereign debt nexus is an important amplification mechanism driven by externalities that call for macroprudential policies. I run instrumental variable regressions to estimate a causal relationship running from aggregate corporate leverage to sovereign spreads. I use the weighted sum of idiosyncratic shocks to top 50 large firms in each Eurozone country as an instrument for aggregate corporate leverage to rule out potential reverse causality and omitted variable bias. The regressions suggest that rising corporate leverage causes sovereign spreads to rise, which confirms the existence of the corporate-sovereign nexus. To understand the mechanism, I build a model in which both firms and the government can default. When corporate debt increases, tax revenues are expected to be lower, as firms stop paying taxes and dividends when they default, which raises sovereign default risk. This tax revenue channel is supported by empirical evidence. Country-level tax revenue regressions show that increases in corporate debt-to-GDP ratios reduce future tax revenue growth. Difference-in-difference regressions using firm-level data suggest that highly-leveraged firms reduce tax payments more compared to less-leveraged firms in response to the 2008 global financial crisis. Moreover, I analyze an externality that arises from firms' limited liability, which is distinct from the pecuniary and aggregate demand externalities. I find that there exist time-consistent optimal policies that correct the limited liability externality. A quantitative model calibrated to six Eurozone countries shows that such policies consists of a low constant debt tax rate together with transfers and investment credits to firms during the crisis. Implementing these policies alleviates the corporate-sovereign linkage, so that the number of defaulting firms decreases, and the government has enough fiscal space to provide transfers to households suffering from low consumption. Furthermore, practical policies such as either constant or cyclical debt tax schedules can correct overborrowing externalities. However, a countercyclical debt policy (which raises the debt tax rate during corporate credit booms) induces more firm defaults during crises, and thus it is less effective than constant and procyclical debt tax policies. This suggests that policymakers should be cautious about implementing countercyclical debt tax policies such as countercyclical capital buffers, and should even consider relaxing regulations when corporate default risk is high. The second essay (co-authored) documents new facts on the relationship between sector-level capital flows and sectoral leverage. We highlight the interconnections between different approaches and argue that harmonization of the macro and micro approaches can yield a more complete understanding of these effects of capital flows on country-, sector- and firm/bank-level leverage associated with credit booms and busts. The third essay (co-authored) uses a historical quasi-experiment in the Ottoman Empire to estimate the causal effect of trade shocks on capital flows. We argue that fluctuations in regional rainfall within the Ottoman Empire capture the exogenous variation in exports from the Empire to Germany, France, and the U.K., during 1859-1913. Our identification is based on the following historical facts: First, only surplus production was allowed to be exported in the Ottoman Empire (provisionistic policy). Second, different products grew in different regions that were subject to variation in rainfall. Third, Germany, France, and the U.K. imported these different products. When a given region of the Empire gets more rainfall than others, the resulting surplus production is exported to countries with higher ex-ante export shares for those products, and this leads to higher foreign investment by those countries in the Ottoman Empire. Our findings support theories predicting complementarity between trade and finance, where causality runs from trade to capital flows.
EMPIRICAL ESSAYS ON FINANCIAL ECONOMICS
(2019) Wang, Jun; Kyle, Albert; Shea, John; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Using institutional investors’ holdings data from Thomson Reuters’ 13F filings, the first chapter studies and tests the market microstructure invariance hypothesis proposed by Kyle and Obizhaeva (2016a), and in particular its implied −2/3 law on the relationship between investors’ bets and stock trading activity, defined by the product of price, volume, and volatility. With the identifying assumption that institutional asset managers’ holdings are proportional to their bets, our empirical results support the −2/3 law implied by the invariance hypothesis. The −2/3 law is robust to a variety of estimation strategies and robustness checks. Then we study whether distributions of bets are invariant and log-normal. Data strongly support the hypothesis before March 1998, and the weak version of the invariance hypothesis (the mean of distributions of bets is invariant) continues to hold in the remaining periods. The strong version failing to hold after March 1998 may be due to adjustment costs and very tiny positions. The second chapter studies the role of convertible debt on investment. Convertible debt in the capital structure facilitates investment for a firm (especially for a firm with high leverage) since it reduces the firm's interest payments and leverage upon conversion, making it easier for the firm to issue new financial instruments. However, the same property may bring an agency issue: The potential of conversion into equity dilutes existing shareholders' profits, decreasing the firm's motivation to do investment. We hypothesize that the agency issue brought by convertible debt is minimal in very competitive markets since the external pressure is high, so that the facilitation role may outweigh the dilution role, suggesting a positive effect on investment, and that the agency issue brought by convertible debt may outweigh or just offset the facilitation role in less competitive markets since the external pressure is not high, suggesting a negative or insignificant effect on investment. Using data from Compustat, we find that convertible debt has a positive and quadratic effect on investment rates in competitive industries (industries with very low HHI), a negative and quadratic effect on investment rates in oligopoly industries (intermediate HHI), and an insignificant effect on investment rates in highly monopolistic industries (high HHI). These effects are robust to including different control variables. We also suspect the interaction of warrants and competition has similar effects. These results may have implications on the announcement effects or long term effects of convertible debt issuance under different industry structures.
