Optimal Microstructures

This paper considers the basic issue of the optimal microstructure for trading financial assets. I propose a framework for addressing optimality that draws on the functions that markets perform. These functions include liquidity, price discovery, and the reduction of uncertainty. Because the characteristics of financial assets and their investors differ, I show that their optimal microstructure may differ as well. I illustrate these points by analysing the evolution of corporate and municipal bond trading in the USA. The paper also discusses the particularly important role that microstructure plays for developing financial markets.     

THE LIQUIDITY ROUTE TO A LOWER COST OF CAPITAL

The managements of many public companies do not pay much attention to the liquidity of their securities. Many if not most CEOs and CFOs feel powerless to affect what goes on in financial markets, and a common attitude among top executives is that maintaining liquidity is the concern of the securities exchanges and the Securities and Exchange Commission. This approach may work for those companies whose stocks are already highly liquid—a group made up mainly of large‐cap companies, as well as a number of smaller high‐flying, high‐tech firms. But, for the vast majority of public companies—especially smaller and mid‐sized firms—this is likely to be the wrong policy. As the authors of this article demonstrated in their pioneering study (published in the Journal of Financial Economics in 1986), liquidity appears to be a major determinant of a company's cost of capital. As their theory suggests and their empirical tests confirmed, the more liquid a company's securities, the lower its cost of capital and the higher its stock price. And, as discussed in this article, academic research since then has produced a large and impressive body of evidence linking greater liquidity to higher stock prices. Although recent technological innovations such as Internet‐based trading have increased liquidity generally, not all companies appear to have benefited equally. The authors offer a number of suggestions for companies intent on increasing the liquidity of their stock. Specifically, they propose that managers do the following: (1) consider measures, such as stock splits, designed to increase their investor base by attracting small investors; (2) seek trading venues for their securities that promise to increase liquidity; and (3) take advantage of the new Internet technology to provide more and better information to investors. Moreover, for smaller companies with little or no analyst coverage, the authors offer the radical suggestion that such companies actually pay analysts to cover their stock, much as companies pay Moody's or Standard & Poors to rate their bonds. This, in the authors' view, would be a more efficient alternative to the current practice of using stock splits to encourage intermediaries to make markets in the firm's shares.     

THE EFFECTS OF BANK CONSOLIDATION ON RISK CAPITAL ALLOCATION AND MARKET LIQUIDITY

We investigate the effects of financial market consolidation on the allocation of risk capital in a financial institution and the implications for market liquidity in dealership markets. An increase in financial market consolidation can increase liquidity in foreign exchange and government securities markets. We assume that financial institutions use risk‐management tools in the allocation of risk capital and that capital is determined at the firm level and allocated among separate business lines or divisions. The ability of market makers to supply liquidity is influenced by their risk‐bearing capacity, which is directly related to the amount of risk capital allocated to this activity.     

Deleveraging Corporate America: Job and Business Recovery Through Debt Restructuring

When the Great Recession roiled capital and labor markets in early 2009, up to a third of U.S. public corporations, and nearly 60% of privately owned companies, reported high levels of financial distress resulting from frozen credit markets. And the problems of “debt overhang” and corporate underinvestment were clearly in evidence as the combination of default risk and a relatively new provision of the tax code restricted the ability of distressed companies to deleverage their capital structures. But as described in this article, at least 110 U.S. companies used a little known provision in the American Recovery and Reinvestment Act of 2009 to defer taxes on the cancellation of debt income (CODI) resulting from exchanges or repurchases of significant amounts of debt. This suspension of tax policy gave many distressed U.S. companies the flexibility to cut costs, shore up balance sheets, and boost liquidity, thereby keeping themselves in business and their workers employed throughout the economic crisis. The 110 companies examined either repurchased or exchanged a total of $32.5 billion of corporate debt. The deleveraging of these companies, which represented more than $2.2 trillion in total assets and $520 billion in market capitalization, helped them to remain solvent throughout the downturn and retain their collective 2.2 million employees. The resulting tax savings are estimated to have saved (or in some cases created) almost 90,000 jobs, while contributing $3.2 billion to total corporate earnings and $10.7 billion of output to the national gross domestic product. Although this approach could be criticized as adding to the federal budget deficit, the deferral of taxes on CODI is viewed as a targeted financial policy tool aimed directly at boosting the productive capacity and employment of corporate enterprises.     

