Krishnamurthy Subramanian

Bankruptcy Codes and Innovation

Do legal institutions governing financial contracts affect the nature of real investments in the economy? We develop a simple model and provide evidence that the answer to this question is yes. We consider a levered firms choice of investment between innovative and conservative technologies, on the one hand, and of financing between debt and equity, on the other. Bankruptcy code plays a central role in these choices by determining whether the firm is continued or liquidated in case of financial distress. When the code is creditor-friendly, excessive liquidations cause the firm to shy away from innovation. In contrast, by promoting continuation upon failure, a debtor-friendly code induces greater innovation. This effect remains robust when the firm attempts to sustain innovation by reducing its debt under creditor-friendly codes. Employing patents as a proxy for innovation, we find support for the real as well as the financial implications of the model: (1) In countries with weaker creditor rights, technologically innovative industries create disproportionately more patents and generate disproportionately more citations to these patents relative to other industries; (2) This difference of difference result is further confirmed by within-country analysis that exploits time-series changes in creditor rights, suggesting a causal effect of bankruptcy codes on innovation; (3) When creditor rights are stronger, innovative industries employ relatively less leverage compared to other industries; and (4) In countries with weaker creditor rights, technologically innovative industries grow disproportionately faster compared to other industries. Finally, while overall financial development fosters innovation, stronger creditor rights weaken this effect, especially for highly innovative industries.

Term Structure Estimation in Illiquid Markets

Government debt markets in the developing economies are generally less liquid than in developed ones. There are many fewer liquid on the run securities. Yield curve estimation must therefore include illiquid securities in the data set. Pooling liquid and illiquid securities to estimate the term structure leads to errors in the estimation methodology. The author suggests a method to circumvent this problem, proposing the use of liquidity-weighted objective functions for parameter estimation. The liquidity of individual securities is modeled using observable quantities like number and volume of trades in a security. The model is demonstrated using data from the Indian government bond market.

Law and Project Finance

We investigate Project Finance as a private response to inefficiencies created by weak legal protection of outside investors. We offer a new illustration that law matters by demonstrating that for large investment projects, Project Finance provides a contractual and organizational substitute for investor protection laws. Project Finance accomplishes this by making cash flows verifiable through two mechanisms: (i) contractual arrangements made possible by structuring the project within a single, discrete entity legally separate from the sponsor; and (ii) private enforcement of these contracts through a network of project accounts that ensures lender control of project cash flows. Comparing bank loans for Project Finance with regular corporate loans for large investments, we show that Project Finance is more likely in countries with weaker laws against insider stealing and weaker creditor rights in bankruptcy. We identify the predicted effects using difference-in-difference and triple-difference tests that exploit exogenous country-level legal changes and inter-industry differences in free cash flow and tangibility of assets.

Employment Protection Laws and Privatization

Do employment protection laws hinder privatization? Using privatization deals in fourteen European countries from 1977-2003 and within-country variation in employment protection laws, we find that stringent employment protection laws significantly deter privatization. The fear of job cuts apparently leads organized labor in the state-owned enterprises to vehemently oppose privatization. We find that stringent employment protection laws inhibit privatization disproportionately more in industries that are less productive and require lower level of job skill, consistent with the fear of retrenchment being greater in the less-productive and low-skilled sectors. We also find that stringent employment protection laws inhibit privatization disproportionately more in unionized industries, consistent with the fact that workers in these industries exert considerable political pressure. To obtain these results exploiting inter-industry differences, we use industry-level measures for the United States as an instrument to alleviate potential endogeneity concerns. We employ panel regressions that include fixed effects to control for unobserved factors at the country, industry and year levels. We also examine specifications including country-specific and industry-specific trends to account for spurious correlations stemming from such trends in privatization and in enacting employment protection laws. Our results are also robust to controlling for endogenous changes in employment protection laws due to: (i) changes in a country’s government, specifically adopting or rejecting a left-of-center political stance; (ii) trade liberalization; and (iii) country-level economic growth.

Executive Compensation in India

We present an introductory regulatory and empirical analysis of executive compensation in listed companies in India.Our descriptive overview of levels and trends leads to several interesting conclusions. First, executive pay in the echelon representing the largest firms is several times greater than in smaller firms. It also includes a much greater component of variable pay, is much more sensitive to stock market movements, and exhibits much greater dispersion both across time and across firms. For this echelon of the largest firms, the features of executive pay are not qualitatively different from those documented for the US by Frydman and Saks (2010). However, for even upto the 75th percentile firm by size, there is little variable component in executive pay. CEO pay is considerably greater than the pay other executive directors (i.e., CXOs), and the ratio of CEO to CXO pay also displays high dispersion both across time and across firms. CXO pay displays a much lower variable component and much lower sensitivity to stock market movements, and hence a much lower variation across time. The real values of both CEO and CXO compensation have been following a sharply increasing trend in recent years in India. Second, CEO and CXO pay is considerably higher (about 30% for both CEOs and CXOs) for firms that are part of business groups, and increase significantly with the proportion of promoters’ equity. These results are qualitatively similar to the inferences that currently exist in the literature for the impact of vertical agency costs on executive pay.Questions must now be asked to better assure that international standards implemented in India are tailored and fit for the specific risks generated, such that disclosure, corporate oversight, and say-on-pay, are meaningful and fulfill the intended regulatory rationales.

