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Tough love in risk management: the market as financial parent
Journal of Economics and Business 54 (2002) 3– 6
Tough love in risk management: the market as financial parent Linda Allen* CUNY-Baruch College, Department of Economics and Finance, 17 Lexington Avenue, New York, NY, 10010, USA
Just as “spare the rod, spoil the child” was parenting advice for another generation, we struggle to find the correct combination of discipline and permissiveness to monitor the risk-taking behavior of growing financial enterprises. We are reluctant to appear too strict because of the possibility that innovation and development will be impeded. At the same time, turning a blind eye to the financial mischief of “rambunctious youth” has enabled institutions to undertake excessive risk to the detriment of both stakeholders and the entire financial system. It is the market’s challenge to design the equivalent of a financial woodshed to induce aggressive risk monitoring and control. The papers in this special issue wrestle with the interplay between market and regulatory forces to achieve this goal. A common theme throughout this special issue is the role played by institutional and informational frictions in undermining market forces. The first paper examines the role of auditing costs in the design of optimal lending contracts. Gangopadhyay and Mudkhopadhyay model the hierarchy of creditors and debt claims in a costly state verification model. If communication and coordination between lenders is impossible, the paper shows that the optimal form of financing consists of multiple lenders with prioritized claims. Moreover, it is optimal for the lender with the highest cost of auditing to hold the senior claim, thereby delegating the auditing function to junior claimants with lower (deadweight) costs of auditing. Park (2000), assuming identical auditing costs for all lenders, obtains another optimal claim structure demonstrating the importance of institutional factors (in this model, differential auditing costs across banks) on the optimal form of financing. Alternatively, when communication across bank lenders is possible, Gangopadhyay and Mukhopadhyay find that syndicated lending dominates consortium lending because it econ* Tel.: ⫹1-646-312-3463; fax: ⫹1-646-312-3451. E-mail address: [email protected] (L. Allen). 0148-6195/02/$ – see front matter © 2002 Elsevier Science Inc. All rights reserved. PII: S 0 1 4 8 - 6 1 9 5 ( 0 1 ) 0 0 0 6 0 - 1
4
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
omizes on the cost of information acquisition by delegating the auditing function to the lead lender in the loan syndicate. Therefore, the growth in the syndicated loan markets in recent years may have been encouraged by improvements in communication techniques and consolidation among international bank lenders. The next two papers further expound upon the importance of the role of information. First, Marshall and Weetman examine the role of regulatory disclosure requirements of hedging activities. They analyze market transparency by comparing financial statement disclosures to data about hedging activities obtained in a survey of firms. Agency conflicts may lead to incomplete voluntary disclosure of information to shareholders. In particular, managers may be reluctant to reveal their uses of hedging strategies for fear that this will eliminate a source of noise from the firm’s financial statements, thereby making profits a more informative signal of managerial quality. As a result, regulations requiring disclosure of hedging activities have been introduced in both the US and the UK in recent years. In the US, the regulations focus on disclosure of the risk of derivatives activities, whereas the focus in the UK is on disclosure of corporate governance and internal controls as applied to risk management. Less than 50% of all relevant information regarding risk management is released by firms in both the US and the UK according to the results of Marshall and Weetman. They conclude that the regulatory requirements in place in the two countries have not elicited full disclosure. This casts doubt on the efficacy of new SEC disclosure regulations (specifically SFAS 133, which was implemented after the study was completed). Apparently, regulations have limited power to overcome private incentives to limit transparency. Krausz and Paroush elaborate on this theme in their paper examining the conflict of interests in information provided by financial advisors to investment clients. In particular, financial advisors release information on the return and risk of particular financial securities in order to guide investors’ asset allocation decisions. However, the private interests of financial advisors may distort the information released. This conflict of interest is exacerbated when the financial advisor has discretionary control over the client’s portfolio allocation. Krausz and Paroush find that the financial advisor has incentives to distort information (i.e., reduce risk evaluations and raise expected return forecasts) for those securities that offer the advisor greater commission income and carry lower penalties for detection. The “optimal level of deception” increases as competition among financial advisors