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The Financial Review

Abstracts of Volume 39, 2004

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Symposium Papers on Financial Institutions

Larry D. Wall

Financial institutions are the topic of the 2003 Eastern Finance Association Symposium. The symposium papers illustrate the importance of bank research for improving our understanding of both financial and nonfinancial firms. Benston begins the symposium with an overview of banking. Three papers consider different aspects of banks' commercial lending: Frame, Padhi, and Woosley; Gottesman and Roberts; and Gonas, Highfield, and Mullineaux. Next, DeYoung and Rice analyze increases in bank's increased noninterest income. Finally, two papers illustrate the benefits of using banking data: Hasan and Wall, in examining the management of financial reporting, and Sfiridis and Daniels, in examining the implications of different organizational forms.

Keywords: banks, loans, research

What’s Special about Banks?

George J. Benston

I delineate six aspects of how banks have been “special” (although not unique) and then consider whether and to what extent these attributes are still relevant. These include efficiently produced products, importance for the development and growth of economies, international scope, role in economic instability and the conduct of monetary policy, early regulation by governments, and source of data for academic researchers and institutions. Despite changes in the environment and in the ways in which financial services are provided, banks still are special. However, their specialness for public policy concerns is limited, now, to frauds and deposit insurance. I suggest ways in which these concerns can be dealt with efficiently.

Keywords: banks, financial intermediaries, bank specialness, bank regulation

Credit Scoring and the Availability of Small Business Credit in Low- and Moderate-Income Areas

W. Scott Frame, Michael Padhi, Lynn Woosley

This paper estimates that credit scoring is associated with about a $3,900 increase in small business lending per sample banking organization, per low- and moderate-income (LMI) area served, and this effect is roughly equivalent to that estimated for higher-income areas. For our sample, this corresponds to a $536 million increase in small business credit in LMI areas in 1997 than otherwise would have been the case. This effect appears to be driven by increased out-of-market lending by banking organizations, as in-market lending generally declines. Overall, it does not appear that credit scoring has a disparate impact on LMI areas.

Keywords: credit scoring, small business lending, low-income, Community Reinvestment Act

Maturity and Corporate Loan Pricing

Aron A. Gottesman, Gordon S. Roberts

We investigate the relation between corporate loan spreads and maturity to test whether lenders are compensated for longer maturity loans (tradeoff hypothesis) or limit their exposure by forcing riskier borrowers to take short-term loans (credit-quality hypothesis). Earlier studies reject the tradeoff hypothesis. We use the LPC DealScan database to create a matched sample of pairs of loans to the same borrower on the same day holding credit quality constant. We perform mean of difference tests and cross-sectional and regression analyses, and find evidence supporting both the tradeoff and credit quality hypotheses.

Keywords: bank, borrower, loan, contract terms

When Are Commercial Loans Secured?

John S. Gonas, Michael J. Highfield, Donald J. Mullineaux

We analyze the factors that influence the decision to secure a commercial loan. We find evidence that variables reflecting adverse selection, moral hazard, and the prospects for default all affect the likelihood a loan will be collateralized. We find no evidence in favor of the predictions of certain theoretical models that high-quality firms signal by providing collateral. Our results also show that lenders with less risk protection in the form of equity capital are more likely to require collateral, but that banks themselves are less likely to secure loans than nonbanks. Certain loan characteristics also influence the collateralization decision.

Keywords: secured loans, collateral, credit risk, information asymmetry, moral hazard

Noninterest Income and Financial Performance at U.S. Commercial Banks

Robert DeYoung, Tara Rice

Noninterest income now accounts for over 40% of operating income in the U.S. commercial banking industry. This paper demonstrates a number of empirical links between bank noninterest income, business strategies, market conditions, technological change, and financial performance between 1989 and 2001. The results indicate that well-managed banks expand more slowly into noninterest activities, and that marginal increases in noninterest income are associated with poorer risk-return tradeoffs on average. These findings suggest that noninterest income is coexisting with, rather than replacing, interest income from the intermediation activities that remain banks’ core financial services function.

