Michael S. Pagano

Large Capital Infusions, Investor Reactions, and the Return and Risk-Performance of Financial Institutions Over the Business Cycle

We examine investors’ reactions to announcements of large capital infusions by U.S. financial institutions (FIs) from 2000 to 2009. These infusions include private market infusions (seasoned equity offerings (SEOs)) as well as injections of government capital under the Troubled Asset Relief Program (TARP). The sample period covers both business cycle expansions and contractions, and the recent financial crisis. We present evidence on the factors affecting FIs’ decisions to raise capital, the determinants of investor reactions, and post-infusion risk-taking of the recipients, as well as a sample of matching FIs. Investors reacted negatively to the news of private market SEOs by FIs, both in the immediate term (e.g., the two days surrounding the announcement) and over the subsequent year, but positively to TARP injections. Reactions differed depending on the characteristics of the FIs, and the stage of the business cycle. Smaller, more financially constrained non-bank institutions were more likely to have raised capital through private market offerings during the period prior to TARP, and firms receiving a TARP injection tended to be riskier and more levered. In the case of TARP recipients, they appeared to finance an increase in credit risk with more stable financing sources such as core deposits, which lowered their liquidity risk. However, we find no evidence that banks’ capital adequacy increased after the capital injections.

How Theories of Financial Intermediation and Corporate Risk-Management Influence Bank Risk-Taking Behavior

This paper examines the rationales for risk-taking and risk-management behavior from both a corporate finance and a banking perspective. After combining the theoretical insights from the corporate finance and banking literatures related to hedging and risk-taking, the paper reviews empirical tests based on these theories to determine which of these theories are best supported by the data. Managerial incentives are the most consistently supported rationale for describing how banks manage risk. In particular, moderate/high levels of equity ownership reduce bank risk while positive amounts of stock option grants increase bank risk-taking behavior. The review of empirical tests in the banking literature also suggests that financial intermediaries coordinate different aspects of risk (e.g., credit and interest rate risk) in order to maintain a certain level of total risk. The empirical results indicate hedgeable risks such as interest rate risk represent only one dimension of the risk-management problem. This implies empirical tests of the theories of corporate risk-management need to consider individual sub-components of total risk and the bank’s ability to trade these risks in a competitive financial market. This finding is consistent with the reality that banks have non-zero expected financial distress costs and bank managers cannot fully diversify their bank-related personal investments.

Crises, Cronyism, and Credit

This paper examines the effects of several potential explanatory factors related to the 1997-1998 East Asian crisis. We find that a crisis can improve a poorly functioning credit system by making domestic lending rates more responsive to market-based returns. We report that the responsiveness of short-term lending rates is directly related to the level of transparency in the economy. Thus, countries with greater transparency (less corruption) are more likely to make credit decisions based on market-wide forces rather than succumb to the influence of special interest groups. Nations with greater transparency also experience significantly shorter and less severe economic downturns. Copyright 2002 by the Eastern Finance Association.

A comprehensive approach to measuring the relation between systemic risk exposure and sovereign debt

Using an integrated model to control for simultaneity, as well as new risk measurement techniques such as Adapted Exposure CoVaR and Marginal Expected Shortfall (MES), we show that the aggregate systemic risk exposure of financial institutions is positively related to sovereign debt yields in European countries in an episodic manner, varying positively with the intensity of the financial crisis facing a particular nation. We find evidence of a simultaneous relation between systemic risk exposure and sovereign debt yields. This suggests that models of sovereign debt yields should also include the systemic risk of a countrys financial system in order to avoid potentially important mis-specification errors. We find evidence that systemic risk of a countrys financial institutions and the risk of sovereign governments are inter-related and shocks to these domestic linkages are stronger and longer lasting than international risk spillovers. Thus, the channel in which domestic sovereign debt yields can be affected by another nations sovereign debt is mostly an indirect one in that shocks to a foreign countrys government finances are transmitted to that countrys financial system which, in turn, can spill over to the domestic financial system and, ultimately, have a destabilizing effect on the domestic sovereign debt market.

Accentuated Intraday Stock Price Volatility: What Is the Cause?

