Financial Stability and the Organization of the Asset Management Industry
The organization of the asset management industry is crucial for enhancing long-term financial stability. The objective of this research project is to investigate which characteristics of financial intermediaries are more or less conducive to financial crises and fire sales and to propose corrective mechanisms to improve financial stability.
Final report
The objective of this research project was to investigate which characteristics of financial intermediaries are more or less conducive to financial crises and fire sales and to propose corrective mechanisms to improve financial stability.
The output aiming to answer these questions consist of six papers, four of which have already been published, and that consider banks, hedge funds, mutual funds and money market funds. I also consider how creditor rights reduce firms' precautionary behaviour thus increasing economic resilience.
The three most prominent results of the projects are:
1) I propose that banks with large shares of a market internalize externalities and limit fire sales. I am currently show that these ideas extends to bond funds.
2) Using the money market funds as a laboratory a show that funds that offer money like liabilities take less risk and that preventing funds from doing so increases risk taking
3) I show that hedge funds affiliated with financial conglomerates have more stable fundings and provide liquidity at times of crises reducing fire sales.
Not only the project delivered the papers described in the initial plans, but the final project output exceeds that.
Below I describe each of the papers.
PUBLICATIONS
The first paper is "Costs and Benefits of Financial Conglomerate Affiliation: Evidence from Hedge Funds (with Francesco Franzoni, Swiss Finance Institute)", published on the Journal of Financial Economics.
The paper explores how affiliation to financial conglomerates affects asset managers’ access to capital, trading behavior, and performance. Focusing on a sample of hedge funds, we find that financial-conglomerate-affiliated hedge funds (FCAHFs) have lower flow-performance sensitivity than other hedge funds and that this difference is particularly pronounced during financial turmoil. Arguably, thanks to more stable funding, FCAHFs allow their investors to redeem capital more freely and are able to capture price rebounds. Since investors may value these characteristics, our findings provide a rationale for why financial conglomerate affiliation is widespread, although it slightly hampers performance on average.
Our findings can inform the debate about the Volcker Rule and similar regulations around the world. These regulations aim to separate systemically-important financial institutions from hedge funds in order to contain the threats to financial stability. Since FCAHFs take risk during periods of turmoil, our results support the concern of regulators, especially if financial institutions feel compelled to provide a liquidity backstop.
It has also been argued that limiting proprietary trading by banking institutions could have unintended negative consequences on market making and liquidity in financial markets. Our findings suggest the severing the ties between financial conglomerates and hedge funds may curtail liquidity provision by FCAHFs. We acknowledge, however, that the change in status of a FCAHFs affiliated with banks would not necessarily have negative effects on financial markets, because their assets could flow to hedge funds affiliated with other financial institutions.
It has been widely presented at the very top conference in financial economics and in a variety of universities. The venues at which the paper has been presented include: the American Finance Association, the Western Finance Association, the University of Texas, Austin AIM Investment Conference, the Financial Intermediation Research Society, the ESMT 2017 Asset Management Conference, the 5th Luxembourg AMS, the Stockholm School of Economics, and the Goethe University Conference on Regulating Financial Markets.
The paper has also been reviewed in a financial industry magazine: http://www.opalesque.com/663926/Paper_examines_ties_between_hedge_funds_and_financial392.html
The paper currently has 30 citations on google scholar.
A second paper on “Shock Propagation and Banking Structure”, coauthored with Farzad Saidi, then a junior faculty member at the Stockholm School of Economics, has been published in the Review of Financial Studies, another of the very best journals in finance, in 2019, as a lead article and editor choice, indicating that it is considered one of the best papers published in the journal.
The paper advances the conjecture that lenders' decisions to provide liquidity in periods of distress are affected by the extent to which they internalize the negative spillovers of industry downturns. We conjecture that high-market-share lenders are more likely to internalize negative spillovers, and show that they provide liquidity to industries in distress when fire sales are likely to ensue. High-market-share lenders also provide liquidity to customers and suppliers of distressed industries when the disruption of supply chains is expected to be costly. The results suggest a novel channel explaining why credit concentration may favor financial stability.