Keywords: banks, noninterest income, deregulation

Determinants of the Loan Loss Allowance: Some Cross-Country Comparisons

Iftekhar Hasan, Larry D. Wall

This paper analyzes the determinants of banks’ loan loss allowance for samples of U.S. banks and three non-U.S. samples: a group of 21 countries, Canada, and Japan. The model includes fundamental (or nondiscretionary) determinants of the allowance, such as nonperforming loans, and discretionary determinants, such as income before the loan loss provision. The results suggest that the loan loss allowance is sensitive to preprovision income in almost all samples. However, the results also suggest that some variables thought to reflect fundamental factors in U.S. analysis, such as net charge-offs, are not significant factors for non-U.S. banks.

Keywords: loan loss allowance, accounting standards, international banking, nonperforming loan, discretionary accruals

The Relative Cost Efficiency of Stock versus Mutual Thrifts: A Bayesian Approach

James M. Sfiridis, Kenneth N. Daniels

The relative cost efficiency of the mutual versus stock forms of ownership for thrifts has been a relevant issue in an era of deregulation and competition in the financial services industry. In this study, Bayesian- based Markov chain Monte Carlo (MCMC) resampling methods are used to solve a stochastic cost frontier model and effectively determine cost efficiencies for the stock and mutual thrift groups. We find a statistically significant difference between both the cost frontiers and the cost efficiencies of the two groups, with the stock group operating at the lower-cost point. Agency problems explain a significant portion of the cost efficiency difference. Capital structure differences, though not helping to explain differences in cost efficiency, do help to explain differences in cost structure and managerial attitudes toward risk.

Keywords: thrifts, cost efficiency, stochastic cost frontier, Gibbs sampler, data augmentation

Unpublished appendix

Closed-End Fund Discounts and Expected Investment Performance

Robert Ferguson and Dean Leistikow

This paper provides empirical support for the theory that closed-end fund discounts reflect expected investment performance. Evidence is presented to explain how equity closed-end fund initial public offerings (IPOs) can sell at a premium when existing funds sell at a discount and why the initial IPO premiums decay after the IPO. Relative premium decay data are presented. Tests on (a) the relation between relative premium changes and investment performance following IPOs, (b) relative premium mean-reversion following management changes, and (c) net redemptions following closed-end fund open-endings for funds trading at pre-open-ending announcement discounts individually support and collectively strongly support the theory.

Keywords: closed-end fund discounts, expected investment performance

Bank Mergers and Insider Nontrading

Tom Madison, Greg Roth, and Andy Saporoschenko

Insiders with nonpublic information that their firms are acquisition targets can profit by purchasing their firms’ stock or by delaying planned sales of their firms’ stock. Under current securities laws, insiders who execute the former strategy expose themselves to civil and criminal liability, whereas insiders who execute the latter strategy do not. Using a sample of bank mergers, we find that target bank insiders significantly decrease both share purchases and share sales before merger announcements. These findings suggest that securities laws effectively deter some forms of illegal insider trading and that insiders exploit opportunities to profit legally from nonpublic information.

Keywords: insider trading, commercial banks, mergers

The Pricing of Sequential Bank Loans

Manoj Athavale and Robert O. Edmister

The theory of financial intermediation assigns banks a unique role in the resolution of information asymmetry. Banks, in general, obtain private information about the borrower and the project during the screening of loan applicants and during the monitoring of loan recipients. Incumbent banks, in particular, utilize information obtained while monitoring previous loan extensions to resolve information asymmetry when granting subsequent loans. We examine the rate on a sequence of loans to a borrower and find that the incumbent bank information advantage has finite magnitude and is quickly reflected in the pricing of the second loan. We also find that the lending relationship does not deteriorate to the detriment of the borrower. This research also provides further evidence supporting the hypothesis that an incumbent bank resolves information asymmetry during the monitoring of loan extensions.

