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- Volume 14, 2022
Annual Review of Financial Economics - Volume 14, 2022
Volume 14, 2022
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The Village Money Market Revealed: Financial Access and Credit Chain Links Between Formal and Informal Sectors
Vol. 14 (2022), pp. 1–20More LessAn all-or-nothing view of financial access leading to overly simplistic policy recommendations has been largely overturned in the data. Heterogeneity and explicit obstacles to trade are key aspects that need to be incorporated into models when looking at intermediate outcomes in the data. Networks in particular can amplify or work against policy interventions and do so in different directions for different groups at the same time. Work on village money markets allows us to better understand how these networks function, and how and why they can change with policy interventions. Nevertheless, though village economies are as sophisticated as those in New York financial markets, both suffer from familiar problems. One is reliance on relationships that segment markets and limit more universal benefits. A second problem is market contagion. Policy interventions facilitating financial access and the functioning of markets need to be guided by this stricter yet more realistic view.
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Zombie Lending: Theoretical, International, and Historical Perspectives
Vol. 14 (2022), pp. 21–38More LessThis article surveys the theory on zombie lending incentives and the consequences of zombie lending for the real economy. It also offers a historical perspective by reviewing the growing empirical evidence on zombie lending along three dimensions: (a) the role of undercapitalized banks, (b) effects on zombie firms, and (c) spillovers and distortions for non-zombie firms. We then provide an overview of how zombie lending can be attenuated. Finally, we use a sample of US publicly listed firms to compare various measures proposed in the literature to classify firms as “zombies.” We identify definitions of zombie firms that are adequate to investigate economic inefficiency in the form of real sector competitive distortions of zombie lending. We find that only definitions based on interest rate subsidies are able to detect these spillovers and thereby provide evidence in support of credit misallocation.
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Bank Supervision
Vol. 14 (2022), pp. 39–56More LessWe provide a critical review of the empirical and theoretical literature on bank supervision. This review focuses on microprudential supervision: the supervision of individual banking institutions aimed at assessing the financial and operational health of those firms. Theory suggests that supervision is required not only to ensure compliance with regulation but also to allow for the use of soft information in mitigating externalities of bank failure. Empirically, more intensive supervision results in reduced risk-taking, but less consensus has been found on whether the risk-reducing impact of supervision comes at the cost of reduced credit supply. Theoretical costs and benefits of supervisory disclosure have been outlined, and this disclosure is informative to investors; however, it is difficult to identify the impact of disclosure distinct from supervisory and regulatory changes.
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The Economics of Liquidity Lines Between Central Banks
Saleem Bahaj, and Ricardo ReisVol. 14 (2022), pp. 57–74More LessLiquidity lines between central banks are a key part of the international financial safety net. In this review article, we lay out some of the economic questions that they pose. Research has provided answers to some of these questions, but many more require further research.
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Sovereign Debt Sustainability and Central Bank Credibility
Vol. 14 (2022), pp. 75–93More LessThis article surveys the literature on sovereign debt sustainability from its origins in the mid-1980s to the present and focuses on four debates. First, we evaluate the shift from an accounting-based view of debt sustainability using government borrowing rates to a model-based view that uses stochastic discount rates. Second, we review empirical tests, focusing on the relationship between primary balances and debt. Third, we discuss debt sustainability in the presence of rollover risk. And fourth, we evaluate whether government borrowing costs below rates of growth (r < g) generate a free lunch, in the sense that debt sustainability does not require future primary surpluses. We argue that liquidity services provided by sovereign debt may indeed lead to a free lunch, albeit one of limited size. The value of such services depends on the credibility of the central bank, which can be accumulated via prudent policies and subsequently drawn on to allow for looser fiscal policy.
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Bitcoin and Beyond
Vol. 14 (2022), pp. 95–115More LessWe survey extant literature on the economics of blockchain fundamentals, with particular focus on Bitcoin, proof-of-work, and proof-of-stake. We formally clarify Bitcoin's economic significance in solving the double-spending problem without a centralized entity. We then transition to the economics literature, highlighting the key endogenous economic interactions among participants in the Bitcoin ecosystem as well as the economics of proof-of-stake and other potential consensus algorithms. Along the way, we discuss various literature that provides important insights regarding fees, forks, and price volatility. We conclude by reflecting on the next generation of blockchain innovations.
