The Cost of Capital for Banks: Evidence from Analyst Earnings Forecasts (with Jacob Gyntelberg and Christoffer Thimsen)

Journal of Finance, 2022, 77(5): 2577-2611

Abstract: We extract cost of capital measures for banks using analyst earnings forecasts, which we show are unbiased. We find that the cost of equity and the cost of debt decrease in the Tier 1 ratio, whereas total cost of capital is uncorrelated with the Tier 1 ratio. These findings suggest that investors adjust their return expectations for banks in accordance with the Modigliani-Miller (1958) conservation of risk principle. Hence, increased capital requirements are not made socially costly based on a notion that market pricing violates risk conservation. Equity can nevertheless still be privately costly for banks because of reduced subsidies.

The Value of Bond Underwriter Relationships (with Mads Stenbo Nielsen and Stine Louise von Rüden)

Journal of Corporate Finance, 2021, 68: 101930

Abstract: We show that corporate bond issuers benefit from utilizing existing underwriter relationships when rolling over bonds, but at the same time become exposed to underwriter distress. A strong relationship enables the underwriter to credibly certify the issuer resulting in lower direct issuance costs and lower underpricing. However, if the underwriter becomes distressed, this spills over to the issuer's credit risk, because it weakens the relationship and increases the risk of involuntary relationship termination. The credit risk spillover is more pronounced for risky, information-sensitive issuers with high rollover exposure, i.e., those issuers most in need of certification by an underwriter.   

Highly Liquid Mortgage Bonds with the Match Funding Principle (with Jacob Gyntelberg)

Quarterly Journal of Finance, 2020, 10(1): 2050001

Abstract: We show that pass-through funding of mortgages with covered bonds supported by strong creditor rights is one way of providing highly liquid mortgage bonds. Despite a 30% drop in house prices during the 2008 crisis, these mortgage bonds remained as liquid as comparable government bonds with high trading volume and low bid-ask spreads. Market liquidity of these covered bonds is primarily driven by the availability of funding liquidity. Funding liquidity is the main concern because the pass-through funding approach effectively eliminates other types of risks from the investor’s perspective. Banking regulators should take into account the implications of these findings, particularly when it comes to the interplay between liquidity and capital requirements.  

The Cost of Immediacy for Corporate Bonds (with Marco Rossi)

Review of Financial Studies, 2019, 32(1): 1-41

Abstract: Liquidity provision for corporate bonds has become significantly more expensive after the 2008 crisis. Using index exclusions as a natural experiment during which uninformed index trackers request immediacy, we find that the cost of immediacy has more than doubled. In addition, the supply of immediacy has become more elastic with respect to its price. Consistent with a stringent regulatory environment incentivizing smaller dealer inventories, we also find that dealers revert deviations from their target inventory more quickly after the crisis. Finally, we investigate the pricing impact of information, changes in ownership structure, and differences between bank and non-bank dealers.  

Corporate Bond Liquidity Before and After the Onset of the Subprime Crisis (with Peter Feldhütter and David Lando)

Journal of Financial Economics, 2012, 103: 471-492

Abstract: We analyze liquidity components of corporate bond spreads during 2005–2009 using a new robust illiquidity measure. The spread contribution from illiquidity increases dramatically with the onset of the subprime crisis. The increase is slow and persistent for investment grade bonds while the effect is stronger but more short-lived for speculative grade bonds. Bonds become less liquid when financial distress hits a lead underwriter and the liquidity of bonds issued by financial firms dries up under crises. During the subprime crisis, flight-to-quality is confined to AAA-rated bonds.    