Keywords: loan pricing, sequential loans, monitoring, relationship lending

Specialists, Limit-Order Traders, and the Components of the Bid-Ask Spread

Kee H. Chung, Bonnie F. Van Ness, and Robert A. Van Ness

This study compares the components of the bid-ask spread estimated from quotes that reflect the trading interest of specialists with those estimated from limit-order quotes and all available quotes for a sample of NYSE stocks. The results show that the adverse selection component of the spread estimated from specialist quotes is significantly smaller than the corresponding figures from limit-order quotes and entire quotes. We interpret this as evidence that New York Stock Exchange specialists transfer at least a part of adverse selection costs to outsiders through the discretionary use of limit orders. Our results show that the estimation/ interpretation of the components of the spread using quote data that include both specialist and limit-order interests is problematic.

Keywords: limit order, bid-ask spread, NYSE specialists, spread components

To Trade or Not to Trade: The Effect of Broker Search and Discretionary Trading on Securities Market Performance

Wei Zhang, Jinliang Li, and Chunchi Wu

In this paper we examine the interaction of brokerage search with the Bayesian learning behavior of competitive dealers under asymmetric information. We particularly focus on the effects of price search and discretionary trading on the performance of a dealer market. A search process is incorporated into a model in which brokers determine their reservation price and whether to continue their trades. The model enables us to uncover the interrelationships among search cost, bid-ask spread, and price volatility. We show that both spread revision and price volatility are dependent upon the optimal search process, inventory fluctuation, and search cost. Furthermore, our model predicts a negative relationship between price volatility and liquidity trading volume.

Keywords: search, price dispersion, trading costs

Orange County Bankruptcy: Financial Contagion in the Municipal Bond and Bank Equity Markets

John M. Halstead, Shantaram Hegde, and Linda Schmid Klein

We examine the spillover wealth effects of the Orange County, California bankruptcy announcement in December 1994 on municipal bonds, municipal bond funds, and bank stocks. This bankruptcy is prominent because of unprecedented losses and because it was caused by a highly leveraged derivatives strategy rather than a shortage of tax revenues and excess spending. We find contagion in the bond market with significantly negative abnormal returns for municipal bond funds without direct exposure to Orange County and for non-Orange County municipal bonds. In addition, our findings suggest the contagion spills over to the common stocks of investment and commercial banks that deal in or use derivatives; however, the equities of banks unexposed to derivatives are not affected.

Keywords: municipal financing, contagion, derivatives, fixed income, bank equity

Who Benefits from Deregulating the Separation of Banking Activities? Differential Effects on Commercial Bank, Investment Bank, and Thrift Stock Returns

Kathy Czyrnik and Linda Schmid Klein

We analyze the deregulation impact on commercial banks, investment banks, and thrifts associated with four major events progressively integrating commercial and investment banking activities in the United States during the 1990s. We find that commercial banks are the only group to react favorably to Federal Reserve announcements relaxing firewalls and easing restrictions on commercial bank revenues from investment banking activities. These regulations primarily benefit large banks. The Bankers Trust acquisition announcement of investment bank Alex Brown is associated with increased wealth for each of the three types of financial service institutions. At the eventual deregulation of the financial services industry, with the passage of the Financial Services Modernization Act in 1999, the values of commercial banks and investment banks increase significantly although thrifts are not affected.