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Some Simple Economics of Stablecoins
Vol. 14 (2022), pp. 117–135More LessStablecoins have the potential to drastically increase competition and innovation in financial services by reducing our reliance on traditional intermediaries. But they also introduce new challenges, as regulators rely on intermediaries to ensure financial stability, market integrity, and consumer protection. Because they operate at the interface between traditional banking and cryptocurrencies, stablecoins also represent an ideal setting for understanding the key trade-offs cryptocurrencies involve, and insights from robust stablecoin design and regulation are highly relevant for related innovations in decentralized finance (DeFi), nonfungible tokens, and Web3 protocols. In this review, we describe the following: key stablecoin design choices, from reserve composition to stability mechanism; legal claim against the issuer; noninterference with macroeconomic stability; and interoperability with public sector payment rails and central bank digital currencies. Last, we cover the key benefits of stablecoins in the context of real-time, low-cost programmable payments, financial inclusion, and DeFi.
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Nonbanks and Mortgage Securitization
Vol. 14 (2022), pp. 137–166More LessThis article reviews the dramatic growth of nonbank mortgage lending after the Global Financial Crisis, especially to borrowers with lower credit scores, and the related importance of mortgage-backed securitization. Our literature review suggests that the existing theoretical and empirical work on securitization is more relevant to bank than to nonbank lenders, thus leaving outstanding questions as to why nonbank market shares have increased to their current levels and how best to structure nonbank oversight. To highlight key differences in the mortgage-lending incentives of banks and nonbanks, we build a simple theoretical model of bank versus nonbank mortgage lending and use it to generate and test empirical hypotheses. We find, in particular, that loans issued by nonbanks are more likely to prepay early than loans issued by banks, the difference not explainable by nonbank borrowers prepaying more rationally. Using regulatory filings from nonbanks that are typically unavailable to academic researchers, we examine the balance sheets and liquidity and capital positions of large Ginnie Mae nonbank servicers, which face and pose more risk in the current mortgage system. We find that on average these servicers have reasonable liquidity and capital positions relative to standard regulatory thresholds, particularly in 2022:Q1 after a few quarters of elevated profits. However, some large Ginnie Mae servicers appear to have inadequate capital, as gauged by risk-based capital measures. If defaults rise on a large scale, the liquidity and capital positions of these servicers may amplify the disruption in the mortgage and housing markets.
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Student Loans and Borrower Outcomes
Vol. 14 (2022), pp. 167–186More LessThis review surveys the literature on student lending, emphasizing empirical studies of default, credit outcomes, and earnings. Student loans exist to alleviate credit constraints and, in theory, may have different effects on outcomes through multiple channels. There is significant heterogeneity in outcomes across types of borrowers, with many adverse outcomes driven by a subset of primarily for-profit institutions. We conclude by exploring policy options such as student loan forgiveness, income-driven repayment, income-share agreements, and penalizing schools for adverse borrower outcomes. These policies lead to possible equity and efficiency trade-offs.
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FinTech Lending
Vol. 14 (2022), pp. 187–207More LessIn this article, we review the growing literature on financial technology (FinTech) lending—the provision of credit facilitated by technology that improves the customer–lender interaction or used in lenders’ screening and monitoring of borrowers. FinTech lending has grown rapidly, though in developed economies like the United States it still accounts for only a small share of total credit. An increase in convenience and speed appears to have been more central to FinTech lending's growth than improved screening or monitoring, though there is certainly potential for the latter, as is the case for increased financial inclusion. The COVID-19 pandemic has shown potential vulnerabilities of FinTech lenders, although in certain segments they have displayed rapid growth.
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Financing Health Care Delivery
Vol. 14 (2022), pp. 209–229More LessI review the key issues that arise in financing health care delivery. I begin by documenting the key features of health care markets that make financing so central in this sector, such as the skewed and unpredictable nature of health care spending and market failures in health care delivery. I then review the key issues that public and private payers face in designing health care markets, from the proper mix of public and private provision to the role of risk bearing for consumers and providers. Finally, I illustrate how these issues manifest in practice by comparing the design of insurance systems in the United States and Canada.
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Financing Biomedical Innovation
Vol. 14 (2022), pp. 231–270More LessWe review the recent literature on financing biomedical innovation, with a specific focus on the drug development process and how it may be enhanced to improve outcomes. We begin by laying out stylized facts about the structure of the drug development process and its associated costs and risks, and we present evidence that the rate of discovery for life-saving treatments has declined over time while costs have increased. We make the argument that these structural features require drug development (i.e., biopharmaceutical) firms to rely on external financing and at the same time amplify market frictions that may hinder the ability of these firms to obtain financing, especially for treatments that may have large societal value relative to the benefits going to the firms and their investors. We then provide an overview of the evidence for various types of market frictions to which these drug development firms are exposed and discuss how these frictions affect their incentive to invest in the development of new drugs, leading to underinvestment in valuable treatments. In light of this evidence, numerous studies have proposed ways to overcome this funding gap, including the use of financial innovation. We discuss the potential of these approaches to improve outcomes.