Finance and Productivity
(2019) Sever, Can; Kalemli-Ozcan, Sebnem; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Financial crises are associated with large and persistent output losses, pointing to productivity losses. A potential channel for this phenomenon is the negative impact of disruptions in financial markets on innovative activity, since innovation is the key driver of productivity and economic growth. Throughout three chapters of my dissertation, I provide evidence for this channel. Using data from advanced, emerging market and European economies, following different financial crisis episodes, I show that financial crises lead to a persistent decline, not only in the economic output, but also in innovation. The findings in this dissertation have implciations for macroeconomic policies such as monetary and fiscal policies, structrucal reforms, crisis prevention policies and policies that can shelter productive investment projects from financial frictions.
ESSAYS ON FINANCIAL REFORMS AND FIRM PERFORMANCE IN EMERGING MARKETS
(2017) Li, Wei; Kalemli-Ozcan, Sebnem; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation describes three studies on the linkages between changes in financial markets and firm-level performance in the real economy. The first chapter studies the impact of foreign bank deregulation on domestic firms' credit access and real outcomes in China, using an extensive firm-level data set from the manufacturing census. Following the deregulation policies implemented by the government in 2001, foreign banks were allowed to enter the Chinese banking market gradually, in different years in different cities. As a result, from 2001 to 2006 firms in different cities had differential access to foreign bank credit. Empirical results suggest that after foreign bank entry, private-owned firms which were previously more credit-constrained obtained more bank loans, increased investment and increased sales significantly more than state-owned firms, which were previously less constrained. The findings provide evidence that policy-driven positive foreign credit supply shocks could reduce domestic firms' financing constraints, especially for private-owned enterprises. In addition, I investigate the hypothesis that foreign bank entry intensified competition in the domestic banking sector, using a newly constructed regional bank competition index. Results confirm that increases in bank competition brought by foreign bank entry improved credit access for private-owned firms relative to state-owned firms. The second chapter studies determinants and impacts of foreign currency borrowing by firms in emerging Europe. Most of the existing studies on currency mismatch focus on large corporations, and this study complements literature by using firm-level survey data mainly covering small non-listed firms. The third chapter presents evidence on zombie firms and stimulating policies in China. We apply the framework from the seminal study of zombie firms in Japan to a broader manufacturing census sample in China between 1998 and 2013. We show that the number and the magnitude of undesirable zombie firms increased sharply after an enormous monetary expansion right after the 2008 financial crisis.
Essays on Macroeconomics and Corporate Financing Decisions
(2017) Park, Jongho; Shea, John; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This thesis comprises two studies in the relationship between corporate firms' financing decisions and business cycles. In the first chapter, I propose a transmission mechanism linking uncertainty shocks to macroeconomic variables through firms' financing decisions, with an emphasis on the role of equity financing. When uncertainty is high, equity issuance is limited, as firms are less likely to generate positive profits, and are more tempted to divert profits. As a result, external equity financing shrinks, and this generates additional amplification since total equity financing decreases. Based on this mechanism, I address two questions. First, how are equity financing decisions and associated agency costs affected by uncertainty shocks, and how does equity amplify the response of macroeconomic variables to uncertainty shocks? I build a DSGE financial accelerator model with both debt and equity financing that generates amplification of macroeconomic variables in response to uncertainty shocks. The troughs of macroeconomic variables generated by my model are approximately 30 percent deeper compared to a standard model with only a debt contract. The amplification allows the model to predict procyclical debt and equity financing, and countercyclical external financing costs, a combination which existing models are unable to explain. Second, how does uncertainty affect corporate firms' equity financing decisions empirically? Using balance sheet data of U.S. listed firms from 1993 to 2014, I find that a one standard deviation increase in the level of uncertainty is associated with a 0.7 percentage point decrease in the ratio of equity financing to total assets. In the second chapter, we study the influence of external financial factors on economic activity in emerging economies (EMEs), motivated by a considerable increase in foreign financing by the corporate sector in EMEs since the early 2000s, mainly in the form of bond issuance. We build a quarterly external financial indicator for several EMEs using bond-level data on spreads of corporate bonds issued in foreign capital markets, and examine its relationship with economic activity. Results show that this indicator has considerable predictive power for future economic activity. Furthermore, an identified adverse shock to the financial indicator generates a large and protracted fall of real output growth. About a third of the forecast error variance for output is associated with this shock. These findings are robust to controlling for possible spillovers from sovereign to corporate risk, among other considerations.