Keywords: banking, deregulation, wealth effects, Glass-Steagall, financial modernization, Gramm-Leach-Bililey Act, event study

The Puzzling Increase in the Underpricing of Seasoned Equity Offerings

Kenneth A. Kim and Hyun-Han Shin

Using a sample of over 3,000 seasoned equity offerings (SEOs) from 1983 to 1998, we test the hypothesis that the U.S. Securities and Exchange Commission’s Rule 10b-21, which disallows the covering of short positions with newly issued SEOs, makes pre-offer stock prices less informative, which, in turn, causes the new seasoned equity to be priced at discounts. Consistent with this hypothesis, we find that the year the rule went into effect coincides with the year from which we begin observing significant SEO discounts. Further, we also find that ex ante uncertainty and SEO discounts are positively related. We also conduct tests specifically related to short selling, and we also consider an exhaustive set of alternative explanations for the discounts. Based on all of the evidence, we conclude that it is the rule that makes issue discounts larger in the 1990s.

Keywords: seasoned equity offerings, underpricing, Rule10b-21, short sale

Mixed Messages: Open-Market Repurchases Following Stock Acquisitions

Jann C. Howell and Janet D. Payne

Management decisions and market reactions to those decisions do not occur in isolation. Despite this fact, little or no research has examined two events when they occur in a sequence, even when theory suggests that those two events convey opposite signals. We examine firms that do a stock-based acquisition then announce an open-market repurchase program. These two actions, according to signaling theory, signal conflicting valuation errors. This paper is the first to examine a sequence of events that convey seemingly conflicting signals. Among other results, we find that repurchasers who had previously made a stock-based acquisition have a less positive market reaction than do otherwise comparable repurchasers with no previous acquisition. These results indicate that the market reactions to events are tempered by previous information-releasing events.

Keywords: repurchases, acquisitions, managerial decision making

Equity Ownership and Firm Value: Evidence from Targeted Stock Repurchases

Saeyoung Chang and Michael Hertzel

In contrast to the negative average abnormal return associated with the announcement of a control-related targeted repurchase (greenmail transaction), we find that the announcement of a non-control-related targeted repurchase is associated with a positive and significant average abnormal return. Cross-sectional analysis indicates that the change in firm value at the announcement of a non-control-related targeted repurchase is negatively related to the resulting changes in both insider ownership and outside blockholdings. We also find significant differences in announcement-period stock price effects depending on the identity of the selling shareholder.

Keywords: targeted stock repurchases, managerial entrenchment, insider holdings, event study

Informed Trading Around Earnings Announcements: Another Look

Dennis J. Whalen and Charles D. Collver

This study is an empirical test of the Easley, O’Hara, and Srinivas (1998) multimarket sequential trade model of stock and option markets. We employ two approaches to determine the information content of signed stock and option trades executed around quarterly earnings announcements. The first approach expands the vector autoregression (VAR) technique of Hasbrouck (1991a) to include signed option trade volumes and inter-trade durations. Estimates from the VAR models provide insight into whether both equity and option trades are viewed as informative by the equity specialist. The second approach focuses on the information content of the earnings releases to determine whether signed equity and option trades executed prior to the announcements are informed. Results indicate that although informed traders prefer to transact in both markets around earnings announcements, option market transactions contain no incremental information.

Keywords: vector autoregression, lead-lag, informed trading, earnings announcements

Pricing Efficiency in a Thin Market with Competitive Market Makers: Box Spread Strategies in the Hang Seng Index Options Market

Joseph K. W. Fung, Henry M. K. Mok and Kenneth C. K. Wong

Using a box spread arbitrage strategy, we examine the pricing efficiency of the emerging, thinly traded Hang Seng Index options market in Hong Kong, where market makers operate under a competitive open outcry system. In 20 months of tick-by-tick bid/ask quotes we find very few arbitrage opportunities. Our examination of the reporting time of quotes shows that in effect, all the apparent mispricings are deceptive and could be explained by stale quotes. The absence of real arbitrage opportunities supports the pricing rationality hypothesis in the Hong Kong options market.

