We use firms' decisions in the cross-section about their sources and uses of funds in order to make inferences about the aggregate cost of external finance. The basic intuition is as follows: Firms which raise costly external finance can invest the issuance proceeds in productive capital assets, or in liquid financial assets with a low physical rate of return. If firms raise costly external finance and allocate some of the funds to liquid assets, either the cost of external finance is relatively low, or the total return to liquidity accumulation, including its value as a hedging asset, is particularly high. We construct and estimate a quantitative, dynamic model of firms' financing and savings decisions. We then use the model's predictions for variation in firm policies and implied cross sectional moments, along with empirical moments from Compustat, to infer the average cost of external finance per dollar raised in the US time series 1980-2010.
"The Financial Soundness of US Firms 1926-2012" (with Andrew Atkeson and Pierre-Olivier Weill)
Insolvency Crises 1929-2012: Median Distance below 1.
Building on the Merton (1974) and Leland (1994) structural models of credit risk, we develop a simple, transparent, and robust method for measuring the financial soundness of individual firms using data on their equity volatility. We use this method to retrace quantitatively the history of firms' financial soundness during U.S. business cycles over most of the last century. We highlight three main findings. First, the three worst recessions between 1926 and 2012 coincided with insolvency crises, but other recessions did not. Second, fluctuations in asset volatility appear to drive variation in firms' financial soundness. Finally, the financial soundness of financial firms largely resembles that of nonfinancial firms.
"The Market for OTC Derivatives" (with Andrew Atkeson and Pierre-Olivier Weill)
size of the positions taken by their traders because of risk-management concerns. Although all banks in our model are endowed with access to the same trading technology, some large banks endogenously arise as "dealers," trading mainly to
provide intermediation services, while medium sized banks endogenously participate as "customers" mainly to share risks. We use the model to address positive questions regarding the growth in OTC markets as trading frictions decline, and normative questions of how regulation of entry impacts welfare.
This paper studies the level and dynamics of the value of aggregate liquidity induced by firms’ financing shortfalls. We model liquidity and cash flows as internal funds available for investment in an economy where external funds are costly. We study whether the use of liquidity to hedge investment opportunities can generate substantial liquidity premia with empirically observed countercyclical properties, and show how firms’ financial positions affect the value of aggregate liquidity. Cash flows affect the “natural supply” of liquidity and are procyclical. Thus, we argue that shortfalls between firms’ financing needs and available liquid funds are more likely to occur in bad times when current cash flows are low, rendering liquidity premia countercyclical. We investigate the relationship between such shortfalls and the value of aggregate liquidity empirically using US Flow of Funds and Compustat data.
In many developing countries, the institutional framework governing economic life has its roots in the colonial period, when the interests of European settlers clashed with those of the native population or imported slaves. We examine the economic implications of this conflict in a framework where institutions are represented by the number of people with property-rights protection, i.e., “gun owners.” In the model, gun owners can protect their own property, they can exploit others who do not own guns, and they may decide to extend property rights by handing out guns to previously unarmed people. The theory generates a “reversal of fortune” between colonies with many and few oppressed: income per capita is initially highest in colonies with many oppressed that can be exploited by gun owners, but later on excessive concentration of economic power becomes a hindrance for development.
American Economic Review, Forthcoming, Papers and Proceedings.
Eisfeldt Papanikolaou Aggregate and Industry Organization Capital Data
Intangible capital which relies on essential human inputs, or "organization capital", presents a unique challenge for measurement. Organization capital cannot be fully owned by firms' financiers, because it is partly embodied in key labor inputs. Instead, cash flows must be shared with key talent and thus neither book nor market values will fully capture its value. Measurement of organization capital requires a model featuring these unique property rights. We use accounting data along with a simple example of such a model to measure the fraction of the US capital stock which is missing from book and market values.
Journal of Financial Economics, August 2013, 351-372.
There is widespread concern about whether CEOs are appropriately punished for poor performance. While CEOs are more likely to be forced out if their performance is poor relative to the industry average, overall industry performance also matters. This seems puzzling if termination is disciplinary, however, we show that both absolute and relative performance driven turnover can be natural and efficient outcomes of a competitive assignment model in which CEOs and firms form matches based on multiple characteristics. The model also has new predictions about replacement managers' equilibrium pay and performance. We document CEO turnover events during 1992-2006 and provide empirical support for our model.
Amundi Smith Breeden First Place Paper Award 2013.
Journal of Finance, August 2013, 1365-1406.
The supplementary appendix contains further details.
The UCLA Anderson Blog summarizes the paper here.
Organization capital is a production factor that is embodied in the firm's key talent and has an efficiency that is firm specific. Hence, both shareholders and key talent have a claim to its cash flows. We develop a model in which the outside option of the key talent determines the share of firm cash flows that accrue to shareholders. This outside option varies systematically and renders firms with high organization capital riskier from the shareholders' perspective. We find that firms with more organization capital have risk adjusted returns that are 4.7% higher than firms with less organization capital.
“Leasing, Ability to Repossess, and Debt Capacity.” (with Adriano Rampini.)
“Managerial Incentives, Capital Reallocation, and the Business Cycle.” (with Adriano Rampini.)
“New or Used? Investment with Credit Constraints.” (with Adriano Rampini.)
“Smoothing with Liquid and Illiquid Assets.”
See updated time series, and a link to data, below.
“Endogenous Liquidity in Asset Markets.”
This paper analyzes a model in which long-term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high quality projects, causing liquidity to increase.
Capital Reallocation and the Business Cycle: Data Update to EOY 2012
Solid green line is the cyclical component of GDP, dotted blue line is the cyclical component of sales of PP&E, and dashed red line is the cyclical component of acquisitions.
The correlation of the cyclical component of GDP with the cyclical component of sales of PP&E plus acquisitions over total book assets is 0.68 with a standard error of 0.10.