The Value of Investment Banking Relationships: Evidence from the Collapse of Lehman Brothers

We examine the long‐standing question of whether firms derive value from investment bank relationships by studying how the Lehman collapse affected industrial firms that received underwriting, advisory, analyst, and market‐making services from Lehman. Equity underwriting clients experienced an abnormal return of around ?5%, on average, in the 7 days surrounding Lehman's bankruptcy, amounting to $23 billion in aggregate risk‐adjusted losses. Losses were especially severe for companies that had stronger and broader security underwriting relationships with Lehman or were smaller, younger, and more financially constrained. Other client groups were not adversely affected.     

Are Investment Banks Special Too? Evidence on Relationship‐Specific Capital in Investment Bank Services

The question of whether optimal provision of these services comes mainly from established relationships between banks and client firms or can result from arms'‐length market transactions has been the topic of considerable recent debate. This discussion has paralleled the debate in the commercial banking literature on the “specialness” of banks and whether lending can and should be relational or purely transactional. Whether the provision of investment bank services is relationship‐based or transactional is especially relevant now thanks to recent trends that have blurred the distinction between commercial and investment banks, and changed the competitive landscape for investment bank services. In their study summarized in this article, the authors examine whether investment bank‐client relationships create valuable relationship‐specific capital using stock market evidence from the period surrounding the collapse of Lehman Brothers. Specifically, they studied the effect of the Lehman collapse on companies that used Lehman for (1) underwriting equity offerings, (2) underwriting debt offerings, (3) advice on mergers and acquisitions, (4) analyst research services, and (5) market‐making services. The study addressed two specific questions. First, which investment bank services, if any, are associated with the creation of relationship‐specific capital; and second, what are the value drivers of this relationship capital? The authors report finding that companies that used Lehman as lead underwriter for public equity offerings experienced significantly negative abnormal stock returns in the days surrounding Lehman's bankruptcy announcement. By contrast, they find no significant reaction to the announcement for Lehman's debt underwriting clients or any of the other client categories they examine. While most of these investment bank services have at least the potential to create relationship‐specific capital, the authors' findings suggest that except for equity underwriting, all the other investment bank services appear to be transactional rather than relationship‐based, at least in the average case. Moreover, the authors report significant differences even among different groups of Lehman's equity underwriting clients. An equity underwriting relationship with Lehman appears to have been especially valuable for smaller, younger, and more financially constrained firms—those firms which presumably had a high degree of dependence on Lehman to access the capital market.     

Financial constraints on credit ratings and cash-flow sensitivity

This study investigates whether financial constraints, as measured by the level of credit ratings and their migrations would affect the firm's cash flow allocation policies and reflect the main financial constraints on a firm's cash flow sensitivity of cash. For a given credit quality shock, control for firm-level characteristics and endogeneity of cash flow allocation, our results suggest that firms with higher credit financial constraints have significantly higher cash flow sensitivities on cash holding, investment, and debt financing activities. Our results provide evidence that credit rating risk has a larger impact on cash flow allocation and drives the financial constraints on cash flow sensitivity for various reasons, including precautionary motivation and restricted access to external financing.     

Credit Contagion Channels: Market Microstructure Evidence from Lehman Brothers’ Bankruptcy

Immediately after Lehman Brothers’ bankruptcy, many firms disclosed their financial exposure (or lack thereof) to Lehman. This offers a clean setting to test two credit contagion channels through which a financial firm's bankruptcy can affect other firms—“counterparty risk” and “information transmission” channels. Using market microstructure variables to measure the various dimensions of contagion effects, we provide robust evidence supporting the significance of counterparty risk. Firms with exposure to Lehman suffered more severe negative effects—wider bid‐ask spread, higher price impact, greater information asymmetry, and greater selling pressure—than unexposed firms. We find mixed evidence regarding the information transmission hypothesis.     

Access to capital,investment, and the financial crisis

During the recent financial crisis, corporate borrowing and capital expenditures fall sharply. Most existing research links the two phenomena by arguing that a shock to bank lending (or, more generally, to the corporate credit supply) caused a reduction in capital expenditures. The economic significance of this causal link is tenuous, as we find that (1) bank-dependent firms do not decrease capital expenditures more than matching firms in the first year of the crisis or in the two quarters after Lehman Brother's bankruptcy; (2) firms that are unlevered before the crisis decrease capital expenditures during the crisis as much as matching firms and, proportionately, more than highly levered firms; (3) the decrease in net debt issuance for bank-dependent firms is not greater than for matching firms; (4) the average cumulative decrease in net equity issuance is more than twice the average decrease in net debt issuance from the start of the crisis through March 2009; and (5) bank-dependent firms hoard cash during the crisis compared with unlevered firms.     

