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Who Bears Risk in China's Non-financial Enterprise Debt?

July 30, 2020


This paper analyses of how risk is allocated in China's markets for debt issued by non-financial enterprises. Compared to other major corporate bond markets China's is unusual in that unlisted, state-owned enterprises account for a large fraction of the debt issued and that the foundations of the corporate and bankruptcy law are young and still evolving. The implications of these features are described and quantified. The results show that the major changes in relative pricing across different market segments cannot be explained well by standard measures of solvency and liquidity. Rather, the most successful explanation is that major policy actions have had the effect of withdrawing implicit guarantees from private issuers and making more explicit the limits of guarantees afforded to state issuers   A copy of the paper can be found here.


Understanding China’s Evolving Credit Risk Maze

February 11, 2019


This paper analyses factors that account for credit risk in the Chinese market for bonds issued by non-financial enterprises.  By exploring a data set of covering monthly observations of individual corporate and enterprise bonds a number of important structural features of the market are seen to account for cross sectional and time series variations of yield spreads.  The analysis sheds light on the issue of implicit government guarantees.  The results suggest that steps taken by Chinese authorities to restructure local public finance are concentrating such guarantees to a few segments and are bringing greater financial discipline to other segments of the market.   A copy of the paper can be found here.



Sustainable Local Public Finance in China: Are Muni Bonds the Structural Solution?

with Lu Hua,

April 8, 2018


In this paper we assess the economic and institutional factors that have driven the growth of debt in China.  We ask whether there is a clear strategy for managing the risk that such debt levels pose and assess the likelihood that policy actions will prove successful.  In particular, we explain how much of the growth of debt is attributable to particular features of Chinese local public finance and why a program involving swapping municipal bonds for older city construction bonds and other debt has emerged as a crucial component of the Chinese strategy.  We assess this strategy in detail and argue that this constitute a deep structural reform that is having clear and important consequences for the structure of China’s domestic debt markets.  We present evidence that these changes in structure are being reflected in bond market pricing.  A copy of the paper can be found here.  The findings of this research were presented in a talk entitled “Assessing China’s Debt Overhang: Risks and Policy Responses” at several institutions in Beijing.  The slides from this talk can be found here.


Bankers and bank investors: Understanding the performance of large, complex banks, with Karin Jõeveer

September 29, 2017


This is a substantially revised version of the “Bankers and bank investors: Reconsidering the economies of scale in banking,” (2014). We study efficiency in banking recognizing that banks of different sizes operate in different banking markets and employ different business models. Banks with competitive advantage in some lines of business may generate rents, but some of these benefits may accrue to bankers. By combining returns to bank investors and to bankers we find efficiency benefits to large, complex banks. However, using observable proxies for banking scope, funding efficiency, presence in wholesale banking activities and risk taking we find most of the efficiency benefits of large banks are explained by differences in business models rather than pure size effects.  A copy of the paper is available for download here



Chinese Debt Capital Markets: An emerging global market…With Chinese Characteristics

July 19, 2017


This paper surveys the current state of the Chinese debt capital markets. As judged by its size and sophistication of its infrastructure the Chinese bond market it is already a leading market globally.  China is unusual in that non-financial corporate issues account for a large fraction of the market as compared to financial and sovereign issues.  Despite the fact that a large part of the market is made up of information sensitive securities, domestic ratings and other forms of information disclosure are relatively underdeveloped.  The structure of the corporate bond market is shaped by three alternative channels that regulate security issuance and by different regimes governing alternative issuer types.  These features are by-products of China’s gradualist approach to enterprise reform which has allowed central and local state owned enterprises to slowly shrink in importance relative to the private economy.  In addition, large scale infrastructure investments undertaken by local SOE’s account for a large proportion of non-financial bond issues.  Comparing bond values by issuer type and issue type reveals strong signs of market segmentation which may reflect varying degrees of implicit state guarantees. A copy of the paper can be found here. 


Stress Testing and Macroprudential Regulation: A Trans-Atlantic Assessment

May 2016


Since the onset of the financial crisis in 2007-08, stress testing has emerged as a major component of the supervisory toolkit. For most of the large global banks in the US and Europe meeting the standard to pass their annual supervisory stress tests is the binding regulatory constraint.  This has been a remarkable development for a tool which ten years ago was little known, apart from a small fraternity of banks’ risk modellers and their supervisory counterparts. A conference held at the London School of Economics in October 2015 assembled an expert group of specialists to take stock of how stress testing has developed.  This CEPR eBook collects the main policy presentations from this conference.  The first chapter gives an overview of the main themes that emerged, thereby serving as a statement of the current state of the art of stress testing for bank supervision and macroprudential regulation. A VoxEu article introducing the book plus a link to the book itself can be found here.