Also this paper has been widely presented at the very top conference in financial economics and in a variety of universities including the 2018 AFA Annual Meeting, the 2017 WFA Annual Meeting, the 2017 Wharton Conference on Liquidity and Financial Fragility, the 2018 FIRS Annual Meeting, the 11th Swiss Winter Conference on Financial Intermediation, the 3rd EuroFIT Research Workshop on Syndicated Loans at London Business School, the 2018 Chicago Financial Institutions Conference, the Arne Ryde Conference on Financial Intermediation, the Cass Business School Workshop on Corporate Debt Markets, the Bocconi-Sapienza Conference on “Banks, Systemic Risk, Measurement and Mitigation,'' the CEPR Second Annual Spring Symposium in Financial Economics, the 2017 University of Kentucky Finance Conference, the 9th EBC Network Conference, the First Bank of Spain Conference on Financial Stability, the First Marstrand Finance Conference, the 6th MoFiR Workshop on Banking, the 2017 CEPR ESSFM, the IWH-FIN-FIRE Workshop, the FDIC/JFSR Annual Bank Research Conference, Banque de France, Deutsche Bundesbank, Sveriges Riksbank, McGill University, INSEAD, University of Edinburgh, and University of Cambridge.
The paper currently has 67 citations on google scholar.
Both papers have been publicly available on social science research networks and have been disseminated through the center of economic policy research series before open access publication.
The project has also brought new research questions. I explored what is the structure of money market funds that may stave off fire sales with Ramin Baghai, an associate professor in my own department, and Ivika Jager then a Ph.D student, and how the institutional environment affects the impact of uncertainty shocks on the economy.
The paper titled “Liability Structure and Risk-Taking: Evidence from the Money Market Fund Industry”, is forthcoming in the Journal of Financial and Quantitative Analysis, one of the top 4 journals in financial economics.
We show that the structure of financial intermediaries’ liabilities affects their asset holdings. We investigate the consequences of the 2014 money market fund (MMF) reform, which imposed redemption gates and liquidity fees on prime MMFs and forced prime funds marketed to institutional investors to switch from constant to floating net asset value. These changes made prime MMFs’ liabilities less money-like. As a consequence, the affected MMFs experienced an increase in the flow-performance sensitivity and started taking more risk. In addition, the total funding provided by MMFs to the corporate sector, and especially to safer issuers, has decreased.
The paper has been widely presented internationally including at the following conferences and seminars: seminar and conference participants at the 2nd World Symposium on Investment Research, the 2018 European Finance Association Meetings, the 2019 Western Finance Association Meetings, the 2019 Financial Intermediation Research Society Meetings, the University of Maryland and Federal Reserve Board Third Conference on Short Term Funding Markets, the Banque de France, the University of Bristol, the University of Exeter, the University of Zurich, the 2018 EuroFIT Workshop, the BoF/CEPR conference on Money in the Digital Age, the European Central Bank workshop on “Money markets, monetary policy implementation, and central bank balance sheets,” the European Central Bank workshop on “Monetary Policy, Macroprudential Policy and Financial Stability,” and the First Endless Summer Conference on Financial Intermediation and Corporate Finance
The paper has 13 citations on google scholar.
Finally, I published a paper on how the structure of the bankruptcy law affect the impact of uncertainty shocks with Giovanni Favara (Federal Reserve Board) and Janet Gao (Indiana University). The paper entitled “Uncertainty, access to debt, and firm precautionary behavior” appeared in the Journal of Financial Economics in 2021.
We show that better access to debt markets mitigates the effects of uncertainty on corporate policies. We establish this result using the staggered introduction of anti-recharacterization laws in US states. These laws enhanced firms’ ability to borrow by strengthening creditors’ rights to repossess collateral pledged in special purpose vehicles. After the passage of the laws, firms that face more uncertainty hoard less cash and increase payouts, leverage, and investment in intangible assets. Our findings suggest that better access to debt markets shields firms from fluctuations in uncertainty and decreases firms’ precautionary behavior, contributing to the deployment of cash and other internal resources to investment in intangible capital.
The paper has been presented at the European Central Bank, Indiana University, Southern
Methodist University, the Stockholm School of Economics, the University of Bonn, the European Finance Association, the Center for Economic Policy Research Third Annual Spring Symposium in Financial Economics at Imperial College, the Workshop on Corporate Debt Markets at Cass Business School, the Annual Corporate Finance Conference at the University
of Exeter, the Midwest Finance Association 2019 annual meeting, and the Ninth ITAM (Instituto Tecnológico Autónomo de México) Finance Conference.
New ideas and working papers
I am currently working on the following ideas that are directly following from the project and for which the funding has played an instrumental role for purchasing the data.
One aspect I am investigating is how foreign financial intermediaries may create bubbles and contribute to financial instability.
Specifically, in “Who Lends Before Banking Crises? Evidence from the International Syndicated Loan Market”, joint with Yeejin Jang (University of New South Wales) we show that foreign lenders and low market share lenders extend more credit in comparison to other lenders during lending booms leading to banking crises, but not during other credit expansions. Less established lenders also increase the amount of credit they extend to riskier borrowers, without asking for collateral or imposing covenants and higher interest rates. Our results suggest that taking lenders’ characteristics into account could provide an indicator for how much risk an economy is accumulating and be a useful barometer for macroprudential policies.