decreases and as the risk of the securities increases. Thus, financial analyst recommendations are less accurate for less competitive markets in risky securities. The overly optimistic and skewed forecasts of financial analysts, particularly during the high tech stock market bubble in the US, have come under scrutiny by the SEC recently. Krausz and Paroush’s results may explain the level of distortion in financial analyst recommendations particularly for high tech IPOs. Not only were these emerging firms extremely risky, but the new issues market was quite uncompetitive with oligopolistic underwriters using their market power to allocate shares. High risk and low levels of competition are the factors that Krausz and Paroush show lead to high levels of information distortion. Confidence in the market’s valuation capability has been shaken over the past year by the boom and bust cycle in high tech markets. Large swings in the valuation of high tech firms have cast doubt on the market valuations of young firms with predominately intangible
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
5
assets. Garner, Nam and Ottoo investigate the determinants of stock prices of Internet and biotech firms using an options-theoretic model to estimate the real growth opportunities of emerging firms. They find that valuation is highly interdependent across firms, particularly within industries that engage in basis research and development. These firms participate in a “race to innovate” in which the first to realize the technological breakthrough obtains the value of the real discovery option. Thus, a firm’s valuation is dependent in part upon the R&D activities of its competitors. They find that the speed of innovation is a critical determinant of firm value. Moreover, real growth options are less sensitive to volatility for very high stakes fundamental technological breakthroughs than would be expected using standard options pricing formulations. Market microstructure issues may also affect valuation in securities markets. Saunders, Srinivasan and Walter are the first to examine the structure of the over the-counter secondary market for corporate bonds. They utilize a unique database of actual transaction prices and bid-ask quotes in the investment-grade corporate bond market, the emerging country debt market, and the below investment-grade (junk) bond market. These bond markets are not very competitive, with only a small number (most often, three bidders) of large traders participating in block trades on behalf of institutional clients. Saunders, Srinivasan and Walter find an inverse relationship between the number of bidders and the level of price improvement (i.e., the difference between the best and the next best bid). This suggests that sellers would benefit from greater competitiveness in the bond market’s microstructure. The junk bond market was the thinnest and displayed the widest price dispersion, followed by the emerging debt market, and the investment-grade corporate market, respectively. The lack of competitiveness in corporate debt markets undermines proposals to introduce a subordinated debt requirement for commercial banks. Lang and Robertson survey proposals that would require banks to issue subordinated debt in order to promote market discipline by creating a class of creditors that would be subject to loss in the event of bank insolvency. Because of this credit risk exposure, subordinated debtholders would be induced to monitor bank risk taking activities –a form of direct market discipline. Moreover, subordinated debt prices would serve as a market signal of the bank’s credit risk exposure. Thus, subordinated debt credit risk premiums may also be used as a regulatory trigger in a form of indirect discipline. Questions about the feasibility of issuing subordinated debt as well as its efficacy as a method of direct market discipline are explored in depth in the paper. Lang and Robertson are more sanguine about the prospects of subordinated debt as a regulatory trigger than as a form of direct market discipline. Goldberg and Kabir examine an interesting market puzzle. Why are equity shares in central banks publicly traded? They document the stock performance of the National Bank of Belgium and the Bank of Japan over a long time period and find long term underperformance relative to a range of market indices. Goldberg and Kabir examine the hypothesis that central bank shares complete financial markets by allowing direct trading in macroeconomic policy tools. That is, they hypothesize that central bank share prices should be influenced by the market’s confidence in the central bank’s ability to conduct monetary policy in pursuit of the country’s macroeconomic policy goals. However, they find no significant econometric interrelationship, leaving the puzzle unanswered. The papers in this special issue have asked (and sometimes even answered) many
6
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
interesting questions about the role of the market in creating innovative techniques for risk management and control. It is my hope as the special editor that it will spark more research and debate in the future.
References Park, C. (2000). Monitoring and structure of debt contracts. Journal of Finance, 55, (5), 2157–2195.