Understanding the market reaction to shockwaves: Evidence from the failure of Lehman Brothers

The spectacular failure of the 150-year-old investment bank Lehman Brothers on September 15th, 2008 was a major turning point in the global financial crisis that broke out in the summer of 2007. Through the use of stock market data and credit default swap (CDS) spreads, this paper examines investors’ reaction to Lehman's collapse in an attempt to identify a spillover effect on the surviving financial institutions. The empirical analysis indicates that (i) the collateral damage was limited to the largest financial firms; (ii) the institutions most affected were the surviving “non-bank” financial services firms; and (iii) the negative effect was correlated with the financial conditions of the surviving institutions. We also detect significant abnormal jumps in CDS spreads that we interpret as evidence of sudden upward revisions in the market assessment of future default probabilities assigned to the surviving financial firms.     

How the Subprime Crisis went global: Evidence from bank credit default swap spreads

How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks' credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman's failure, the prospect of global recession became imminent, auguring the further deterioration of banks' loan portfolios. At this point the entire global financial system had become infected.     

Access to Collateral and the Democratization of Credit: France's Reform of the Napoleonic Security Code

France's Ordonnance 2006-346 repudiated the notion of possessory ownership in the Napoleonic Code, easing the pledge of physical assets in a country where credit was highly concentrated. A differences-test strategy shows that firms operating newly pledgeable assets significantly increased their borrowing following the reform. Small, young, and financially constrained businesses benefitted the most, observing improved credit access and real-side outcomes. Start-ups emerged with higher “at-inception” leverage, located farther from large cities, with more assets-in-place than before. Their exit and bankruptcy rates declined. Spatial analyses show that the reform reached firms in rural areas, reducing credit access inequality across France's countryside.     

Green credit policy and corporate cash holdings: Evidence from China

In 2012, China implemented a green credit policy (GCP) that restricts bank credits to heavily polluting firms. Using a difference-in-differences research design, we find that polluting firms increased their cash reserves by 9.5% after the GCP's issuance relative to non-polluting firms. We also document that the GCP significantly reduces firms' access to bank finance but increases the value of cash. Cross-sectional analysis shows that the increase in cash holdings is more significant for firms with greater financial constraints, firms with more investment opportunities, and high-tech companies. Overall, our findings are consistent with a constraint explanation: when external financing is restricted, firms retain more cash to meet future investment needs.     

The real effects of relationship lending✰

This paper studies the real effects of relationship lending on firm activity in Italy following Lehman Brothers’ default shock and Europe's sovereign debt crisis, two different crisis situations where in the latter, bank solvency was at the centre of the economic shock while being more peripheral in the former. We use a large data set that merges the comprehensive Italian Credit and Firm Registers. We find that following Lehman's default, banks offered more favourable continuation lending terms to firms with which they had stronger relationships. Such favourable conditions enabled firms to maintain higher levels of investment and employment. The insulation effects of tighter bank-firm relationships were still present during the European sovereign debt crisis, especially for firms tied to well capitalised banks.     

Employee Costs of Corporate Bankruptcy

An employee's annual earnings fall by 13% in the first full calendar year after her firm's bankruptcy, and the present value of lost earnings from bankruptcy to six years following bankruptcy is 87% of pre-bankruptcy annual earnings. More worker earnings are lost in thin labor markets and among small firms. Ex ante compensating wage differentials for this “bankruptcy risk” are up to 2% of firm value for a firm whose credit rating falls from AA to BBB, comparable in magnitude to debt tax benefits. Thus, wage premia for expected costs of bankruptcy are sufficiently large to be an important consideration in capital structure decisions.     

Cash holding,trade credit and access to short-term bank finance

Since 1988, cash holding of the UK companies has increased from 10.6% to 16.4% of total assets. To explain this increase, we develop a panel vector autoregression and analyse the dynamics between cash holding and its closest substitutes, trade credit and short-term bank finance. Impulse response functions confirm the signalling theory, as trade credit facilitates access to bank finance. Firms experiencing liquidity shocks resort to cash or trade credit but not to bank finance. Cash holding improves access to trade credit. Additional cash and trade credit trigger a slowdown of the cash conversion cycle explained by agency theory. Cash-rich firms have accumulated more cash than predicted because of an unexpected decline in short-term debt, stressing the role of banks in explaining the increase in cash holding.     

Bank risk-taking and corporate investment: Evidence from the Global Financial Crisis of 2007–2009

In this paper, we explore the relation between the banking sector's risk-taking and a firm's investment (“corporate investment”). Specifically, we ask whether firms' cash holdings moderate the effect of the banking sector's risk-taking on corporate investment. Based on a panel sample of publicly listed non-financial firms in 15 EU countries during the period 1990–2015, we document several key findings. First, both cash holdings and the banking sector's risk-taking are positively associated with corporate investment. Second, bank loan growth, which roughly captures the supply of bank credit, is not related to corporate investment. Third, firms with smaller cash holdings disproportionately invest more than do firms with larger cash holdings during periods of higher risk-taking by the banking sector.     