Essays on Market Frictions and Securitization
(2016) Wang, An; Korinek, Anton; Shea, John; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation provides a novel theory of securitization based on intermediaries minimizing the moral hazard that insiders can misuse assets held on-balance sheet. The model predicts how intermediaries finance different assets. Under deposit funding, the moral hazard is greatest for low-risk assets that yield sizable returns in bad states of nature; under securitization, it is greatest for high-risk assets that require high guarantees and large reserves. Intermediaries thus securitize low-risk assets. In an extension, I identify a novel channel through which government bailouts exacerbate the moral hazard and reduce total investment irrespective of the funding mode. This adverse effect is stronger under deposit funding, implying that intermediaries finance more risky assets off-balance sheet. The dissertation discusses the implications of different forms of guarantees. With explicit guarantees, banks securitize assets with either low information-intensity or low risk. By contrast, with implicit guarantees, banks only securitize assets with high information-intensity and low risk. Two extensions to the benchmark static and dynamic models are discussed. First, an extension to the static model studies the optimality of tranching versus securitization with guarantees. Tranching eliminates agency costs but worsens adverse selection, while securitization with guarantees does the opposite. When the quality of underlying assets in a certain security market is sufficiently heterogeneous, and when the highest quality assets are perceived to be sufficiently safe, securitization with guarantees dominates tranching. Second, in an extension to the dynamic setting, the moral hazard of misusing assets held on-balance sheet naturally gives rise to the moral hazard of weak ex-post monitoring in securitization. The use of guarantees reduces the dependence of banks' ex-post payoffs on monitoring efforts, thereby weakening monitoring incentives. The incentive to monitor under securitization with implicit guarantees is the weakest among all funding modes, as implicit guarantees allow banks to renege on their monitoring promises without being declared bankrupt and punished.
Essays on Strategic Behavior in Financial Markets
(2014) Pedraza, Alvaro Enrique; Shea, John; Kyle, Albert; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation explores the role of strategic behavior in financial markets and highlights the effects of such behavior on portfolio choice, trading behavior and asset prices. In Chapter 1 I study portfolio choice of strategic fund managers in the presence of a peer-based underperformance penalty. While the penalty generates herding behavior, correlated trading among managers is exacerbated when a strategic setting is considered. The equilibrium portfolios are driven by the least restricted manager, who may vary according to the realization of returns. I compare model predictions to evidence from the Colombian pension fund management industry, where six asset managers are in charge of portfolio allocation for the mandatory contributions of the working population. These managers are subject to a peer based underperformance penalty, known as the Minimum Return Guarantee (MRG). I study trading behavior by managers before and after a change in the strictness of the MRG in June 2007. The evidence suggests that a tighter MRG results in more trading in the direction of peers, a behavior that is more pronounced for underperforming managers. I show that these findings are consistent with the qualitative and quantitative predictions of the theoretical model. In Chapter 2 I explore the limits to the allocational role of stock prices in a strategic setting. Stock prices are thought to help firms' managers make more efficient real investment decisions, because they aggregate information about fundamentals that is not otherwise known to managers. In this chapter I identify a limitation to this view. I show that if informed traders internalize that firms use prices as signal, stock price informativeness depends on the quality of managers' prior information. In particular, managers with low quality information would like to learn about their own fundamental by relying on the information aggregated in the stock price. However, in this case, the profitability of trading falls for informed speculators, who therefore reduce their trading volume, reducing the informativeness of prices. As a result, stock prices are not as useful to guide capital towards the most productive use, leading to inefficient investment decisions. Using a sample of U.S. publicly traded companies between 1990-2010, I document a positive correlation between the quality of managerial information and stock price informativeness. Contrary to the conventional view that less informed managers should rely more on stock prices when making investment decisions, I find no differences in the sensitivity of investment to stock price for different levels of managerial information. The evidence suggests that while firms do learn from prices, the learning channel and its effects on real investment are limited.
Accounting for Information: Case Studies in Editorial Decisions and Mortgage Markets
(2014) Bandeh-Ahmadi, Ayeh; Rust, John; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
I measure information on distinct facets of quality from a corpus of reviews and characterize how decision-makers integrate this information present in text with that available through other channels. Specifically, I demonstrate that referee comments at a scholarly journal contain information on submissions' future citation impact above and beyond information available in referee scores. I measure this signal on future citation impact and show that it does not enter into editorial decision-making directly but rather through an interaction that amplifies the information content of referee scores: the more citations a low- or mediocre-scoring paper is likely to get the less likely it is to be published. Secondly, I describe referee comments that are highly predictive of greater citations. Papers that referees say have access to unique datasets, or are written on topics of relevance to ongoing debates or government applications receive greater citations on average. Third, I show the appearance of favoritism amongst editors who accept a higher share of papers that cite themselves is partly a reflection of an ability to draw and select for papers that receive more citations. Finally, I characterize budget constraints on publication space and referee capital and provide some guidance on what types of information editorial systems could capture to promote transparency in future analyses while protecting privacy of authors or referees. A second chapter introduces a theoretical framework for assessing the empirical discussion of asymmetric information amongst mortgage lenders and adds the idea of lender competition into this framework.