The Leveraging of Corporate America: A Long‐Run Perspective on Changes in Capital Structure

In a study published recently in the Journal of Financial Economics, the authors of this article documented a substantial increase in the use of debt financing by U.S. companies over the past century. From 1920 until the mid‐1940s, the aggregate leverage of unregulated U.S. companies was low and stable, with the average debt‐to‐capital ratio staying within the narrow range of 10% to 15%. But during the next 25 years, the use of debt by U.S. companies more than doubled, rising to 35% of total capital. And since 1970, aggregate leverage has remained above 35%, peaking at 47% in 1992. Moreover, this pattern has been observed in companies of all sizes and operating in all unregulated sectors. Changes in the characteristics of U.S. public companies during this period provide little help in explaining the increase in corporate leverage. For example, the displacement of tangible by intangible assets in many sectors of the U.S. economy during the past 50 years would have led most economists to predict, holding all other things equal, a reduction rather than an increase in aggregate corporate leverage. Instead, according to the authors' findings, the main contributors to the increases in U.S. corporate leverage since the 1940s have been external changes, including increases in corporate income tax rates, the development of financial markets and intermediaries, and the reduction in government borrowing in the decades following World War II. The authors' analysis also identifies these last two changes—the development of financial markets, including the rise of institutional investors and shareholder activism, and the post‐War reduction in government debt—as having played the biggest roles in the leveraging of corporate America.     

Social Capital,Trust, and Corporate Performance: How CSR Helped Companies During the Financial Crisis (and Why It Can Keep Helping Them)

The authors summarize the findings of their study, published recently in the Journal of Finance, that shows that CSR investments can help companies when they perhaps need it most—that is, during sharp downturns when overall trust in companies and markets declines. Companies with high‐CSR rankings experienced stock returns that were five to seven percentage points higher than their low‐CSR counterparts during the 2008–2009 financial crisis, and even larger excess returns during the Enron crisis of 2001–2003. High‐CSR companies during the crisis also reported better operating performance, higher growth, higher employee productivity, and greater access to debt markets—while continuing to generate higher shareholder returns as late as the end of 2013. Many of these operating improvements continued well into the post‐crisis period, though at more modest levels. As the authors view their findings, the ‘social capital’ built up by corporate CSR programs complements effective financial capital management in increasing shareholder wealth mainly by limiting companies' downside risk. CSR is seen as not only reducing systematic as well as firm‐specific risk, but as also providing protection against overall ‘loss of trust.’ The social capital created by CSR programs is said to provide a kind of insurance policy that pays off when investors and the overall economy face a severe crisis of confidence.     

The deregulation of capital markets in France

This paper investigates how the deregulation of French capital markets affected corporate investment in the 1980s. Access to public financial markets may be less important in countries that have traditionally relied on institutional investors to finance their corporate investment projects. This should be true for France where, contrary to the US, banks and government agencies have always been involved in firms’ long term activities. In this study, French firms are categorized based on their ownership structure and trading characteristics. Two investment models are augmented with measures of corporate liquidity in order to test the role of internal funds on investment. Empirical results show that only small French firms trading on the secondary stock market have to rely on liquid assets to finance their capital expenditures. French firms with strong bank ties avoid this constraint since they are allowed to maintain higher debt levels.     

Exit Options in Corporate Finance: Liquidity versus Incentives

This paper provides a first study of the optimal design of active monitors'exit options in a problem involving a demand for liquidity and costly monitoring of the issuer. Optimal incentives to monitor the issuer may involve restricting the monitor's right to sell her claims on the firm's cash-flow early. But the monitor will then require a liquidity premium for holding such an illiquid claim. In general, therefore, there will be a trade off between incentives and liquidity. The paper highlights a fundamental complementarity between speculative monitoring in financial markets (which increases the informativeness of prices) and active monitoring inside the firm: in financial markets where price discovery is better and securities prices reflect the fundamentals of the issuer better, the incentive cost of greater liquidity may be smaller and active monitoring incentives may be preserved. The paper spells out the conditions under which more or less liquidity is warranted and applies the analysis to shed light on common exit provisions in venture capital financing.     