In equity markets, the opening and closing of trading are particularly stressful periods. Ozenbas, Pagano, and Schwartz investigate the quality of price determination at these times (compared to midday periods) for large-, mid-, and smallcapitalization stocks on the NYSE, NASDAQ, and London Stock Exchange. Using three different metrics, they consistently find lower quality at both the open and the close.The deterioration of market quality at openings is greatest for large-cap stocks, but no systematic association with cap size is observed at the close. Large-cap stocks evidently lead smaller-cap stocks in finding new equilibrium values, and accentuated volatility at the open is in large part attributable to the complexities of price discovery.

Life after the Big Board Goes Electronic

The NYSEs Hybrid Market will be a floor-based facility (a slow market) combined with an electronic platform (a fast market). Technological advances, regulatory pressure, and competition have forced the exchange to introduce an electronic platform, but its success will not be known for some time. This article addresses some of the broad issues involved. The Big Board is considered as a network that provides price and quantity discovery. The article raises several questions about the integration of fast- and slow-market components and presents evidence that in one European electronic exchange, roughly half the euro value of trades does not go through the electronic order book.

International market structure: global problems and micro solutions

Purpose - The purpose of this paper is to present new empirical evidence on global trends in equity-related transaction costs and trading volume, as well as to highlight recent research in international market microstructure. Design/methodology/approach - Estimates of brokerage commissions, indirect trading costs, and trading volume are obtained from a comprehensive institutional investor database. Quarterly data are used to compute trends in transaction costs and trading volume, as well as shifts in trading between mature and emerging markets. Findings - The results indicate a steady decline in brokerage commissions around the world but indirect trading costs appear to have reached a plateau. The fastest growth in trading volume can be found in the emerging markets of South America but the USA leads the way in terms of the steepest reductions in transaction costs. Research limitations/implications - The paper relies on one source of transaction cost estimates over a relatively short period (March 2005-December 2007). Originality/value - The paper provides comprehensive and current empirical evidence on important trends in international market microstructure.

Sovereign Wealth Funds’ Impact on Debt and Equity Markets during the 2007–09 Financial Crisis

The authors found that news related to the financial crisis and sovereign wealth fund investments in U.S. and European firms not only affected returns on U.S. money market instruments and U.S. firms’ common stock but also created negative “spillover” effects on Canadian money markets and Canadian firms’ equity returns. We examined the largely unexplored effect of sovereign wealth fund (SWF) investments in two major developed markets that have strong economic linkages: the United States and Canada. The economic relationship between the United States and Canada is one of the most successful relationships in global economic history. Between the Automotive Products Trade Agreement (also known as the Auto Pact), the United States–Canada Free Trade Agreement, the North American Free Trade Agreement, and scores of other bilateral and multilateral agreements, the United States and Canada have embraced a fully interconnected and market-based economy. Although both countries encourage a free market approach, the Canadian financial system has a different organizational structure (five large commercial banks are dominant), tighter regulation (including lower leverage ratios than their U.S. counterparts), and a generally lower risk appetite. Thus, despite their strong economic linkages, the two countries might not have the same reaction to the recent financial crisis and the devastating effects that the crisis has had on the global economy. By engaging in this analysis, we can identify how news related to the financial crisis and SWFs’ capital injections into large U.S. and European financial institutions has not only affected returns on U.S. money market instruments and the common stock of U.S. financial institutions but also created negative “spillover” effects on Canadian money markets and the equity returns of Canadian financial institutions. These spillover effects may be the result of the aforementioned economic linkages between these two countries. Therefore, investors might fear the threat of large institutional failures in Canada when U.S. and European financial institutions require capital infusions from sovereign wealth funds or other large investors. Overall, we found that news of an SWF capital injection into a large U.S. or European financial institution caused across-the-board declines of 13–61 bps in U.S. short-term rates, such as one- and three-month commercial paper rates (a “stabilizing” effect of SWF investments). These news announcements also created a negative spillover, or “destabilizing,” effect for short-term Canadian corporate rates, such as the overnight money market rate and the Canadian Deposit Offered Rate (Canada’s equivalent to LIBOR), with heightened global systemic risk causing rates to increase 15–29 bps. This increase in Canadian rates suggests that SWF investments in the United States can have unintended “crowding-out” effects on the demand for capital in other parts of the world because other countries might feel the need to increase rates in order to attract capital and remain competitive in the global capital markets. In contrast to Canadian debt market rates, U.S. money market rates reacted more consistently and significantly to news specifically related to the financial crisis (with declines of 24–72 bps). A “flight-to-quality” effect is also clearly evident for both U.S. and Canadian short-term treasury rates (with rate declines of 43–97 bps when major news related to the crisis was publicly released). These debt-specific reactions to news related to SWF investments and the financial crisis highlight how the credit crunch, initiated by problems in the subprime credit sector, quickly rippled through both the U.S. and Canadian markets.