The working paper has already been presented at the American Finance Association, the Bundesbank Workshop on Financial Intermediation and Corporate Debt Markets, the European Central Bank, the Financial Intermediation Research Society, KU Leuven, the London School of Economics Systemic Risk Center, the Annual Workshop of the ESCB on Financial Stability, Macroprudential Regulation and Microprudential Supervision, and the 2020 FINEST Autumn Workshop.
The paper is publicly available on social science research network and have been disseminated through the center of economic policy research series.
The bond market is another possible source of financial instability that has been prominently discussed in policy circles. It is particularly important for policy understanding whether bond mutual funds can create financial instability.
I explore this in a joint paper with Chotibhak (Pab) Jotikasthira (Southern Methodist University) entitled “Bond Price Fragility and the Structure of the Mutual Fund Industry.” We show that mutual funds with a large share of a bond issue sell their holdings of that issue to a lower extent when they experience redemptions, arguably because they attempt to avoid a drop in the bond price and the consequent negative feedback effects on the unsold part of their position. Since large bond funds tend to hold large shares of outstanding bond issues, they end up exercising a stabilizing effect on the bonds they hold. Bonds with greater ownership concentration outperform during periods of turmoil and have lower overall price volatility. We provide evidence that the tendency of bond funds to limit negative price spillovers on their large positions can help explain how the Fed's Secondary Market Corporate Credit Facility quickly stabilized both eligible and ineligible bonds.
The paper has been presented at the Paris Annual Hedge Funds Research Conference, and seminar participants at Cambridge University Judge School of Business, Cornell University, the Copenhagen Business School, the Bank for International Settlements, the Frankfurt School of Finance and Management, Goethe University, George Mason University, the Hong Kong University, the Hong Kong University of Science and Technology, and Nanyang Technological University.
Also this paper is publicly available on social science research network and have been disseminated through the center of economic policy research series.
Besides having lots of international visibility the project has led to new collaborations. In particular, for the project on how the structure of bankruptcy laws affect the impact of uncertainty shocks on the real economy I started to collaborate with Giovanni Favara from the Federal Reserve Board of Governors, with Janet Gao from Indiana University, Jotikasthira, Chotibhak from Southern Methodist University and Yeejn Jang from University of New South Wales.
The output aiming to answer these questions consist of six papers, four of which have already been published, and that consider banks, hedge funds, mutual funds and money market funds. I also consider how creditor rights reduce firms' precautionary behaviour thus increasing economic resilience.
The three most prominent results of the projects are:
1) I propose that banks with large shares of a market internalize externalities and limit fire sales. I am currently show that these ideas extends to bond funds.
2) Using the money market funds as a laboratory a show that funds that offer money like liabilities take less risk and that preventing funds from doing so increases risk taking
3) I show that hedge funds affiliated with financial conglomerates have more stable fundings and provide liquidity at times of crises reducing fire sales.
Not only the project delivered the papers described in the initial plans, but the final project output exceeds that.
Below I describe each of the papers.
PUBLICATIONS
The first paper is "Costs and Benefits of Financial Conglomerate Affiliation: Evidence from Hedge Funds (with Francesco Franzoni, Swiss Finance Institute)", published on the Journal of Financial Economics.
The paper explores how affiliation to financial conglomerates affects asset managers’ access to capital, trading behavior, and performance. Focusing on a sample of hedge funds, we find that financial-conglomerate-affiliated hedge funds (FCAHFs) have lower flow-performance sensitivity than other hedge funds and that this difference is particularly pronounced during financial turmoil. Arguably, thanks to more stable funding, FCAHFs allow their investors to redeem capital more freely and are able to capture price rebounds. Since investors may value these characteristics, our findings provide a rationale for why financial conglomerate affiliation is widespread, although it slightly hampers performance on average.
Our findings can inform the debate about the Volcker Rule and similar regulations around the world. These regulations aim to separate systemically-important financial institutions from hedge funds in order to contain the threats to financial stability. Since FCAHFs take risk during periods of turmoil, our results support the concern of regulators, especially if financial institutions feel compelled to provide a liquidity backstop.
It has also been argued that limiting proprietary trading by banking institutions could have unintended negative consequences on market making and liquidity in financial markets. Our findings suggest the severing the ties between financial conglomerates and hedge funds may curtail liquidity provision by FCAHFs. We acknowledge, however, that the change in status of a FCAHFs affiliated with banks would not necessarily have negative effects on financial markets, because their assets could flow to hedge funds affiliated with other financial institutions.
