Steven A. Sharpe

Market Structure and the Nature of Price Rigidity: Evidence from the Market for Consumer Deposits

Panel data on consumer bank deposit interest rates reveal asymmetric impacts of market concentration on the dynamic adjustment of prices to shocks. Banks in concentrated markets are slower to raise interest rates on deposits in response to rising market interest rates, but are faster to reduce them in response to declining market interest rates. Thus, banks with market power skim off surplus on movements in both directions. Since deposit interest rates are inversely related to the price charged by banks for deposits, the results suggest that downward price rigidity and upward price flexibility are a consequence of market concentration.(This abstract was borrowed from another version of this item.)

Does Corporate Lending By Banks and Finance Companies Differ? Evidence on Specialization in Private Debt Contracting

This paper establishes empirically that specialization in private-market corporate lending exists, adding a new dimension to the public vs. private debt distinctions now common in the literature on debt contracting and financial intermediation. Using a large database of individual loans, we compare lending by finance companies to that by banks. The evidence implies that it is intermediaries in general that are special in solving information problems, not banks in particular. But lending by the two types of institutions is not identical. Finance companies tend to serve observably riskier borrowers, especially highly leveraged borrowers, although banks and finance companies do compete across the spectrum of borrower risk. The evidence supports both regulatory and reputational explanations for this specialization and perhaps an explanation based on institutional differences in borrower monitoring and control. In passing, we shed light on various theories of debt contracting and intermediation and also present facts about finance companies, which have received little attention.

The Effect of Consumer Switching Costs on Prices: A Theory and its Application to the Bank Deposit Market

As demonstrated by Klemperer (1987), if households face a cost of switching among brands of a differentiated good, pricing is likely to be more competitive, the greater is the fraction of customers that move into or around the market. I generalize this theory to a world with arbitrary market structure and test it empirically using panel data on bank retail deposit interest rates. I find that the amount of household migration in a market has a significant competitive influence on price markups, that is, a positive effect on the level of deposit interest rates. Consistent with the model, the magnitude of this effect depends in some cases upon the degree of market concentration.

ANCHORING BIAS IN CONSENSUS FORECASTS AND ITS EFFECT ON MARKET PRICES

Previous empirical studies on the “rationality” of economic and financial forecasts generally test for generic properties such as bias or autocorrelated errors but provide only limited insight into the behavior behind inefficient forecasts. This paper tests for a specific form of forecast bias. In particular, we examine whether expert consensus forecasts of monthly economic releases are systematically biased toward the value of previous months’ releases. Such a bias would be consistent with the anchoring and adjustment heuristic described by Tversky and Kahneman (1974) or could arise from professional forecasters’ strategic incentives. We find broad-based and significant evidence for this form of bias, which in some cases results in sizable predictable forecast errors. To investigate whether market participants’ expectations are influenced by this bias, we examine interest rate reactions to economic news. We find that bond yields react only to the residual, or unpredictable, component of the forecast error and not to the component induced by anchoring, suggesting that expectations of market participants anticipate this bias embedded in expert forecasts.

Post-Deregulation Bank-Deposit-Rate Pricing: The Multivariate Dynamics

The relationship between wholesale and retail interest rates since deregulation is of substantial interest to economists and policymakers, because the predictability of the monetary aggregates and their relationship to bank reserves depend on adjustment patterns in the wholesale and retail monetary markets. We provide evidence on the nature of wholesale-retail interest rate relationships by examining the dynamic interactions among two wholesale interest rates (federal funds and six-month treasury bills) and three retail deposit rates (six-month consumer certificates of deposit, money market deposit accounts, and super NOWs). We perform a multivariate time series analysis, with particular attention paid to a causal patterns and the shapes of impulse response functions. A number of stylized facts, related to size of adjustment, speed of adjustment, and pattern of adjustment, are established for the response of retail rates to unanticipated shocks in wholsale rates.