Agency, Firm Growth and Managerial Turnover

with Cecilia Bustamante, Stephane Guibaud, Mihail Zervos, November 2016,

forthcoming Journal of Finance


This paper is a revised is a major revision of the paper of the same title from 2014 that was formulated as an infinite horizon discrete time model.  The revised version is cast in continuous time which has allowed a cleaner characterisation of the main qualitative results.  We include a two-period model to introduce some of the main issues we explore and to state some of the testable hypotheses.  We also include an empirical exploration of the main model predictions.  The paper accepted for publication can be found here.  Slides from Stéphane Guibaud’s recent presentation of the paper can be found here.


Cash Holding and Control-oriented Finance, with Malika Hamadi, December 2016

Journal of Corporate Finance. 41, 410-425


We critically reassess the notion that high liquid asset holding by firms faced with weak investor protection is evidence of managerial rent extraction. We use a sample of 196 Belgian listed firms from 1991 to 2006 and show that in the rare cases where managerial shareholding occurs it has no impact on the cash held by firms. We find instead a positive association between large controlling shareholders ownership and the cash in firms. This result reflects the risk aversion of large controlling shareholders who in the face of poor investor protection tend to hold large blocks in the firm resulting in their wealth concentrated in a few holdings. We find that family-firms hold more cash when shareholders are organized in voting blocks. We show that firm market valuation is positively affected by the amount of cash held by firms. A copy of the paper accepted for publication can be found here.


Scale, scope and complexity: assessing banking business models with Karin Jõeveer, November 2014

Journal of Financial Perspectives, 2(3).


In this paper we study how the complexity of a bank’s business model is related to its returns. Our approach allows for the possibility that bank returns may be retained in part by mobile and powerful bankers and that the amount of rent extraction may vary across different lines of business. Using data on U.S. bank holding companies over the years 2003-12, we find strong evidence that the scope of a bank’s business is an important determinant of bank returns and that, all else equal, wide scope favors bank shareholders relative to bankers. Establishing a presence across a wide range of wholesale banking activities requires a complex organization that would be difficult to replicate elsewhere and in this way serves to moderate bankers’ compensation demands. We use our statistical results to shed light on the evolution of the business models of some of the largest U.S. banks over the last ten years. A copy of the paper is available for download here.


The economics of collateral, with Karin Jõeveer

March 2014


In this paper we study how the use of collateral is evolving under the influence of regulatory reform and changing market structure.  We start with a critical review of the recent empirical literature on the supply and demand of collateral which has focussed on the issue of `collateral scarcity'. We argue that while limited data availability does not allow a comprehensive view of the market for collateral, it is unlikely that there is an overall shortage of collateral. However, it is quite possible that there may be bottlenecks within the system which mean that available collateral is immobilized in one part of the system and unattainable by credit-worthy borrowers.  We then describe how these problems sometimes can be overcome by improved information systems and collateral transformation. We discuss how collateral management techniques differ between banks and derivatives markets infrastructures including, in particular, CCPs. In order to assess the impact of alternative institutional arrangements on collateral demand, we introduce a theoretical model of an OTC derivatives market consisting of investors and banks arrayed in several regions or market segments.  We simulate this model under alternative forms meant to capture the implications of moving to mandatory CCP clearing and mandatory initial margin requirements for non-cleared OTC derivatives. A copy of the paper is available for download here.  The slides to a presentation of this paper can be found here



Bankers and bank investors: Reconsidering the economies of scale in banking, with Karin Jõeveer

FMG DP712 and CEPR DP9146, September 2012, revised December 2014


Studies of economies of scale in banking based on pure cost efficiency measures and assuming competitive input pricing fail to satisfactorily account for the preponderance of a small number of very large banks within most financial systems. In this paper we have argued that a more fruitful starting point in understanding this phenomenon is to view banks as combining financial and human capital to create rents which are then allocated to investors and bankers through a bargaining process that will reflect the mix of businesses operated by the bank. To implement this approach empirically we have measured bank performance not only by investor returns (measured as return on equity) but also by an estimate of bankers' rents. Applying this approach to annual data of US bank holding companies since 1990, we find much stronger evidence of economies of scale in returns to bankers as compared to returns to investors. The scale economies appear to be particularly strong in the top size decile of banks measured by total assets. We find that these economies of scale are to a significant degree attributable to a bank's involvement in wholesale banking activities. The importance of wholesale banking in accounting for increasing returns to scale is apparent only when returns to bankers are taken into account. Our results also suggest that the use of wholesale funding to expand the scale of the banks operations can increase bank returns even if it squeezes the bank's average net interest margin. We find these increased returns accrue largely to bankers rather than bank shareholders. We suggest that the the most plausible explanation for our results is that large banks achieve a degree of operational efficiency which gives them a competitive edge over smaller rivals, and this advantage allows them to retain some producers' surplus that creates value for their shareholders and for bankers themselves. A copy of the paper is available for download here