股票流动性与中国企业创新策略:流水不腐还是洪水猛兽？

中国情境下股票流动性对企业创新的影响是激励机制还是压力机制占主导地位？本文基于上市公司分类专利的申请、授权、终止数据研究发现:一方面,股票流动性使企业发明专利申请显著增加,但能通过实质审查的授权增长极少,说明申请质量明显下滑;另一方面,股票流动性使创新含量较低的实用新型与外观设计授权显著增加,且这些专利拖累了企业盈利表现,法律效力提前终止的数量也明显更多,揭示企业实际上是以“策略性创新”来应对资本市场压力,加剧了“专利泡沫”问题。分样本检验发现,“重数量轻质量”的创新策略集中体现于民营、传统行业及长期机构投资者持股较少的企业。稳健性检验替换关键指标构造和模型估计方法、构造工具变量克服潜在内生性问题,前述结论仍然成立。本文启示,金融制度设计应防范资本市场压力对企业创新的“意外伤害”,更好地实现“以金融助实体、以改革促发展”的目标。     

ESG Integration in Investment Management: Myths and Realities

The number of public companies reporting ESG information grew from fewer than 20 in the early 1990s to 8,500 by 2014. Moreover, by the end of 2014, over 1,400 institutional investors that manage some $60 trillion in assets had signed the UN Principles for Responsible Investment (UNPRI). Nevertheless, companies with high ESG “scores” have continued to be viewed by mainstream investors as unlikely to produce competitive shareholder returns, in part because of the findings of older studies showing low returns from the social responsibility investing of the 1990s. But studies of more recent periods suggest that companies with significant ESG programs have actually outperformed their competitors in a number of important ways. The authors’ aim in this article is to set the record straight on the financial performance of sustainable investing while also correcting a number of other widespread misconceptions about this rapidly growing set of principles and methods: Myth Number 1: ESG programs reduce returns on capital and long‐run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets; and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. Myth Number 2: ESG is already well integrated into mainstream investment management. Reality: The UNPRI signatories have committed themselves only to adhering to a set of principles for responsible investment, a standard that falls well short of integrating ESG considerations into their investment decisions. Myth Number 3: Companies cannot influence the kind of shareholders who buy their shares, and corporate managers must often sacrifice sustainability goals to meet the quarterly earnings targets of increasingly short‐term‐oriented investors. Reality: Companies that pursue major sustainability initiatives, and publicize them in integrated reports and other communications with investors, have also generally succeeded in attracting disproportionate numbers of longer‐term shareholders. Myth Number 4: ESG data for fundamental analysis is scarce and unreliable. Reality: Thanks to the efforts of reporting and investor organizations such as SASB and Ceres, and of CDP data providers like Bloomberg and MSCI, much more “value‐relevant” ESG data on companies has become available in the past ten years. Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets. Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non‐financial” considerations when investing in companies.     

The Sarbanes‐Oxley Act of 2002 and Market Liquidity

Investors rely heavily on the trustworthiness and accuracy of corporate information to provide liquidity to the capital markets. We find that the rash of financial scandals caused a severe deterioration in market liquidity in the form of wider spreads, lower depths, and a higher adverse selection component of spreads vis‐à‐vis their benchmark levels. Regulatory responses including the Sarbanes‐Oxley Act of 2002 (SOX) had inconsequential short‐term liquidity effects but highly significant and positive long‐term liquidity effects. These liquidity improvements are positively associated with the improved quality of financial reports, several firm‐specific variables (e.g., size), and market factors (e.g., price, volatility, volume).     

When Do Listed Firms Pay for Market Making in Their Own Stock?

A recent innovation in the equity markets is the introduction of market maker services procured by the listed companies themselves. Using data from the Oslo Stock Exchange, we investigate what motivates issuing firms to pay to improve the secondary market liquidity of their listed shares. By examining the timing of market maker hirings relative to corporate events, we show that hirings are more likely when the firm will interact with the capital markets in the near future. Futhermore, a typical firm employing a designated market maker is more likely to raise capital, repurchase shares, or experience an exit by insiders.     