It has been widely presented at the very top conference in financial economics and in a variety of universities. The venues at which the paper has been presented include: the American Finance Association, the Western Finance Association, the University of Texas, Austin AIM Investment Conference, the Financial Intermediation Research Society, the ESMT 2017 Asset Management Conference, the 5th Luxembourg AMS, the Stockholm School of Economics, and the Goethe University Conference on Regulating Financial Markets.
The paper has also been reviewed in a financial industry magazine: http://www.opalesque.com/663926/Paper_examines_ties_between_hedge_funds_and_financial392.html
The paper currently has 30 citations on google scholar.
A second paper on “Shock Propagation and Banking Structure”, coauthored with Farzad Saidi, then a junior faculty member at the Stockholm School of Economics, has been published in the Review of Financial Studies, another of the very best journals in finance, in 2019, as a lead article and editor choice, indicating that it is considered one of the best papers published in the journal.
The paper advances the conjecture that lenders' decisions to provide liquidity in periods of distress are affected by the extent to which they internalize the negative spillovers of industry downturns. We conjecture that high-market-share lenders are more likely to internalize negative spillovers, and show that they provide liquidity to industries in distress when fire sales are likely to ensue. High-market-share lenders also provide liquidity to customers and suppliers of distressed industries when the disruption of supply chains is expected to be costly. The results suggest a novel channel explaining why credit concentration may favor financial stability.
Also this paper has been widely presented at the very top conference in financial economics and in a variety of universities including the 2018 AFA Annual Meeting, the 2017 WFA Annual Meeting, the 2017 Wharton Conference on Liquidity and Financial Fragility, the 2018 FIRS Annual Meeting, the 11th Swiss Winter Conference on Financial Intermediation, the 3rd EuroFIT Research Workshop on Syndicated Loans at London Business School, the 2018 Chicago Financial Institutions Conference, the Arne Ryde Conference on Financial Intermediation, the Cass Business School Workshop on Corporate Debt Markets, the Bocconi-Sapienza Conference on “Banks, Systemic Risk, Measurement and Mitigation,'' the CEPR Second Annual Spring Symposium in Financial Economics, the 2017 University of Kentucky Finance Conference, the 9th EBC Network Conference, the First Bank of Spain Conference on Financial Stability, the First Marstrand Finance Conference, the 6th MoFiR Workshop on Banking, the 2017 CEPR ESSFM, the IWH-FIN-FIRE Workshop, the FDIC/JFSR Annual Bank Research Conference, Banque de France, Deutsche Bundesbank, Sveriges Riksbank, McGill University, INSEAD, University of Edinburgh, and University of Cambridge.
The paper currently has 67 citations on google scholar.
Both papers have been publicly available on social science research networks and have been disseminated through the center of economic policy research series before open access publication.
The project has also brought new research questions. I explored what is the structure of money market funds that may stave off fire sales with Ramin Baghai, an associate professor in my own department, and Ivika Jager then a Ph.D student, and how the institutional environment affects the impact of uncertainty shocks on the economy.
The paper titled “Liability Structure and Risk-Taking: Evidence from the Money Market Fund Industry”, is forthcoming in the Journal of Financial and Quantitative Analysis, one of the top 4 journals in financial economics.
We show that the structure of financial intermediaries’ liabilities affects their asset holdings. We investigate the consequences of the 2014 money market fund (MMF) reform, which imposed redemption gates and liquidity fees on prime MMFs and forced prime funds marketed to institutional investors to switch from constant to floating net asset value. These changes made prime MMFs’ liabilities less money-like. As a consequence, the affected MMFs experienced an increase in the flow-performance sensitivity and started taking more risk. In addition, the total funding provided by MMFs to the corporate sector, and especially to safer issuers, has decreased.
The paper has been widely presented internationally including at the following conferences and seminars: seminar and conference participants at the 2nd World Symposium on Investment Research, the 2018 European Finance Association Meetings, the 2019 Western Finance Association Meetings, the 2019 Financial Intermediation Research Society Meetings, the University of Maryland and Federal Reserve Board Third Conference on Short Term Funding Markets, the Banque de France, the University of Bristol, the University of Exeter, the University of Zurich, the 2018 EuroFIT Workshop, the BoF/CEPR conference on Money in the Digital Age, the European Central Bank workshop on “Money markets, monetary policy implementation, and central bank balance sheets,” the European Central Bank workshop on “Monetary Policy, Macroprudential Policy and Financial Stability,” and the First Endless Summer Conference on Financial Intermediation and Corporate Finance
The paper has 13 citations on google scholar.