Tough love in risk management: the market as financial parent Linda Allen* CUNY-Baruch College, Department of Economics and Finance, 17 Lexington Avenue, New York, NY, 10010, USA
Just as “spare the rod, spoil the child” was parenting advice for another generation, we struggle to find the correct combination of discipline and permissiveness to monitor the risk-taking behavior of growing financial enterprises. We are reluctant to appear too strict because of the possibility that innovation and development will be impeded. At the same time, turning a blind eye to the financial mischief of “rambunctious youth” has enabled institutions to undertake excessive risk to the detriment of both stakeholders and the entire financial system. It is the market’s challenge to design the equivalent of a financial woodshed to induce aggressive risk monitoring and control. The papers in this special issue wrestle with the interplay between market and regulatory forces to achieve this goal. A common theme throughout this special issue is the role played by institutional and informational frictions in undermining market forces. The first paper examines the role of auditing costs in the design of optimal lending contracts. Gangopadhyay and Mudkhopadhyay model the hierarchy of creditors and debt claims in a costly state verification model. If communication and coordination between lenders is impossible, the paper shows that the optimal form of financing consists of multiple lenders with prioritized claims. Moreover, it is optimal for the lender with the highest cost of auditing to hold the senior claim, thereby delegating the auditing function to junior claimants with lower (deadweight) costs of auditing. Park (2000), assuming identical auditing costs for all lenders, obtains another optimal claim structure demonstrating the importance of institutional factors (in this model, differential auditing costs across banks) on the optimal form of financing. Alternatively, when communication across bank lenders is possible, Gangopadhyay and Mukhopadhyay find that syndicated lending dominates consortium lending because it econ* Tel.: ⫹1-646-312-3463; fax: ⫹1-646-312-3451. E-mail address: [email protected] (L. Allen). 0148-6195/02/$ – see front matter © 2002 Elsevier Science Inc. All rights reserved. PII: S 0 1 4 8 - 6 1 9 5 ( 0 1 ) 0 0 0 6 0 - 1
4
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
omizes on the cost of information acquisition by delegating the auditing function to the lead lender in the loan syndicate. Therefore, the growth in the syndicated loan markets in recent years may have been encouraged by improvements in communication techniques and consolidation among international bank lenders. The next two papers further expound upon the importance of the role of information. First, Marshall and Weetman examine the role of regulatory disclosure requirements of hedging activities. They analyze market transparency by comparing financial statement disclosures to data about hedging activities obtained in a survey of firms. Agency conflicts may lead to incomplete voluntary disclosure of information to shareholders. In particular, managers may be reluctant to reveal their uses of hedging strategies for fear that this will eliminate a source of noise from the firm’s financial statements, thereby making profits a more informative signal of managerial quality. As a result, regulations requiring disclosure of hedging activities have been introduced in both the US and the UK in recent years. In the US, the regulations focus on disclosure of the risk of derivatives activities, whereas the focus in the UK is on disclosure of corporate governance and internal controls as applied to risk management. Less than 50% of all relevant information regarding risk management is released by firms in both the US and the UK according to the results of Marshall and Weetman. They conclude that the regulatory requirements in place in the two countries have not elicited full disclosure. This casts doubt on the efficacy of new SEC disclosure regulations (specifically SFAS 133, which was implemented after the study was completed). Apparently, regulations have limited power to overcome private incentives to limit transparency. Krausz and Paroush elaborate on this theme in their paper examining the conflict of interests in information provided by financial advisors to investment clients. In particular, financial advisors release information on the return and risk of particular financial securities in order to guide investors’ asset allocation decisions. However, the private interests of financial advisors may distort the information released. This conflict of interest is exacerbated when the financial advisor has discretionary control over the client’s portfolio allocation. Krausz and Paroush find that the financial advisor has incentives to distort information (i.e., reduce risk evaluations and raise expected return forecasts) for those securities that offer the advisor greater commission income and carry lower penalties for detection. The “optimal level of deception” increases as competition among financial advisors decreases and as the risk of the securities increases. Thus, financial analyst