Proactive Leverage Increases and The Value of Financial Flexibility

Traditional tradeoff models of corporate capital structure, although still featured prominently in finance textbooks and widely accepted by practitioners, have been criticized by financial economists for doing a poor job of explaining observed debt ratios. Moreover, the observed ratios are far less stable than what would be predicted by the standard tradeoff models. In a study published several years ago in the Review of Financial Studies, the authors of this article aimed to shed more light on the underlying forces governing capital structure decisions by analyzing a set of major changes in capital structure in which companies initiated large increases in leverage through substantial new borrowings. They then attempted to explain why these companies chose to increase leverage and how their capital structures changed during the years after the large debt issues. As summarized in this article, the authors' findings indicate, first of all, that the large debt financings were used primarily to fund major corporate investments—and not, for example, to make large distributions to shareholders. And the changes in leverage ratios that came after the debt offerings were driven far more by the evolution of the companies' realized cash flows and their investment opportunities than by deliberate or decisive attempts to rebalance their capital structures toward a stationary target. In fact, many of the companies chose to take on even more debt when faced with cash‐flow deficits, despite operating with leverage that was already well above any reasonable estimate of their estimated target leverage. At the same time, companies that generated financial surpluses used them to reduce debt, even when their leverage had fallen well below their estimated targets. Taken as a whole, the findings of the authors' study support the idea that unused debt capacity represents an important source of financial flexibility, and that preserving such flexibility—and making use of it when valuable investment opportunities materialize—may well be the critical missing link in connecting capital structure theory with observed corporate behavior.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M & M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. As the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the target.     

Creating Value Through Best‐In‐Class Capital Allocation1

With the economy showing signs of recovery, companies are shifting their focus from liquidity and balance sheet concerns back towards capital allocation and value creation. This article provides a comprehensive framework to examine shareholder value creation through capital allocation, and discusses important capital allocation lessons that have re‐emerged over the last few years. Notable among the key lessons are the following:

• ? Growth alone does not guarantee value creation, which suggests that companies should allocate capital based on the economic value of each investment opportunity.
• ? The limits of diversification in a financial crisis should be considered when allocating capital and managing liquidity.
• ? Companies should be conservative with base‐case cash flow projections and incorporate the possibility of downside scenarios into their projections.
• ? It is important to incorporate all forms of capital when managing liquidity.
• ? Whether using a long‐term or current‐market approach, companies should be consistent throughout the cycle in their cost of capital methodology.
• ? Companies should continually rethink investments and allocate capital in an attempt to maintain a competitive advantage.
• ? Evaluate returns relative to risk and cost of capital, and not against the company's average ROIC.
• ? Comparing the IRR of share repurchases to new investments is not an apples‐to‐apples comparison.

Finally, companies should concentrate on the strategic uses and value of particular assets and not allow their decisions to be driven by the value they might receive relative to their initial cost.     

Managing Pension Risks: A Corporate Finance Perspective

Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital. The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long‐term strategic and financial priorities. Financial executives should consider the follow pension strategies:

• Voluntary Pension Contributions: Funding the pension gap by issuing new debt or equity can provide valuation and capital structure benefits—and in many cases is both NPV‐positive and EPS‐accretive. The authors show that investors have reacted favorably to both debt‐ and equity‐financed contributions.
• Plan de‐risking: Shifting the pension plan's assets from equity to fixed income has become an increasingly popular approach. The primary purpose of pension assets is to fund pension liabilities while limiting risk to the operating company. The pension plan should not be viewed or run as a profit center.
• Plan Restructuring: Companies should also consider alternatives such as terminating and freezing plans, paying lump sums, and changing accounting reporting.

     

An analysis of working capital efficiency and shareholder return

Since 1997, CFO Magazine has published a ranking of 1000 companies in its “Working Capital Scorecard.” Our research explores the question as to whether working capital management practices based on the accounting metrics used by CFO Magazine serve as a basis for investor-based strategies for superior return generation. We examine the stock performance of top ranked companies from 1997 to 2012 against benchmark portfolios. Controlling for market, market capitalization, book to market, momentum factors, liquidity factors, and corporate governance; the higher ranked firms produce statistically higher excess returns than bottom ranked firms. In bull market periods, firms with superior working capital management outperformed their counterparts on a raw and risk-adjusted basis. These top ranked firms also provide statistically significant active returns regardless of market cycle. In sum, our results indicate that shareholders reward firms with superior working capital management strategies with higher raw and risk-adjusted performance over longer holding periods across the economic cycle especially in bear markets cycles.     

