Short-term Debt and Incentives for Risk-Taking (with Marco Della Seta and Erwan Morellec)
Journal of Financial Economics, 137 (1): 179–203, 2020 (Paper, Supplementary Appendix)
We challenge the view that short-term debt curbs moral hazard and demonstrate that, in a world with financing frictions and fair debt pricing, short-term debt generates incentives for risk-taking. To do so, we develop a model in which firms are financed with equity and short-term debt and cannot freely optimize their default decision because of financing frictions. We show that the dynamic interaction of operating and rollover losses fuels default risk. In such instances, shareholders find it optimal to increase asset risk to improve interim debt repricing and prevent inefficient liquidation. These risk-taking incentives do not arise when debt maturity is sufficiently long.
Shareholder Bargaining Power and the Emergence of Empty Creditors (with Stefano Colonnello and Matthias Efing)
Journal of Financial Economics 134 (2): 297–317, 2019 (Paper, Internet Appendix)
Credit default swaps (CDSs) can create empty creditors who may push borrowers into inefficient bankruptcy but also reduce shareholders’ incentives to default strategically. We show theoretically and empirically that the presence and the effects of empty creditors on firm outcomes depend on the distribution of bargaining power among claimholders. Firms are more likely to have empty creditors if these would face powerful shareholders in debt renegotiation. The empirical evidence confirms that more CDS insurance is written on firms with strong shareholders and that CDSs increase the bankruptcy risk of these same firms. The ensuing effect on firm value is negative.
Liquidity, Innovation, and Endogenous Growth (with Semyon Malamud)
Journal of Financial Economics 132 (2): 519–541, 2019 (Paper, Internet Appendix)
We build a model of endogenous, innovation-driven growth in which innovative firms have costly access to outside financing and hoard cash reserves to maintain financial flexibility. We show that financing frictions slow down Schumpeterian creative destruction by discouraging entry. As a result, financing frictions importantly affect the composition of growth, by reducing the contribution of entrants but spurring the contribution of incumbents. We investigate the net impact of these countervailing effects on the equilibrium growth rate and welfare.
Innovation, Industry Equilibrium, and Discount rates
(with Maria Cecilia Bustamante)
We develop a model to examine how discount rates affect the nature and composition of innovation within an industry. Challenging conventional wisdom, we show that higher discount rates do not discourage firm innovation when accounting for the industry equilibrium. Higher discount rates deter fresh entry—effectively acting as entry barriers—but encourage innovation through the intensive margin, which can lead to a higher industry innovation rate on net. Simultaneously, high discount rates foster explorative over exploitative innovation. Considering fluctuations in discount rates, the model further rationalizes observed patterns in innovation cyclicality, and shows that innovation by rivals inflates incumbents’ risk premia.
Corporate Policies and the Term Structure of Risk
(with Matthijs Breugem and Roberto Marfè)
The relative pricing of short-term (transitory) versus long-term (persistent) risks is a key, yet overlooked, aspect of firms’ intertemporal decisions. In a dynamic model with financing frictions, we show that firms should extend their horizon if short-term shocks have a greater market price than long-term ones. Ignoring this relative pricing leads to distorted policies that overweight the short-term, including excessive payouts, underinvestment, lower-than-optimal equity issuances and precautionary savings, and excessive disinvestment when constraints tighten. The analysis is extended to allow for heterogeneous firm exposure to these risks and time variation in their risk prices, consistent with the evidence.
Dynamic Equity Slope
(with Matthijs Breugem, Stefano Colonnello, and Roberto Marfè)
We develop a general equilibrium model that jointly explains important features of the term structure of equity: (i) a negative unconditional term premium, (ii) countercyclical term premia, (iii) procyclical equity yields, (iv) premia to value and growth claims respectively increasing and decreasing with the horizon. The economic mechanism hinges on the interaction between heteroskedastic long-run growth, which steers countercyclical risk premia, and homoskedastic short-term shocks in the presence of limited market participation, which generate sizeable short-term risk premia. The slope dynamics hold irrespective of the sign of its unconditional average. We provide empirical support to our model assumptions and predictions.
The Monetization of Innovation
(with Missaka Warusawitharana)
We develop a dynamic model of the innovative firms that invest in monetization, which represents the process of generating revenues from services provided to customers at no charge. The model reflects the challenges faced by firms that operate via the Internet, whose dynamics are shaped by the decoupling of customer acquisition and revenues growth. Our model captures and explains why such firms often build a large customer base and become highly valued while continuing to suffer losses—traditional models would struggle to explain this pattern. Counterfactual analysis reveals that monetization uncertainty slows technological advancement by diverting resources away from innovation.
I develop a model that studies the interplay between investors’ trading frictions and firms’ financial constraints and the ensuing effects on corporate policies. The model shows that bid-ask spreads increase not only the cost of external financing but also the cost of internal funds, leading to smaller cash reserves and larger payouts. As a result, firm’s financial constraints tighten, liquidation risk increases, investment decreases, and firm value declines. These outcomes are reinforced when internalized by liquidity providers, giving rise to a feedback that makes the bid-ask spread wider and amplifies its detrimental effects on firm financial constraints and value.
Competition, Cash Holdings, and Financing Decisions
(with Erwan Morellec and Boris Nikolov)
We use a dynamic model of cash management in which firms face competitive pressure to show that competition increases corporate cash holdings as well as the frequency and size of equity issues. In our model, these effects are driven by small, financially constrained firms, in contrast with the theories based on strategic interactions in which large leaders or incumbents value more cash. We test these predictions on Compustat firms and show that product market competition has first order effects on the cash holdings and financing decisions of constrained firms, in ways consistent with our theory.
Managerial Discretion, Capital Supply, and Corporate Policies (available upon request)
I examine the dynamic effects of managerial discretion on corporate investment, financing, and saving decisions when the access to outside financing is uncertain. In this setting, a self-interested manager balances rent seeking against the need to ensure dynamic efficiency to avoid forced liquidations. In light of this trade-off, rent seeking is contingent on the firm financial stance. To prevent binding liquidity constraints, the manager implements a series of deviations from the value-maximizing policies that constitute indirect agency costs. Specifically, the manager hoards excessive cash reserves, delays dividends, raises funds even when managing a cash-rich firm, and postpones internal financing of investment. Even when the direct cost of rent seeking is zero due to tight liquidity constraints, the indirect costs can substantially depress equity value.
Disclaimer: The information in this website represents the views of the author and should not be interpreted as reflecting the views of the Federal Reserve System or other members of its staff.