Agency, Firm Growth and Managerial Turnover

with Cecilia Bustamante and Stephane Guibaud

October 2011, Revised, FMG DP711 CEPR DP9146, September 2012


Firms extract value not only from operating their existing assets, but also from the expected future profits of their growth opportunities. Firms often find that major management changes are needed to pursue their growth opportunities successfully. This paper explores how growth-induced management turnover interacts with the provision of managerial incentives in a dynamic moral hazard model. This paper explores the relationship between firm growth and managerial incentive provision in a dynamic moral hazard environment. Extending earlier, seminal contributions to the optimal dynamic contracting literature, we consider a long-lived firm, run by a sequence of managers, that faces exogenous stochastic growth opportunities. We characterize the optimal compensation, firing and growth policies specified in the long-term contracts signed between the firm and its successive managers. Beyond disciplinary replacement upon poor performance, growth-induced turnover arises when incumbent managers are at a disadvantage to implement the growth potential of the firm. The model yields numerous testable implications on the rate of corporate growth, top management turnover, and the use of bonuses and severance pay in managerial compensation. A new form of agency cost arises, due to a form of contractual externality. A copy of the paper is available for download here.



Liquidity and Capital Structure  with Andrew Carverhill

FMG Discussion Paper DP573  and CEPR Discussion Paper 6044, Revised , July 2011. Published as "Corporate Liquidity and Capital Structure," Review of Financial Studies, 25(3), 797-837.


This is an updated version of the paper circulated earlier under the title "A Model of Corporate Liquidity".  We solve for a firm's optimal cash holding policy within a continuous time, contingent claims framework that has been extended to incorporate most of the significant contracting frictions that have been identified in the corporate finance literature. Under the optimal policy the firm targets a level of cash holding that is a non-monotonic function of business conditions and an increasing function of the amount of long-term debt outstanding. By allowing firms to either issue equity or to borrow short-term, we show how share issue and dividends on the one hand and cash accumulation and bank borrowing on the other are all mutually interlinked. We calibrate the

model and show that it matches closely a wide range of empirical benchmarks including cash holdings, leverage, equity volatility, yield spreads, default probabilities and recovery rates. Furthermore, we show the predicted dynamics of cash and leverage are in line with the empirical literature. Despite the presence of significant contracting frictions we show that the model exhibits a near irrelevance of long-term capital structure property. Furthermore, the optimal policy exhibits a state-dependent hierarchy among financing alternatives that is consistent with recent explorations of pecking order theory. In an extension we find that targeted cash holdings are not much increased by the presence of growth opportunities until shortly before the growth occurs. We show that observed bond covenants that establish an earnings restriction on dividend payments may be value increasing. A copy of the paper is available for download here.



What Accounts for Time Variation in the Price of Default Risk? August 2008, Revised with extended data set, October 2009


In this paper we study the pricing of credit risk as reflected in the market for credit default swaps (CDS) and in corporate bonds in order to understand origins of the well documented tendency
for credit spreads on diverse issues to periodically undergo large, common adjustments in the same direction and of similar magnitudes. Our methodology allows us to distinguish co-movements that reflect common revisions in the statistical default distribution from common factors driving time variation in the market price of default risk. These results imply that the market price of credit was not abnormally low in 2004-2006. That is, the low yield spreads during that period were attributable to low expected credit losses forecasted using model of the default process estimated using historical default experience. Furthermore, our results suggest that changes in CDS may be a poor forecasts of future defaults. Changes in these spreads tend to be dominated by changes in the pricing of default risk rather than changes in the physical default process. This suggests that the reliance upon CDS spreads for the purposes of macro-prudential regulation as in Huang et al (2009) or Hart& Zingales (2009) is likely to be misguided unless there is an adequate control for changes in spreads attributable purely to changes in the markets' pricing of credit risk. Overall, our results provide evidence of the partial segmentation of credit and equity markets. A copy of the paper is available for download here.


Financing and Corporate Growth under Repeated Moral Hazard with Kjell Nyborg, revised May 2009, published, Journal of Financial Intermediation, 2011

In this paper we study how the control rights of different financial contracts affect growth at different stages in a corporation's life cycle. Our model traces the firm from an initial stage where an entrepreneur must put in effort to create a growth opportunity (first stage growth) through to a stage where new managers are needed to operate the assets efficiently (second stage growth). The model admits a standard hold-up problem under equity financing; insiders may be disincentivized to do R&D because outside investors can use their control rights to expropriate large parts of the returns by hiring more efficient managers in the future. Surprisingly, we find that the hold-up problem under equity financing is most severe when the cash flow disadvantage to the entrepreneur relative to new managers is small. Equity tends to promote second stage growth at the expense of first stage growth, while debt works the other way. Cross-sectional predictions are derived from those cases where control rights matter. Consistent with the empirical evidence, leverage is inversely related to growth and to profitability. A copy of the paper is available for download here.