Credit rationing, concessionary lending, and debt maturity

Abstract A firm raises capital for a two-period investment. While creditors observe the project status midstream, unobservable managerial perks may consume capital each period. When the firm is unfortunate early on, short-term financing results in either concessionary lending or costly liquidation. Rolling over short-term debt may be problematic because the high risk premium creditors demand when asset value is low relative to debt impares managerial motivation precisely when the incentive to defer perk consumption is weakest. Long-term financing may reduce total agency costs be enabling lenders to charge higher initial premia, in effect, shifting loan repayments to states in which incentive constraints are non-binding.

Footnotes aren’t enough: the impact of pension accounting on stock values

Some research has suggested that companies with defined benefit (DB) pensions are sometimes significantly misvalued by the market. This is because the measures of pension cost and pension net liabilities embedded in financial statements, taken at face value, can provide very misleading picture of pension finances. The more pertinent information on pension finances is relegated to footnotes, but might not receive much attention from portfolio managers. But dramatic swings in the financial conditions of large DB plans around the turn of the decade focused widespread attention on pension accounting practices, and dissatisfaction with current accounting standards has recently prompted the Financial Accounting Standards Board (FASB) to take up a project revamp DB pension accounting. Arguably, the increased attention should have made investors wise to the informational problems, thereby eliminating systematic mispricing in recent years. We test this proposition and conclude that investors continued to misvalue DB pensions, inducing sizable valuation errors in the stock of many companies. Our findings suggest that FASBs current reform efforts could substantially aid the markets ability to value firms with DB pensions.

Expectations of risk and return among household investors: Are their Sharpe ratios countercyclical?

Data obtained from special questions on the Michigan Survey of Consumer Attitudes are used to analyze stock market beliefs and portfolio choices of household investors. We find that expected risk and return are strongly influenced by economic prospects. When investors believe macroeconomic conditions are more expansionary, they tend to expect both higher returns and lower volatility. This implies that household Sharpe ratios are procyclical, which is inconsistent with the view that stock market returns should compensate investors for exposure to macroeconomic risks. The finding of procyclical expected returns holds up when we instead condition on conventional business cycle proxies such as the dividend yield and the consumption-wealth ratio. We further find that perceived risk in equity returns (though not the expected returns themselves) is strongly influenced by household investor characteristics, consistent with documented behavioral biases. The relevance of investor expectations is supported by the finding that the proportion of equity holdings in respondent portfolios tends to be higher for those who report higher expected returns and lower uncertainty.

From the Horse's Mouth: Gauging Conditional Expected Stock Returns from Investor Surveys

We use data obtained from a series of Michigan Surveys of Consumer Attitudes to study stock market beliefs and portfolio choices of individual investors. We find that expected returns over the medium- and long-term horizon appear to be extrapolated from past realized returns. The findings also indicate that a more optimistic assessment of macroeconomic conditions coincides with higher expected returns and lower expected volatility, implying strongly procyclical Sharpe ratios. These results are given added credence by the empirical finding that reported portfolio concentrations in equities tend to be higher for respondents who anticipate higher returns and lower uncertainty. Overall, our empirical results lend support to the hypothesis that equity valuations are lower during recessions - and subsequent returns are higher - because of undue pessimism about future returns, rather than high risk aversion.

From the Horse's Mouth: How Do Investor Expectations of Risk and Return Vary with Economic Conditions?

Data obtained from monthly Gallup/UBS surveys from 1998-2007 and from a special supplement to the Michigan Surveys of Consumer Attitudes, run in 22 monthly surveys between 2000-2005, are used to analyze stock market beliefs and portfolio choices of household investors. We show that the key variables found to be positive predictors of actual stock returns in the asset-pricing literature are also highly correlated with investor’s reported expected returns, but with the opposite sign. Moreover, analysis of the micro data indicates that expectations of both risk and returns on stocks are strongly influenced by perceptions of economic conditions. In particular, when investors believe macroeconomic conditions are more expansionary, they tend to expect both higher returns and lower volatility. This is difficult to reconcile with the canonical view that expected returns on stocks rise during recessions to compensate household investors for increased exposure or sensitivity to macroeconomic risks. Finally, the relevance of these investors’ reported expectations is supported by the finding of a significant link between their expectations and portfolio choices. In particular, we show that portfolio equity positions tend to be higher for those respondents that anticipate higher expected returns or lower uncertainty.