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Private or Public Equity? The Evolving Entrepreneurial Finance Landscape
Vol. 14 (2022), pp. 271–293More LessThe US entrepreneurial finance market has changed dramatically over the last two decades. Entrepreneurs who raise their first round of venture capital retain 30% more equity in their firm and are more likely to control their board of directors. Late-stage start-ups are raising larger amounts of capital in the private markets from a growing pool of traditional and new investors. These private market changes have coincided with a sharp decline in the number of firms going public—and when firms do go public, they are older and have raised more private capital. To understand these facts, we provide a systematic description of the differences between private and public firms. Next, we review several regulatory, technological, and competitive changes affecting both start-ups and investors that help explain how the trade-offs between going public and staying private have changed. We conclude by listing several open research questions.
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The Effects of Public and Private Equity Markets on Firm Behavior
Vol. 14 (2022), pp. 295–318More LessIn this article, I review the theoretical and empirical literature on the effects of public and private equity markets on firm behavior, emphasizing the consequences that emerge from disclosure requirements, ownership concentration, and degree of firm standardization. While publicly listed firms benefit from a lower cost of capital, enabling increased focus on commercialization and profitability, they are less suited to pursue long-term risky investments. Privately held firms are better equipped to pursue innovative projects but face a higher cost of capital, which limits their growth. Complementarities between public and private equity markets can mitigate their respective limitations. Innovation in private equity markets supplements commercialization efforts of public firms, and demand for innovation by public firms accelerates entrepreneurial activity in private equity markets. I conclude by discussing directions for future research.
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Private Finance of Public Infrastructure
Vol. 14 (2022), pp. 319–335More LessPublic-private partnerships (PPPs) have emerged as an organizational form to provide public infrastructure. A key characteristic of PPPs is that private investors participate directly in individual infrastructure projects. The advantage of private finance is that it may improve incentives. However, private finance typically neither frees public funds nor enlarges the pool of viable projects.
Private finance improves risk allocation if exogenous demand risk is assigned to the public, while endogenous risks are assigned to the private parties (PPPs and financiers), which provides strong incentives for efficiency. When funding for the project relies on user fees, variable term contracts can allocate risks efficiently, in contrast to allocation under fixed term contracts.
The exploration of alternative financial contracts that allocate endogenous risks to private parties and determination of the optimal allocation of these risks among borrowers and lenders are potentially fruitful areas for future research. This line of research is probably relevant beyond infrastructure finance.
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Factor Models, Machine Learning, and Asset Pricing
Vol. 14 (2022), pp. 337–368More LessWe survey recent methodological contributions in asset pricing using factor models and machine learning. We organize these results based on their primary objectives: estimating expected returns, factors, risk exposures, risk premia, and the stochastic discount factor as well as model comparison and alpha testing. We also discuss a variety of asymptotic schemes for inference. Our survey is a guide for financial economists interested in harnessing modern tools with rigor, robustness, and power to make new asset pricing discoveries, and it highlights directions for future research and methodological advances.
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Empirical Option Pricing Models
Vol. 14 (2022), pp. 369–389More LessThis article provides an overview of empirical options research, with primary emphasis on research into systematic stochastic volatility and jump risks relevant for pricing stock index options. It reviews evidence from time series analysis, option prices, and option price evolution regarding those risks and discusses required compensation.
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Decoding Default Risk: A Review of Modeling Approaches, Findings, and Estimation Methods
Vol. 14 (2022), pp. 391–413More LessDefault risk permeates the behavior of corporate bond returns and spreads, credit default swap spreads, estimation of default probabilities, and loss in default. Pertinent to this review are salient empirical findings and implications of default process estimation from 1974 to 2021. Both structural and reduced-form models are covered. In structural models, default occurs if the value of assets falls below some threshold obligation. The reduced-form models involve assumptions about the default process combined with recovery in default. Default process estimation and measurements of default probability have improved by exploiting data on defaultable bonds, credit default swaps, tally of default realizations, and options on individual equities. Empirical investigations continue to address the relevance of stochastic asset volatility, jumps in asset values, and modeling of default boundary and firm leverage process.