Nasdaq's Closing Cross Has its new call auction given Nasdaq better closing prices? Early Findings

On March 29, 2004, Nasdaq significantly expanded its hybrid market structure by introducing the Closing Cross, an electronic price discovery call auction that sets closing trades and establishes official closing prices. Three months later, on June 25, the efficiency of the new facility was stress tested by the Russell 2000 rebalancing, an event that involved almost 1,700 Nasdaq stocks. We analyze the efficiency of the Closing Cross by contrasting price dislocations experienced at the 2004 rebalancing with those observed at the 2003 rebalancing. By and large, the findings suggest that the closing procedure was effective, especially for smaller cap stocks in the Russell 2000 index. Nasdaq’s Closing Cross: Early Findings On March 29, 2004, the Nasdaq Stock Market expanded its hybrid market structure by introducing a price discovery call auction into its trading system. The call is run daily at 4:00 pm to close Nasdaq’s normal trading day. Nasdaq refers to it as “Closing Cross,” but the facility is in fact a call auction because it provides price discovery. In this paper, we assess the impact that the call has had on Nasdaq’s official closing prices. The assessment should be considered preliminary because relatively little time has passed since the call has been instituted. Time is required for participants to learn how best to use any new system, and for sufficient data to be generated for a more complete analysis. Nevertheless, we have undertaken this early assessment in view of the importance of the innovation. A call auction differs from continuous trading in the following way. In a continuous market, a trade is made whenever a bid and offer match or cross each other in price. In a call auction, the buy and sell orders are cumulated for each stock for simultaneous execution in a multilateral, batched trade, at a single price, at a predetermined time. By consolidating liquidity at specific times, a call auction is intended to reduce execution costs for individual participants, and to sharpen the accuracy of price discovery for the broad market. Closing call auctions were introduced in Europe (including London, Paris, and Germany) specifically because of customer demands for improved price discovery at 1 We are grateful to Frank Hatheway and Tim McCormick for their insights and factual information that they have provided us. We also thank Yakov Amihud, Corinne Bronfman, Lin Peng, George Sofianos, and Steve Wunsch for their very helpful comments. 2 In contrast, crossing networks such as ITG’s Posit and Instinet’s after hours cross, do not provide price discovery. Rather, they match crossing buy and sell orders at a price (either the mid-point of a stock’s bidask spread or a stock’s closing transaction price) that is set in a major market center. 3 For additional discussion and further references, see Economides and Schwartz (1995), and Schwartz and Francioni (2004).

Who Wants to Dance?: Some Possible Exchange Partners

Due to the recent transformation of many securities exchanges into for-profit, publicly traded companies, we use portfolio theory and historical risk-return relationships to consider several scenarios (78 in total) based on hypothetical mergers between all possible pairings of these exchanges. We identify both the “best” and “worst” merger pairs solely based on these risk-return and correlation patterns, and thus do not include potential merger synergies related to economies of scale or scope. The analysis presented here thus provides an objective measure of the relative attractiveness of various mergers to investors in a relatively new but rapidly growing investment sector: for-profit securities exchanges. We find that Asian Pacific exchanges such as those based in Australia and Singapore consistently represent the strongest combinations of risk and return. In North America, the mergers associated with the Toronto Stock Exchange and Chicago Mercantile Exchange offer the best risk-return relationships. Overall, our approach suggests there is considerable variation in the risk-return characteristics of passively managed mergers of securities exchanges and that the “best” pairings typically include an Asian Pacific exchange as a partner whereas some of the weaker hypothetical mergers include European and / or North American exchanges.