recommendations are less accurate for less competitive markets in risky securities. The overly optimistic and skewed forecasts of financial analysts, particularly during the high tech stock market bubble in the US, have come under scrutiny by the SEC recently. Krausz and Paroush’s results may explain the level of distortion in financial analyst recommendations particularly for high tech IPOs. Not only were these emerging firms extremely risky, but the new issues market was quite uncompetitive with oligopolistic underwriters using their market power to allocate shares. High risk and low levels of competition are the factors that Krausz and Paroush show lead to high levels of information distortion. Confidence in the market’s valuation capability has been shaken over the past year by the boom and bust cycle in high tech markets. Large swings in the valuation of high tech firms have cast doubt on the market valuations of young firms with predominately intangible
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
5
assets. Garner, Nam and Ottoo investigate the determinants of stock prices of Internet and biotech firms using an options-theoretic model to estimate the real growth opportunities of emerging firms. They find that valuation is highly interdependent across firms, particularly within industries that engage in basis research and development. These firms participate in a “race to innovate” in which the first to realize the technological breakthrough obtains the value of the real discovery option. Thus, a firm’s valuation is dependent in part upon the R&D activities of its competitors. They find that the speed of innovation is a critical determinant of firm value. Moreover, real growth options are less sensitive to volatility for very high stakes fundamental technological breakthroughs than would be expected using standard options pricing formulations. Market microstructure issues may also affect valuation in securities markets. Saunders, Srinivasan and Walter are the first to examine the structure of the over the-counter secondary market for corporate bonds. They utilize a unique database of actual transaction prices and bid-ask quotes in the investment-grade corporate bond market, the emerging country debt market, and the below investment-grade (junk) bond market. These bond markets are not very competitive, with only a small number (most often, three bidders) of large traders participating in block trades on behalf of institutional clients. Saunders, Srinivasan and Walter find an inverse relationship between the number of bidders and the level of price improvement (i.e., the difference between the best and the next best bid). This suggests that sellers would benefit from greater competitiveness in the bond market’s microstructure. The junk bond market was the thinnest and displayed the widest price dispersion, followed by the emerging debt market, and the investment-grade corporate market, respectively. The lack of competitiveness in corporate debt markets undermines proposals to introduce a subordinated debt requirement for commercial banks. Lang and Robertson survey proposals that would require banks to issue subordinated debt in order to promote market discipline by creating a class of creditors that would be subject to loss in the event of bank insolvency. Because of this credit risk exposure, subordinated debtholders would be induced to monitor bank risk taking activities –a form of direct market discipline. Moreover, subordinated debt prices would serve as a market signal of the bank’s credit risk exposure. Thus, subordinated debt credit risk premiums may also be used as a regulatory trigger in a form of indirect discipline. Questions about the feasibility of issuing subordinated debt as well as its efficacy as a method of direct market discipline are explored in depth in the paper. Lang and Robertson are more sanguine about the prospects of subordinated debt as a regulatory trigger than as a form of direct market discipline. Goldberg and Kabir examine an interesting market puzzle. Why are equity shares in central banks publicly traded? They document the stock performance of the National Bank of Belgium and the Bank of Japan over a long time period and find long term underperformance relative to a range of market indices. Goldberg and Kabir examine the hypothesis that central bank shares complete financial markets by allowing direct trading in macroeconomic policy tools. That is, they hypothesize that central bank share prices should be influenced by the market’s confidence in the central bank’s ability to conduct monetary policy in pursuit of the country’s macroeconomic policy goals. However, they find no significant econometric interrelationship, leaving the puzzle unanswered. The papers in this special issue have asked (and sometimes even answered) many
6
L. Allen / Journal of Economics and Business 54 (2002) 3– 6
interesting questions about the role of the market in creating innovative techniques for risk management and control. It is my hope as the special editor that it will spark more research and debate in the future.
References Park, C. (2000). Monitoring and structure of debt contracts. Journal of Finance, 55, (5), 2157–2195.