The effect of government quality on corporate cash holdings

We use China as a laboratory to test the effect of government quality on cash holdings. We build on, and extend, the existing literature on government expropriation and its interaction with firm-level agency problems by proposing a financial constraint mitigation argument. We find that firms hold less cash when local government quality is high, which is not consistent with the state expropriation argument, but supports the financial constraint mitigation argument. A good government lowers the investment sensitivity to cash flows and cash sensitivity to cash flows, decreases cash holdings more significantly in private firms, and improves access to bank and trade credit financing. We also test and find support for Stulz's (2005) model on the interaction between government and firm agency problems.     

Effect of cash flow risk on corporate failures,and the moderating role of earnings management and abnormal compensation

In this study, we find that United States firms' average cash flow risk (CFR) shows a significantly increasing trend over the past four decades or so. This does not portend well considering the significance of cash flows in maintaining a firm's financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm's failure. Empirically, we find that CFR has a strong positive effect on a firm's financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm's failure. Our findings are also robust to alternative definitions of a firm's failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.     

How common are credit-less recoveries? Firm-level evidence on the role of financial markets in crisis recovery

We study firm recoveries from systemic sudden stops in developing countries, where firms' cash flows suffer exogenous shocks. Contrary to macro studies suggesting that output recovery precedes that of the financial sector, firm-level data shows that only in less than a third of firms, operating cash flows recover without a recovery in external credit, and even these firms have access to other sources of cash. Specifically, firms with high prior short-term debt exposure do experience a sharp reduction in short-term credit but increase operating cash flows during a crisis. Firms with high prior cash holdings experience negative cash flows and deplete their cash holdings. Thus, firms' financial prepositioning predicts recovery in cash flows and is consistent with trade-off theories of capital structure and with precautionary motives for cash holdings. We find no support for the maturity mismatch hypothesis, which predicts that firms with high short-term debt should have harder recoveries post crisis.     

Information asymmetry and firms’ credit market access: Evidence from Moody's credit rating format refinement

I exploit Moody's 1982 credit rating refinement to examine its effects on firms’ credit market access, financing decisions, and investment policies. While firms’ ex ante yield spread can partially predict the direction of refinement changes, firms with refinement upgrades experience an additional decrease in their ex post borrowing cost compared with firms with downgrades. The former subsequently also issue more debt and rely more on debt financing over equity than the latter. Lastly, upgraded firms have more capital investments, less cash accumulation, and faster asset growth than downgraded firms. These findings show that credit market information asymmetry significantly affects firms’ real outcomes.     

The Impact of Corporate Governance and Audit Quality on the Cost of Private Loans*

The objective of this paper is to examine whether banks discriminate between firms on the basis of their financial condition when assessing the credit default risk, and to what extent corporate governance and auditor quality mitigate such risks in the pricing of new bank loans. The results indicate that, depending on the probability of bankruptcy, banks rely on different monitoring devices. For firms with a low probability of bankruptcy, banks do not rely on the quality of corporate governance or the auditor's industry specialization. However, auditor tenure and a change in auditor affect the spread. For firms with a high probability of bankruptcy, the spread is adjusted for the quality of corporate governance and the auditor's specialization. These results are robust to alternative specifications and measures.     

On-balance-sheet duration hedging and firm value

In this study we consider the determinants and effects of on-balance-sheet duration hedging for non-financial US firms. The difference between the duration of assets and liabilities, or duration gap, is negatively related to growth opportunities, and positively related to profitability, corporate cash holdings, and managerial ownership. We find that both a lower duration gap and a lower absolute value of duration gap are associated with higher firm values. Moreover, we find some evidence that firms with larger duration gaps performed worse during the market-wide liquidity shock accompanying the Lehman Brothers bankruptcy.     

The use of credit default swaps by bond mutual funds: Liquidity provision and counterparty risk

Corporate bond mutual funds increased their selling of credit protection in the credit default swaps (CDS) market during the 2007–2008 financial crisis. This trading activity was primarily in multi-name CDS, greater among larger and established funds, and directed toward counterparty dealers in financial distress. Funds that sold credit protection during the crisis experienced greater credit market risk and superior post-crisis performance, consistent with higher expected returns from liquidity provision. Funds using Lehman Brothers as a counterparty experienced abnormal outflows and returns of –2% immediately following Lehman's bankruptcy, suggesting that funds’ opportunistic trading in CDS exposed investors to counterparty risk.