Finally, I published a paper on how the structure of the bankruptcy law affect the impact of uncertainty shocks with Giovanni Favara (Federal Reserve Board) and Janet Gao (Indiana University). The paper entitled “Uncertainty, access to debt, and firm precautionary behavior” appeared in the Journal of Financial Economics in 2021.
We show that better access to debt markets mitigates the effects of uncertainty on corporate policies. We establish this result using the staggered introduction of anti-recharacterization laws in US states. These laws enhanced firms’ ability to borrow by strengthening creditors’ rights to repossess collateral pledged in special purpose vehicles. After the passage of the laws, firms that face more uncertainty hoard less cash and increase payouts, leverage, and investment in intangible assets. Our findings suggest that better access to debt markets shields firms from fluctuations in uncertainty and decreases firms’ precautionary behavior, contributing to the deployment of cash and other internal resources to investment in intangible capital.
The paper has been presented at the European Central Bank, Indiana University, Southern
Methodist University, the Stockholm School of Economics, the University of Bonn, the European Finance Association, the Center for Economic Policy Research Third Annual Spring Symposium in Financial Economics at Imperial College, the Workshop on Corporate Debt Markets at Cass Business School, the Annual Corporate Finance Conference at the University
of Exeter, the Midwest Finance Association 2019 annual meeting, and the Ninth ITAM (Instituto Tecnológico Autónomo de México) Finance Conference.
New ideas and working papers
I am currently working on the following ideas that are directly following from the project and for which the funding has played an instrumental role for purchasing the data.
One aspect I am investigating is how foreign financial intermediaries may create bubbles and contribute to financial instability.
Specifically, in “Who Lends Before Banking Crises? Evidence from the International Syndicated Loan Market”, joint with Yeejin Jang (University of New South Wales) we show that foreign lenders and low market share lenders extend more credit in comparison to other lenders during lending booms leading to banking crises, but not during other credit expansions. Less established lenders also increase the amount of credit they extend to riskier borrowers, without asking for collateral or imposing covenants and higher interest rates. Our results suggest that taking lenders’ characteristics into account could provide an indicator for how much risk an economy is accumulating and be a useful barometer for macroprudential policies.
The working paper has already been presented at the American Finance Association, the Bundesbank Workshop on Financial Intermediation and Corporate Debt Markets, the European Central Bank, the Financial Intermediation Research Society, KU Leuven, the London School of Economics Systemic Risk Center, the Annual Workshop of the ESCB on Financial Stability, Macroprudential Regulation and Microprudential Supervision, and the 2020 FINEST Autumn Workshop.
The paper is publicly available on social science research network and have been disseminated through the center of economic policy research series.
The bond market is another possible source of financial instability that has been prominently discussed in policy circles. It is particularly important for policy understanding whether bond mutual funds can create financial instability.
I explore this in a joint paper with Chotibhak (Pab) Jotikasthira (Southern Methodist University) entitled “Bond Price Fragility and the Structure of the Mutual Fund Industry.” We show that mutual funds with a large share of a bond issue sell their holdings of that issue to a lower extent when they experience redemptions, arguably because they attempt to avoid a drop in the bond price and the consequent negative feedback effects on the unsold part of their position. Since large bond funds tend to hold large shares of outstanding bond issues, they end up exercising a stabilizing effect on the bonds they hold. Bonds with greater ownership concentration outperform during periods of turmoil and have lower overall price volatility. We provide evidence that the tendency of bond funds to limit negative price spillovers on their large positions can help explain how the Fed's Secondary Market Corporate Credit Facility quickly stabilized both eligible and ineligible bonds.
The paper has been presented at the Paris Annual Hedge Funds Research Conference, and seminar participants at Cambridge University Judge School of Business, Cornell University, the Copenhagen Business School, the Bank for International Settlements, the Frankfurt School of Finance and Management, Goethe University, George Mason University, the Hong Kong University, the Hong Kong University of Science and Technology, and Nanyang Technological University.
Also this paper is publicly available on social science research network and have been disseminated through the center of economic policy research series.
Besides having lots of international visibility the project has led to new collaborations. In particular, for the project on how the structure of bankruptcy laws affect the impact of uncertainty shocks on the real economy I started to collaborate with Giovanni Favara from the Federal Reserve Board of Governors, with Janet Gao from Indiana University, Jotikasthira, Chotibhak from Southern Methodist University and Yeejn Jang from University of New South Wales.