Keywords: box spread; price rationality; thin market; market makers; bid-ask quotes, limits to arbitrage

The Effect of Demand on Stock Prices: Evidence from Index Fund Rebalancing

Ernest N. Biktimirov

I examine the effect of demand on stock prices by analyzing the conversion of the TIPs 35 and TIPs 100 exchange-traded funds into the i60 Fund. This conversion occurred at the Toronto Stock Exchange on March 6, 2000. Forty stocks of the TIPs 100 Fund that were not members of the new units of the i60 Fund were sold to complete this conversion. I find that a decrease in demand produced a permanent stock price decline, which was accompanied by significant abnormal trading volume. The results provide support for the downward-sloping demand curve hypothesis.

Keywords: stock prices, trading volume, event study, stock indexing, mutual funds

An International Investigation of the Factors that Determine Conditional Gold Betas

Robert Faff and David Hillier

We investigate the unconditional and conditional gold betas of four country-based gold industry portfolios. First, we document the similarity of unconditional gold betas across countries. Second, we find that the factors affecting conditional gold betas are different in the Australian/South African gold sectors relative to their North American counterparts. Only the gold bullion return volatility shows a negative association with conditional gold betas in Australian and South African gold mining firms. Moreover, gold price does not appear to play a systematic role in determining Australian or South African conditional gold betas. We discuss possible explanations for these findings.

Keywords: Stock Price Exposures, Gold Beta, International Evidence

Governance and Performance Implications of Diversification Strategies: Evidence from Large U.S. Firms

Manohar Singh, Ike Mathur and Kimberly C. Gleason

Recent research focuses on explaining the diversification discount. However, there is little direct evidence regarding the relation among ownership structure, corporate governance, and corporate diversification. The results in this paper suggest that agency issues do not account for firms adopting a particular diversification strategy. Also, the performance consequences of the shift in the diversification strategy and the subsequent changes in institutional and block ownership structures are not related to agency issues. In fact, investors seem not to avoid diversified firms per se. We suggest that observed board and ownership differences between diversified and focused firms are due to their being at different stages of corporate evolution.

Keywords: diversification discount; diversification strategies; corporate governance; board of directors

Stock Returns and the Business Cycle

Michael DeStefano

This paper examines whether movements in economic factors dictated by the dividend discount model can explain broad movements in stock returns over the business cycle. As anticipated, stock returns decrease throughout economic expansions and become negative during the first half of recessions. Returns are largest during the second half of recessions, suggesting an important role for expected earnings. These results are consistent with the notion that expected stock returns vary inversely with economic conditions, yet suggest that realized returns are especially poor indicators of expected returns prior to turning points in the business cycle.

Keywords: stock, returns, determinants, business, cycle, conditions

The Impact of Regulation Fair Disclosure on Information Asymmetry and Trading: An Intraday Analysis

Chiraphol N. Chiyachantana, Christine X. Jiang, Nareerat Taechapiroontong and Robert A. Wood

This study examines the impact of Regulation Fair Disclosure (FD) on liquidity, information asymmetry, and institutional and retail investors trading behavior. Our main findings suggest three conclusions. First, Regulation FD has been effective in improving liquidity and in decreasing the level of information asymmetry. Second, retail trading activity increases dramatically after earnings announcements but there is a significant decline in institutional trading surrounding earnings announcements, particularly in the pre-announcement period. Last, the decline in information asymmetry around earnings announcements is closely associated with a lower participation rate in the pre-announcement period and more active trading of retail investors after earnings releases.

Keywords: Regulation Fair Disclosure, volatility, liquidity, adverse selection costs

Bank Loan Availability and Trade Credit Demand

Morris G. Danielson and Jonathan A. Scott

This paper investigates the effects of bank loan availability on the trade credit and credit card demand of small firms, using firm-level data from the 1995 Credit, Banks, and Small Business Survey, conducted by the National Federation of Independent Business. We find that firms increase their demand for trade credit and credit card debt when facing credit constraints imposed by banks. These results provide evidence of a pecking order of debt financing, where firms increase their reliance on potentially expensive sources of funds when bank loans are not available.

Keywords: small business, trade credit, credit availability

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