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The Pricing and Ownership of US Green Bonds
Vol. 14 (2022), pp. 415–437More LessWe review the pricing and ownership of green bonds, whose proceeds are used for environmentally focused purposes. After presenting an overview of the literature on green securities and green bonds in particular, we summarize the US corporate and municipal green bond markets. Green municipal bonds provide the best opportunity for detailed empirical study of how pricing and ownership differ from those of ordinary bonds. Green bonds are issued at a small premium of several basis points over similar ordinary bonds except when they are issued simultaneously with ordinary bonds from the same issuer; in that situation, a premium emerges over time on the secondary market. Green bonds, especially small or nearly riskless ones, are also more closely held than ordinary bonds. These facts are consistent with a simple framework that incorporates assets with nonpecuniary utility.
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A Survey of Alternative Measures of Macroeconomic Uncertainty: Which Measures Forecast Real Variables and Explain Fluctuations in Asset Volatilities Better?
Vol. 14 (2022), pp. 439–463More LessIn the past 20 years, measures of economic uncertainty have been developed that are purely market price based; structural model based, using data on real fundamentals and asset prices; text based; or survey based. We compare the performance of these uncertainty measures in forecasting three real variables with irreversibilities—investment, hiring, and credit creation—as well as in explaining fluctuations in stock market and Treasury bond market volatility. In general, we find that structural model–based measures do better than measures constructed using other approaches, with a model of stock market volatility by David and Veronesi performing the best on several (but not all) dimensions. Their learning-based model's volatility places time-varying weights on inflation, earnings, and consumption news, as agents in the economy assess the impact that inflation has on the stability of real economic growth.
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A Review of China's Financial Markets
Grace Xing Hu, and Jiang WangVol. 14 (2022), pp. 465–507More LessThe fast growth of China's economy has brought it not only to the center of the global economy but also to a transition point in its growth model, a transition from scale to efficiency, speed to sustainability, input driven to innovation led. How its financial markets can drive this new growth model and facilitate the transition are pressing challenges, for China and for the world. We provide a comprehensive review of China's financial markets, including government bonds, corporate/credit bonds, stocks, asset-backed securities, financial derivatives, investment management, and currency, focusing on their growth paths, distinct characteristics, and unique opportunities. Despite fast expansion at times, their development is often lagging behind market needs, uneven over time, and unbalanced across markets. This developmental pattern is driven mostly by the government's immediate policy objectives rather than by the markets' ultimate efficiency in serving their key functions, including liquidity provision, price discovery, and risk allocation.
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Corporate Debt and Taxes
Vol. 14 (2022), pp. 509–534More LessWe provide updates to and perspectives on the enduring topic of debt and taxes. The recent decade brought us new empirical strategies, accounting rules, and tax laws. We discuss how these and other developments change our understanding of leverage and taxes. Overall, tax incentives still do not seem to have a consistent, first-order effect on corporate capital structure. This presents a puzzle as governments increasingly limit interest deductibility, citing its contribution to overleverage and distress. We discuss critical empirical challenges such as measurement, highlight issues surrounding assumptions about tax rates and real-world financing decisions, and offer insights and direction for future research. We conclude that rather than asking if taxes are a first-order driver of corporate capital structure, a more productive goal is a greater understanding of when tax incentives yield material effects on corporate capital structure.
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Corporate Culture
Vol. 14 (2022), pp. 535–561More LessCorporate culture is an omnibus term that includes many elements that are relevant to a firm, like norms, values, knowledge, and customs. Economists have made great progress recently in devising methods of measuring different aspects of corporate culture. These empirical measures of culture have explained mergers and acquisitions, corporate risk-taking, and unethical behaviors observed in corporations, among other topics. We argue that unpacking corporate culture into its components is the right way to research it empirically. Theories of corporate culture are still in development, and we discuss the major contributions thus far. We argue that a theory of the firm and of corporate decision-making that is based on corporate culture is more germane to the practical realities of firms’ inner workings than prevailing theories based on property rights and agency costs. Corporate culture has the potential to set the theoretical paradigm for all corporate finance research.
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Kindleberger Cycles: Method in the Madness of Crowds?
Vol. 14 (2022), pp. 563–585More LessCorporate R&D has a social return far above its internal rate of return to the innovating corporation, and so it is chronically underfunded from a social perspective. Kindleberger cycles, irregularly recurring stock market manias, panics, and crashes that are prominent in financial history, are also a major problem for mainstream economics. If manias inundating hot new technologies with capital sufficiently counter chronic underinvestment in innovation, economy-level selection may favor institutions and behavioral norms conducive to Kindleberger cycles despite individual agents’ losses in panics and crashes.
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