Stephen A. Karolyi

Governance and Taxes: Evidence from Regression Discontinuity

We implement a regression discontinuity design to examine the effect of institutional ownership on tax avoidance. Positive shocks to institutional ownership around Russell index reconstitutions lead, on average, to significant decreases in effective tax rates (ETR) and prioritisation of cash over book-tax savings. They also lead to greater use of international tax planning using tax haven subsidiaries. These effects are smaller for firms with initially strong governance and high executive equity compensation, suggesting poor governance as an explanation for the undersheltering puzzle. Furthermore, we observe the largest decreases among high ETR firms, and increases for low ETR firms, consistent with institutional ownership pushing firms towards a common level of tax avoidance.

Personal Lending Relationships

I identify the effects of personal relationships on loan contracting using executive deaths and retirements at other firms as a source of exogenous variation in executive turnover. After plausibly exogenous turnover, borrowers choose lenders with which their new executives have personal relationships 4.1 times as frequently, and loans from these lenders have 20 basis points lower spreads and 12.5% larger amounts. Personal relationships benefit firms across loan terms, especially during macroeconomic downturns. Increased financial flexibility from personal relationships insulated firms from financial shocks during the recent financial crisis: they exhibited less constrained investment and were less likely to layoff employees.

Bank Regulator Bias and the Efficacy of Stress Test Disclosures

We examine the Federal Reserves (the Fed) propensity to bias reported stress test results in the Comprehensive Capital Analysis and Review (CCAR). Using capital market responses to the CCAR, we develop and estimate a model of biased disclosure that incorporates a regulators trade-off between disciplining banks and promoting short-term stability. We find the Fed biases disclosed capital ratios upwards to prop up large banks, but downwards to discipline poorly capitalized banks. These biases have real effects on bank behavior — propped-up banks are less likely to subsequently improve their capital ratios by raising equity or cutting dividends.

Political Uncertainty and Corporate Transparency

We examine the effect of political uncertainty on corporate transparency and market quality using gubernatorial elections as a source of plausibly exogenous variation in uncertainty. Despite real activity falling in the years leading up to a close election, voluntary disclosure, measured by the frequency and content of voluntary 8-K filings and managerial guidance, increases. These effects are stronger before elections in which the incumbent has termed out or with recent party flipping, and reverse after the election. We find that political uncertainty increases trading costs and reduces analyst information production, which firms mitigate by increasing transparency.

Individual Investor Overextrapolation

Individual investors are more likely to purchase stock immediately before earnings announcements for stocks with a recent history of high earnings announcement returns. Consistent with extrapolative pre-announcement purchases pushing up prices, we find evidence that firms with recent high earnings announcement returns see predictable increases in prices before earnings announcements and predictable decreases afterwards. These return patterns are economically significant: investors that buy (sell) a portfolio that is long firms with high recent earnings announcement returns and short firms with low recent earnings announcement returns in the pre-announcement (post-announcement) period earns a five factor daily alpha of 16.1 bps (18.3 bps). Finally, we link extrapolation to a variety of return patterns around earnings announcements and show that extrapolation offers a partial explanation for the pre-earnings-announcement premium.

Does Financial Reporting Matter? Evidence from Accounting Standards

By allowing investors to efficiently allocate capital, developed financial markets promote economic growth. We revisit a key component of financial market development, namely financial reporting standards, to identify a channel underpinning this link. We focus on introductions of new financial reporting standards and construct a novel text-based, firm-level measure of sensitivity to these standards. Relative to insensitive firms, sensitive firms reduce securities issuance by 11.4% and, despite compensating with internal sources of funds, cut investment by 10.8% after standards. These findings demonstrate that new standards trigger a substantial reallocation of capital through financial markets.We exploit firms’ voluntary disclosures as a novel firm-specific measure of ex ante sensitivity to individual FASB accounting standards to study the real effects of information regulation. We find that accounting standards impact capital allocation by increasing the cost and reducing the supply of credit and equity financing for sensitive firms. Affected firms respond by drawing down cash reserves and selling more assets compared to insensitive firms. Facing these financial constraints, affected firms cut payout by 2.6% and investment by 3.6%, on average. Our results suggest that accounting standards have economically significant real effects because they reallocate capital in financial markets. JEL Classification: G21, G28, G32, M41

Do Lenders Have Favorite Auditors

Yes. We construct a novel revealed preference measure of financial statement verification based on matching among lenders, borrowers, and auditors. When borrowers use their lenders’ preferred auditors, they borrow larger amounts and at lower rates and contracts depend more on accounting information. Lender preferences are determined by their historical experience with individual auditors; when borrowers in their loan portfolio default or restate their financials, lenders shift their loan portfolio away from the implicated auditor. These preferences impact borrowers’ post-financing auditor choices as well as subsequent matching between borrowers and lenders. Finally, when borrowers follow their lenders’ preferences, loan terms are more sensitive to financials and borrowers are less likely to default in the future. Our findings suggest that, through financial statement verification, auditors play a significant role in contracting efficiency and matching in the private loan market.

The Burden of Being Public: Evidence from Local Labor Markets

We exploit rich, cross-occupation employment data and quasi-experimental variation in IPO completion to quantify the direct labor compliance costs of being a public company. We precisely estimate a small, positive effect of public listings on local employment for compliance occupations that translates to average annual firm-level compliance costs of no higher than

Short-Termism Spillovers from the Financial Industry

1.3M. Using dynamic cross-sectional variation in the regulatory burden for public companies, we find that labor costs are highly sensitive to capital markets regulation. However, our estimates are substantially lower than self-reported compliance costs and suggest that labor costs are likely not an important determinant of listing status.

Understanding the 'Numbers Game'

To meet short-term benchmarks, lenders may alter their monitoring behavior, providing a channel for short-termism incentives to spillover into the corporate sector. We find that lenders with short-termism incentives enforce material covenant violations at abnormally high rates. Further, they are more likely to target high-quality borrowers with which they have a prior relationship and that are less financially constrained. Affected borrowers are more likely to switch lenders, receive worse loan terms on future loans, and reduce investment. Market reactions to technical default announcements when lenders have short-term incentives are 0.63% lower, suggesting that short-termism spillovers are value-decreasing.