Liquidity Biases in TRACE

Journal of Fixed Income, 2009, 19: 471-492

Abstract: The transactions database TRACE is rapidly becoming the standard data source for empirical research on US corporate bonds. This paper is the first to thoroughly discuss the assumptions needed to clean the disseminated TRACE data and to suggest that different filters should be used depending upon the application. 7.7% of all reports in TRACE are errors and in some cases up to 18% of the reports should be deleted. Failing to correct for these errors will bias popular liquidity measures towards a more liquid market. The median bias for the daily turnover will be 7.4% and for a quarter of the bonds the Amihud price impact measure will be underestimated by at least 14.6%. Further, calculating these two measures on the same data sample would potentially bias one of them.   

Dealer Networks and the Cost of Immediacy (with Thomas Kjær Poulsen and Obaidur Rehman)

Abstract: We show that uninformed corporate bond index trackers pay lower transaction costs when they request immediacy from dealers with central network positions. This centrality discount supports recent network models in which core dealers have a comparative advantage in carrying inventory. We show that core dealers provide more immediacy and revert deviations from their desired inventory faster. When dealers trade with other dealers, we find a centrality premium consistent with core dealers deriving market power from their network position. We rule out alternative explanations based on adverse selection and customer clienteles.      

Personal Taxes and Corporate Cash Holdings (with Kristian Miltersen and Ramona Westermann)

Abstract: Dividends are taxed at the personal level, but injecting funds into firms does not offer the symmetric tax benefit. Hence, there is a personal tax saving incentive to retain cash in the firm. We develop a corporate finance model of liquidity management, in which the firm’s liquidity policy trades off precaution and saved personal taxes against agency and corporate tax costs. The model implies that the tax saving motive is substantial and increasing with the dividend tax rate. Consistent with the model, we show empirically that, after the 2003 dividend tax cut, affected firms reduced their cash accumulation.

Corporate Bond Market Segmentation (with Marco Rossi)

Abstract: The predominant explanation for arbitrage crashes is a lack of investor capital to exploit mispricing. This paper shows that slow-moving capital is only partially responsible for the past arbitrage crashes in the convertible bond market. Even when convertible bonds were severely underpriced, some investors continued to buy strictly dominated straight bonds from the same issuers. Our findings suggest that both market segmentation and slow-moving capital obstructed the recovery from the arbitrage crashes. Furthermore, exploiting the market segmentation with a long/short trading strategy provides positive abnormal returns after accounting for transaction costs.    

The Financial Premium (with Peter Feldhutter and David Lando)

Abstract: We show that bonds issued by financial firms have higher spreads than bonds issued by industrial firms with the same rating and we denote this difference the financial premium. During the period 1987-2020 the premium was on average 43bps in the U.S. corresponding to a 31% higher spread and the premium is higher for lower ratings and in financial crises. Furthermore, the premium relates to measures of systemic risk and predicts economic activity. We derive a model that explains the empirical results: banks hold a diversified portfolio of corporate bonds (loans) and bank bonds therefore reflect more systematic risk than the individual corporate bonds. 

Bank Equity Risk (with Zhuolu Gao and David Lando)

Abstract: Financial regulation has led banks to increase their equity ratios. Yet, several studies find that this has not led to a decrease in bank equity risk. We show theoretically, that keeping less capital in excess of the minimum capital requirement can outweigh the risk-reducing effect on equity of increased total capitalization. Empirically, we find that excess capitalization is a significant determinant of equity risk, and can explain why bank equity risk has not become lower after the Great Financial Crisis. Smaller excess capitalization also leads to decreases in market-to-book ratios. Lower leverage has, however, reduced the cost of bank debt. 

The Blind Spot of Unrealized Losses (with Christoffer Thimsen)

Abstract: The run risk associated with unrealized losses on bank assets were not priced by the market prior to March 2023. Furthermore, regulatory capital ratios looked solid even for highly risky banks. By identifying run risk indicators such as adjusted insolvency, high uninsured deposits, and withdrawal of deposits, we demonstrate that the risk from unrealized losses can be incorporated into regulation. We show that before March 2023, cost of capital did not vary with run risk. However, starting in March 2023 run risk became priced and both cost of equity and realized returns were impacted by cross-sectional variation in the indicators.