Capital Inflows, Financial Development, and Credit Constraints at the Firm Level: Theory and Evidence
(2012) Armenta Reales, Armando Jose; Vegh, Carlos; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation is composed of two related essays on the effects of periods of large capital inflows on macroeconomic aggregates and financing constraints at the firm level, and the relationship of the differences in these effects among developed and emerging economies with the degree of financial development. In the first essay I conduct an empirical exploration of this topic. I show that periods of large capital inflow are associated with more volatile macroeconomic outcomes in economies with a low degree of financial development, relative to economies with more developed financial systems. Employing firm level data for 42 countries, I show that firms in economies with a low level of financial development exhibit a relatively larger loosening in the cost of borrowing and a larger appreciation in equity prices. I show that financing constraints are more prevalent in firms located in countries with a low degree of financial development. Moreover, periods of capital inflow booms relax these financing constraints. This decrease is significant regardless of the composition of capital inflows, stronger when coupled with domestic credit booms, larger for firms in the non-tradable sector and larger for firms that depend more heavily on internal funds to finance their investment opportunities. In the second essay, using a theoretical model, I explain the larger aggregate response around capital inflow booms, as arising from varying degrees of financial development, and their relation to the pervasiveness of credit constraints at the firm level. I propose a heterogeneous agents model in which the share of borrowing-constrained agents depends on the level of financial development. Agents in an economy characterized by a low degree of financial development can use a lower share of their assets, measured at their market value, as collateral to secure debt. I show that a period of large capital inflow causes an increase in the demand for capital for both unconstrained and constrained firms. At the initial valuation of capital, only unconstrained firms can freely adjust their demand for capital. However, the increase in the aggregate demand for capital increases its valuation and thus generates a loosening in financing constraints for ex-ante constrained firms, and an amplified response at the firm level and on macroeconomic aggregates.
Essays on Systemic Liquidity Risk
(2012) Federico, Pablo Mariano; Vegh, Carlos; Reinhart, Carmen; Economics; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation studies two aspects of the implications of liquidity risk-taking by financial institutions on the economy: first, its effects on macroeconomic volatility and the likelihood of financial distress; second, how the exposure to this source of risk is relevant in determining the failure of financial institutions in times of stress. Optimal regulatory responses are derived in the essays on both the macroprudential and the microprudential front. The first essay develops a welfare theoretic model to study prudential regulation in an emerging market economy that is facing large short-term capital inflows into the banking system. The prospect of a sudden reversal of those flows exposes the economy to liquidity risk. In the model banks finance investments in short-term and long-term assets by borrowing both locally and externally. Government intervention is rationalized with an externality arising from financial frictions. The potential disruption in external financing constitutes the only source of aggregate risk. The analysis shows that inefficient equilibria exist. In those equilibria banks underinsure against external financing shocks. The underinsurance is the result of excessive external borrowing together with a relative overinvestment in short-term assets. In the proposed setup efficiency is restored by complementing liability-side instruments, such as unremunerated reserve requirements, with asset-side instruments, such as taxes on short-term assets. The theoretical contribution is twofold: First, the framework rationalizes policy action with instruments that attack distortions in the asset side of banks' balance sheet. Second, the analysis points to the systemic exposure to liquidity risk of banks as being the source of concern and the key vulnerability explaining output collapse after an external financing shock. The latter implication is tested by constructing an index that captures such exposure. Extending a methodology recently introduced by Basel III, the index is developed for a sample of 40 emerging markets and developing countries, covering the financial statements of 1,700 banks. It is shown that the index is a robust explanatory variable for unexpected output declines across emerging markets, after the Lehman's bankruptcy. The second essay studies the determinants of bank failure during the global financial crisis. It exploits a bank-level dataset that covers about 11,000 banks in the U.S. and Europe from 2001 to 2009 to analyze the evolution of bank funding structures in the run up to the global financial crisis and to study the implications for financial stability. Careful measurement of exposure to liquidity risk is achieved by employing a recently introduced metric, the NSFR, by Basel III. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with bank risk-taking. The main finding of the essay is that, in the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border banks were more susceptible to solvency risk due to excessive leverage. The results point to potentially large gains in moving to international banking regulatory standards that are designed to contemplate the heterogeneity of vulnerabilities across different banks.

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