City Size and Financial Development

Stock markets tend to be few in each country, often unique, and located in the largest cities. Typically, much of the economic activity relating to the stock market takes places in this large city. These facts suggest that agglomeration economies are important. In other words, productivity is enhanced for stock market-workers and -firms located in a large city. After discussing this prima facie evidence of agglomeration economies, we consider the cross-country implications. Countries with larger cities will have better developed stock markets because they can benefit from stronger agglomeration economies surrounding the stock market. This provides an economic theory of financial development which is complementary to the standard legal and political theories of financial development. We establish that city size is a robust determinant of stock market size and activity, but not of other types of financial development (banks). We show that this is not driven by reverse causality and that it is not driven by small or new stock markets. Finally, we show that alternative measures of a country's geography, such as urbanization and the population of the second largest city, do not predict stock market development, implying that we do not capture some alternative geographic effect. We conclude that there is a significant positive effect of city size on stock market development, that this reflects agglomeration economies. This explains why countries with large cities have better developed stock markets.City size; agglomeration economies; financial development

The effect of financial development on the investment cash flow relationship: cross-country evidence from Europe

We investigate financing constraints in a large cross-country data set covering most of the European economy. Firm level investment sensitivity to cash flow is used to identify financing constraints. We find that the sensitivities are significantly positive on average, controlling for country and industry fixed effects, as well as firm level controls. Most importantly, the cash flow sensitivity of investment is lower in countries with better-developed financial markets. This suggests that financial development may mitigate financial constraints. This effect is weaker in conglomerate subsidiaries, which are likely to have access to internal capital markets and depend less on the outside financial environment, and possibly for firms in industries with highly liquid assets as well. This result sheds light on the link between financial and economic development. JEL Classification: , E44, G31, L10Europe, financial constraints, Financial Development, Investment

Reputation and competition: evidence from the credit rating industry

The credit rating industry has historically been dominated by just two agencies, Moody’s and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how in fact increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.

Fiduciary Duties and Equity-Debtholder Conflicts

We use an important legal event as a natural experiment to examine the effect of management fiduciary duties on equity-debt conflicts. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors' fiduciary duties in firms incorporated in that state. This change limited managers' incentives to take actions favoring equity over debt for firms in the vicinity of financial distress. We show that this ruling increased the likelihood of equity issues, increased investment, and reduced firm risk, consistent with a decrease in debt-equity conflicts of interest. The changes are isolated to firms relatively closer to default. The ruling was also followed by an increase in average leverage and a reduction in covenant use. Finally, we estimate the welfare implications of this change and find that firm values increased when the rules were introduced. We conclude that managerial fiduciary duties affect equity-bond holder conflicts in a way that is economically important, has impact on ex ante capital structure choices, and affects welfare.

Estimating the Effects of Large Shareholders Using a Geographic Instrument

Large shareholders may play an important role for firm policies and performance, but identifying an effect empirically presents a challenge due to the endogeneity of ownership structures. However, unlike other blockholders, individuals tend to hold blocks in corporations that are located close to where they live. Using this fact, we create an instrument – the density of wealthy individuals near a firm’s headquarters – for the presence of a large, non-managerial individual shareholder in a public firm. We show that these shareholders have a large impact on firms. Consistent with theories of large shareholders as monitors, we find that they increase firm profitability, increase dividends, reduce corporate cash holdings, and reduce executive compensation. Consistent with the view that there exist conflicts between large and small owners in public firms, we uncover evidence of substitution toward less tax-efficient forms of distribution (dividends over repurchases). In addition, our analysis shows that large shareholders reduce the liquidity of the firm’s stock.Large shareholders; blockholders; corporate policies; firm performance; liquidity; instrumental variable estimation

Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge

We use the Business Roundtable’s challenge to the SEC’s 2010 proxy access rule as a natural experiment to measure the value of shareholder proxy access. We find that firms that would have been most vulnerable to proxy access, as measured by institutional ownership and activist institutional ownership in particular, lost value on October 4, 2010, when the SEC unexpectedly announced that it would delay implementation of the Rule in response to the Business Roundtable challenge. We also examine intra-day returns and find that the value loss occurred just after the SEC’s announcement on October 4. We find similar results on July 22, 2011, when the D.C. Circuit ruled in favor of the Business Roundtable. These findings are consistent with the view that financial markets placed a positive value on shareholder access, as implemented in the SEC’s 2010 Rule.

Estimating the Effects of Large Shareholders Using a Geographic Instrument

Large shareholders may play an important role for firm performance and policies, but identifying this empirically presents a challenge due to the endogeneity of ownership structures. We develop and test an empirical framework which allows us to separate selection from treatment effects of large shareholders. Individual blockholders tend to hold blocks in public firms located close to where they reside. Using this empirical observation, we develop an instrument - the density of wealthy individuals near a firm's headquarters - for the presence of large, non-managerial individual shareholders in firms. These shareholders have a large impact on firms, controlling for selection effects.

Cyclicality of Credit Supply: Firm Level Evidence

Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms' substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm's switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices, and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms. We consider and reject several alternative explanations of our findings

Reaching for Yield in the Bond Market

Reaching for yield—the propensity to buy riskier assets in order to achieve higher yields—is believed to be an important factor contributing to the credit cycle. This paper analyses this phenomenon in the corporate bond market. Specifically, we show evidence for reaching for yield among insurance companies, the largest institutional holders of corporate bonds. Insurance companies have capital requirements tied to the credit ratings of their investments. Conditional on ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. This behavior appears to be related to the business cycle, being most pronounced during economic expansions. It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding. The results hold both at issuance and for trading in the secondary market and are robust to a series of bond and issuer controls, including issuer fixed effects as well as liquidity and duration. Comparison of the ex-post performance of bonds acquired by insurance companies does not show outperformance but higher volatility of realized returns

Fiduciary Duties and Equity-Debtholder Conflicts

We use an important legal event to examine the effect of managerial fiduciary duties on equity‐debt conflicts. A 1991 legal ruling changed corporate directors’ fiduciary duties in Delaware firms, limiting managers’ incentives to take actions favoring equity over debt for distressed firms. After this, affected firms responded by increasing equity issues and investment and by reducing risk. The ruling was also followed by an increase in leverage, reduced reliance on covenants, and higher values. Fiduciary duties appear to affect equity‐bond holder conflicts in a way that is economically important, has impact on ex ante capital structure choices, and affects welfare. JEL: G32, G33, L