State Intervention in Banking: The Relative Health of Indian Public Sector and Private Sector Banks

The health of Indian public sector banks has come under intense spotlight in recent times. In this chapter, we undertake a critical analysis of public sector banks by comparing them with new private sector banks.

Infrastructure and FDI: Evidence from District-Level Data in India

The localization of Foreign Direct Investment (FDI) to a few economies represents a puzzling aspect of international business. We study the provision of public infrastructure as a determinant of such localization. We employ unique data at the district level in India. We identify using variation: (i) among sectors within a district depending upon the sector’s propensity to attract FDI at the national level; and (ii) FDI into surrounding districts. We find that FDI inflows remain insensitive to changes in infrastructure till a threshold is reached; thereafter, FDI inflows increase steeply with an increase in infrastructure. This non-linear effect potentially explains why FDI remains restricted to a few countries.

The Color of Money: A Start-Up's Choice Among Venture Capitalists

Venture Capitalists (VCs) differ significantly from one another with respect to the non-financial resources -- from business expertise to the network of contacts with potential suppliers, customers, employees and IPO underwriters -- they offer their portfolio firms. In this paper, I develop a theoretical model incorporating such differences in resources to examine an entrepreneurs choice among VCs. By relating the costs and benefits of associating with a VC ab initio to the resources offered by the VC, the model examines the conditions under which financing by a more resourceful VC is optimal. The results rationalize the empirical findings that: (1) Startups prefer more resourceful VCs even though they have to offer equity at a considerable discount to such VCs. (2) More resourceful VCs may not only create successful startups but are also able to appropriate the benefits from the same and thereby consistently outperform their less resourceful competitors. However, the model points out that these results may only hold locally depending upon the intensity of product market competition and the entrepreneurs and VCs ability to hold each other up. The model generates the following new predictions: (1) In contrast to the hold-up by an informed bank, hold-up by a VC does not necessarily dampen entrepreneurial incentives and can therefore be value-adding. (2) While hold-up involving physical assets is zero-sum, hold-up involving intangible assets is not necessarily so. (3) Financing from a more (less) resourceful VC is optimal when product market competition is low (high) and the likelihood of hold-up is low (high).

Lessons from the financial crisis: Failure of markets or failure of regulation?

The popular, demagogic narrative after the global financial systems collapse in 2008 has held that the financial crisis signalled the failure of capitalism. However, regulators across the world must realize that the financial crisis was not brought about by the failure of markets but by the failure of governments to appropriately regulate markets. Beginning in the 1980s, and continuing over the quarter-century that followed, regulators afforded the world of big finance an unaffordable luxury: insurance against possible failure. As a result, banks and financial institutions became adept at turning their insulation from disorderly failure, as enforced by free markets, into insulation from market discipline, as inflicted by myopic regulators. This ‘too big to fail’ syndrome combined with the incorrect belief perpetrated by the Federal Reserve Chairman Alan Greenspan that financial companies, powered by a rational motive not to lose money, could police themselves and one another. In turn, such sanguine beliefs led to considerable over-supply of financial innovation. The supply created its own demand as the financial world operated under the implicit guarantee (and market distortion) created by the ‘too big to fail’ syndrome. The errors laid bare by the financial crisis clearly call for regulatory reform. But in designing that reform, regulators across the world should avoid the temptation to seek heavy-handed new approaches. Instead, policymakers should look to the long-term success of the system of rules whose decay brought about the crisis. Prudent regulations must seek to reinforce the fundamental principle that no one, however big or small, can be made immune to failure. Such pro-market regulation of finance is essential to preserving and fostering countries’ economic futures.

Effects of CEO Turnover in Banks: Evidence Using Exogenous Turnovers in Indian Banks

We examine the effects of chief executive officer (CEO) turnover in banks. Incoming bank CEOs face problems of information asymmetry because banks’ operations are opaque and bank risk can change dramatically in a short time. These CEOs may therefore change bank policies to manage their personal risks. Since CEO turnover is usually endogenous, we utilize a setting in which CEO turnover is based solely on retirement age and is thus exogenous to bank performance. Consistent with our thesis, incoming CEOs increase provisioning for future delinquencies and shrink lending. Bank stock prices decline following these changes. Politically motivated lending or ever-greening cannot explain our results.