Richard T. Thakor

Customers and Investors: A Framework for Understanding Financial Institutions

Financial institutions have both investors and customers. Investors, such as those who invest in stocks and bonds or private/public-sector guarantors of institutions, expect an appropriate risk-adjusted return in exchange for the financing and risk-bearing that they provide. Customers of a financial intermediary, in contrast, provide financing in exchange for a specific set of services, and do not want the fulfillment of these services to be contingent on the credit risk of the intermediary, even when they are not small, uninformed agents lacking in sophistication. This paper develops a framework that defines the roles of customers and investors in intermediaries, and uses the framework to provide an economic foundation for the aversion to intermediary credit risk on the part of its customers. This customer-investor nexus has implications for a host of issues related to how contracts between financial intermediaries and their customers are structured and how risks are shared between them, as well as the consequences of (unanticipated) deviations from the ex ante efficient contractual arrangement for institutional design, regulatory practices, and financial crises. Moreover, customers and investors are often intertwined in practice, and so this intertwining provides insights into the adoption of “too-big-to-fail” policies and bailouts by regulators in general.

A Theory of Efficient Short-Termism

This paper develops a theory in which the owners of firms pursue short-termism in project choice to limit managerial rent-seeking behavior. Unlike in previous theories, a short-term bias in investment horizons maximizes firm value in the second-best case, whereas managers themselves prefer long-horizon projects. Short-termism benefits the firm in two ways: it limits managerial rent extraction by preventing investments in bad projects that delay information revelation about project quality and managerial ability, and it enables faster learning about managerial ability which allows more efficient subsequent decisions. This result does not depend on any stock mispricing or managerial desire to manipulate stock prices. The likelihood of short-termism is higher when corporate governance is stronger, and at lower levels of the corporate hierarchy. Numerous testable predictions of the analysis are discussed.

Just how good an investment is the biopharmaceutical sector

Uncertainty surrounding the risk and reward of investments in biopharmaceutical companies poses a challenge to those interested in funding such enterprises. Using data on publicly traded stocks, we track the performance of 1,066 biopharmaceutical companies from 1930 to 2015—the most comprehensive financial analysis of this sector to date. Our systematic exploration of methods for distinguishing biotech and pharmaceutical companies yields a dynamic, more accurate classification method. We find that the performance of the biotech sector is highly sensitive to the presence of a few outlier companies, and confirm that nearly all biotech companies are loss-making enterprises, exhibiting high stock volatility. In contrast, since 2000, pharmaceutical companies have become increasingly profitable, with risk-adjusted returns consistently outperforming the market. The performance of all biopharmaceutical companies is subject not only to factors arising from their drug pipelines (idiosyncratic risk), but also from general economic conditions (systematic risk). The risk associated with returns has profound implications both for patterns of investment and for funding innovation in biomedical R&D.

Investment Opportunities, Free-Cash-Flow, and the Market Values of Foreign and Domestic Cash Holdings

It has been suggested that firms with foreign operations stockpile large amounts of cash, primarily in their foreign subsidiaries, because bringing the cash home involves paying a repatriation tax on foreign income. This implies that the stock market should value foreign-held cash less than domestically-held cash. But this effect may be moderated by the impact of investment opportunities abroad that would provide an outlet for the foreign cash and affect how the market values it. This paper empirically examines the difference between the market values of on-balance-sheet cash held domestically and that held abroad by US firms, and the impact of the interaction of the repatriation tax and investment opportunities on this difference. The results show that shareholders assign a higher value to cash held abroad than to cash held domestically, and that the marginal value of foreign-held cash is substantially higher than that of domestic cash for US firms with better foreign investment opportunities. This suggests that the effect of the differential investment opportunities for foreign and domestic cash swamps the repatriation-tax disadvantage of foreign cash. As further evidence, this paper also examines the effect of the exogenous shock provided by the tax repatriation holiday in 2004, and finds that firms with better investment opportunities abroad experienced lower abnormal returns following the passage of that legislation.

Competition and R&D Financing Decisions: Evidence from the Biopharmaceutical Industry

How does competition affect innovation and how it is financed in RD (2) carry more cash and maintain less net debt; and (3) experience declining betas but greater total stock return volatility due to higher idiosyncratic risk. We first establish stylized facts using time-series evidence that is consistent with these predictions. To address the endogeneity issue introduced by the fact that a firms R&D investments and the product-market competition it faces influence each other, we then provide further evidence supporting these predictions through a differences-in-differences analysis.

Trust in Lending

We develop a theory of trust in lending, distinguishing between trust and reputation, and use it to analyze the competitive interactions between banks and non-bank lenders (fintech firms). Trust enables lenders to have assured access to financing, whereas a loss of investor trust makes this access conditional on market conditions and lender reputation. Banks endogenously have stronger incentives to maintain trust. When borrower defaults erode trust in lenders, banks are able to survive the erosion of trust when fintech lenders do not. Trust is also asymmetric in nature—it is more difficult to gain it than to lose it.

The Effect of Cash Injections: Evidence from the 1980s Farm Debt Crisis

What is the effect of cash injections during financial crises? Exploiting county-level variation arising from random weather shocks during the 1980s Farm Debt Crisis, we analyze and measure the effect of local cash flow shocks on the real and financial sector. We show that such cash flow shocks have significant impact on a host of economic outcomes, including land values, loan delinquency rates, the probability of bank failure, employment, and wages. Estimates of the effect of local cash flow shocks on county income levels during the financial crisis yield a multiplier of 1.63.

Sharing R&D Risk in Healthcare via FDA Hedges

The high cost of capital for firms conducting medical research and development (R&D) has been partly attributed to the government risk facing investors in medical innovation. This risk slows down medical innovation because investors must be compensated for it. We analyze new and simple financial instruments, Food and Drug Administration (FDA) hedges, to allow medical R&D investors to better share the pipeline risk associated with FDA approval with broader capital markets. Using historical FDA approval data, we discuss the pricing of FDA hedges and mechanisms under which they can be traded and estimate issuer returns from offering them. Using various unique data sources, we find that FDA approval risk has a low correlation across drug classes as well as with other assets and the overall market. We argue that this zero-beta property of scientific FDA risk could be a main source of gains from trade between issuers of FDA hedges looking for diversified investments and developers looking to offload the FDA approval risk. We offer proof of concept of the feasibility of trading this type of pipeline risk by examining related securities issued around mergers and acquisitions activity in the drug industry. Overall, our argument is that, by allowing better risk sharing between those investing in medical innovation and capital markets more generally, FDA hedges could ultimately spur medical innovation and improve the health of patients.

Liquidity Windfalls and Reallocation: Evidence from Farming and Fracking

Financing frictions may create a misallocation of assets in a market, thus depressing output, productivity, and asset values. This paper empirically explores how liquidity shocks generate a reallocation effect that diminishes this misallocation. Using a unique dataset of agricultural outcomes, I explore how farmers respond to a relaxation of financial constraints through a liquidity shock that is unrelated to farming fundamentals, namely exogenous cash inflows that are caused by an expansion of hydraulic fracturing (fracking) leases. Farmers who receive positive cash flow shocks increase their purchases of land, which results in a reallocation effect. Examining cross-county purchases, I find that farmers in high-productivity counties who receive cash flow shocks buy farmland in low-productivity counties. In contrast, when farmers in low-productivity counties receive positive cash flow shocks, they do not engage in similar behavior. Moreover, farmers increase their purchases of vacant (undeveloped) land. Average output, productivity, and profits all increase following these positive cash flow shocks, and farmland prices rise significantly. These effects are consistent with an efficient reallocation of land towards more productive users.