Large Powerful Shareholders and Cash Holding with Malika Hamadi

CEPR Discussion Paper 7291, May 2009

We study the relationship between liquid asset holding and the pattern of share ownership and control structures within the firm. We explore these issues using a data set of Belgian firms that is particularly well suited to studying the institutions of control oriented finance. The data include information on ownership concentration, voting alliances, managerial ownership, membership in family groups, institutional cross-share holdings, and coordination centers which under Belgian law permit consolidation of earnings and cash flow for a group of firms. We show that financial structures in Belgium are strongly control oriented as evidenced by the very high levels of observed ownership concentration and the prevalence of pyramids, voting alliances, and participation in family groups. We find that the level of liquid asset holding is positively associated with ownership concentration and that this effect is particularly marked for family firms. Given the difficulties of family firms in achieving effective wealth diversification we interpret these results as indicating liquid asset holding is largely motivated by risk aversion. Cash holding is negatively associated with institutional cross share holdings, suggesting that these cross holdings facilitate an effective internal capital market. We find little evidence that managers have an independent influence on cash holdings. A copy of the paper is available for download here.



Some Determinants of the Price of Default Risk May 2008


The rise of the credit derivatives market has meant that we now can observe rather directly how the market views the price of bearing default risk. In this empirical paper I study credit default swap prices observed between 2003 and 2008, a period in which many observers have argued the pricing of credit risk has varied enormously.  My sample consists of 1, 3 and 5-year CDS contracts for 41 North American and European firms drawn from either the energy or media sectors. I estimate for each name separately a latent variable model  which assumes that defaults on a name follow a jump process where the log intensity of arrivals of defaults itself follows a mean reverting process. From these estimates I construct for each name a time series of the implied instantaneous intensity of default under the risk-neutral measure.  A principal components analysis reveals that there is a strong common component in the time variation of these default intensities for each of our subsamples: North American Energy, North American Media, European Energy, European Media.   In order to infer a market price of default the we construct estimates of the default intensity under the physical distribution based on hazard model applied by Zhou (2007) to a large quarterly panel of North American firms.  I then combine estimates to find the implied market price of risk measured as the natural logarithm of the ratio of risk-neutral intensity and statistical intensity of default. A relatively high fraction of the observed variation of this market price of default risk can be accounted for by a common time variation. In order to identify this factor, I explore a linear model of the market price of default risk using as observed covariates macro indicators, firm indicators and indicators of equity market and credit market conditions. These estimates show a strong association between that credit market conditions and the market price of risk. The estimated coefficients have the correct signs. These are robust findings across a variety of alternative proxies for credit market conditions and across our two subsamples. In contrast equity market risk factors and general business conditions do not always have coefficient estimates of the right sign and are not always significant. However, there is some evidence that changes in the value firm premium are partially correlated with changes in the pricing of default risk. Overall, these results provide evidence of the partial segmentation of credit markets. A copy of the paper is available for download here.



Derivatives Markets with Kenneth McKay in X.Freixas, P. Hartmann, and C. Mayer (eds.) Handbook of European Financial Markets and Institutions. Oxford University Press, 2008


We survey the development in derivatives markets over the last twenty years from about 1985 when the American derivatives markets had grown enormously following earlier innovations in exchange traded financial derivatives such as stock options, foreign exchange futures, interest futures and stock index futures. Since then the markets have developed in new directions and innovations in Europe are a large part of this experience.  We describe this development, emphasizing the growing importance of over-the-counter (OTC) derivatives contracts with innovations in credit, equity, and weather being discussed in some detail. A copy of the paper is available for download here.



A Model of Corporate Liquidity, with Andrew Carverhill.  Revised February 2005.

We study a continuous time model of a levered firm with fixed assets generating a cash flow which fluctuates with business conditions. Since external finance is costly, the firm holds a liquid (cash) reserve to help survive periods of poor business conditions. Holding liquid assets inside the firm is costly as some of the return on such assets is dissipated due to agency problems. We solve for the firms optimal dividend, share issuance, and liquid asset holding policies.
The firm optimally targets a level of liquid assets which is a non-monotonic function of business conditions. In good times, the firm does not need a high liquidity reserve, but as conditions deteriorate, it will target higher reserve. In very poor conditions, the firm will declare bankruptcy, usually after it has depleted its liquidity reserve. Our model can predict liquidity holdings, leverage ratios, yield spreads, expected default probabilities, expected loss given default and equity volatilities all in line with market experience. We apply the model to examine agency conflicts associated with the liquidity reserve, and some associated debt covenants. We see that a restrictive covenant applied to the liquidity reserve will often enhance the debt value as well as the equity value.

A copy of the paper is available for download here.