Risk and Regulation in Derivatives (or Why Derivatives Are a Blessing,Not a Curse)

In this article, first published in 1994, the authors aimed to defuse the widespread hysteria about derivatives fueled by media accounts (like Fortune magazine's cover story in the same year) by offering a systematic analysis of the risks to companies, investors, and the entire financial system associated with the operation of the relatively new derivatives markets. Such analysis ended up providing assurances like the following:

• As long as most companies are using derivatives mainly to limit their financial exposures and not to enlarge them in efforts to pad their operating profits, reported losses on derivatives should not be a matter for concern. “Complaining about losses on a swap used to hedge a firm's exposure,” as the authors note, “is like objecting to the costs of a fire insurance policy if the building doesn't burn down.”
• To the extent that companies are using derivatives to hedge—and what evidence we have suggests that most are—the default risk of derivatives has been greatly exaggerated. An interest rate swap used by a B‐rated company to hedge a large exposure to interest rates will generally have significantly less default risk than a AAA‐rated corporate bond issue.
• Thanks to the corporate use of derivatives, much of the impact of economic shocks such as spikes in interest rates or oil prices is being transferred away from the hedging companies to investors and other companies better able to absorb them. And in this fashion, defaults in the economy as a whole, and hence systemic risk, are effectively being reduced, not increased, through the operation of the derivatives markets.

Moreover, the authors warn in closing that the likely effect of then proposed derivatives regulation would be to restrict access to and increase the costs to companies of using derivatives markets. As one example, the excessive capital requirements associated with derivatives facing bank dealers—based on gross rather than net measures of exposure—and which regulators have since proposed extending to nonbank dealers—were expected to have the unintended effect of encouraging dealers to sell precisely the kinds of riskier, leveraged derivatives that Bankers Trust sold Procter & Gamble, and that functioned as Exhibit A in the Fortune article.     

Assessing Bond Market Developments Pot-Euro

As a result of global trends in the financial industry, European financial markets are in the midst of a major transformation, and Economic and Monetary Union (EMU) is acting as a primary catalyst for such change. Over time financial integration will provide European markets with sufficient liquidity and scale to turn them into effective rivals of the U.S. markets.
This paper provides a framework for assessing the likely consequences of EMU for the evolution of European bond markets. First, it discusses broad fundamental shifts in international capital flows and how EMU is expected to affect them. Second, it analyzes in some detail the two most important portfolio shifts expected to accompany Monetary Union: potential changes in currency reserves held by central banks and diversification of international investors' portfolios. Third, it considers the possibility that the asset management industry and households' increased appetite for risk will lead to a major shift on the demand side. On the supply side, it explores the likely effect of Monetary Union on government bond yield spreads and expected changes in the key pricing factors.
The paper concludes with an overview of the considerable growth prospects for the European corporate bond market. In the Euromarket, which has traditionally been the preserve of borrowers of high credit standing, there have already been signs of increased interest in corporate issues, particularly lower-rated ones. The search for higher yields by investors, greater expertise in analyzing credit risks by institutional investors, and reduced issuance in European government bond markets will combine to spur growth in the European corporate bond market. As a consequence, the traditional bank-oriented relations will clearly weaken, and more companies will find opportunities to raise capital and obtain financing at lower cost.     

Accountable Governance in Corporate Groups: The Interrelationship of Law and Accounting

The complex structures of multinational corporate groups and their many subsidiaries facilitate the concealment of internal financial transactions and the profitability and taxation of operations in different jurisdictions. Current provisions for corporate governance by independent directors and auditors in ultimate holding companies fail to provide relevant information for most major stakeholders. Lawyers and accountants need to develop new structures for corporate governance and corporate social responsibility at every level, especially in respect of national taxation, to meet the proper interests of shareholders, employees, local communities and national governments, and to assist in the transition from centrally controlled and often abusive, to more participatory and responsible capitalism. Auditors have a key role in this and should be required to report on issues of variability in financial statements and to carry out special audits on matters of major concern.