jofi_67_5_cover 9/6/12 8:27 AM Page VOL 67, No Vol 67 OCTOBER 2012 No Vol 67 CONTENTS for OCTOBER 2012 No ARTICLES JUSTIN MURFIN The Supply-Side Determinants of Loan Contract Strictness ALEX EDMANS, XAVIER GABAIX, TOMASZ SADZIK, and YULIY SANNIKOV Dynamic CEO Compensation AMAR GANDE and ANTHONY SAUNDERS Are Banks Still Special When There Is a Secondary Market for Loans? CHRISTINE A PARLOUR, RICHARD STANTON, and JOHAN WALDEN Financial Flexibility, Bank Capital Flows, and Asset Prices VINCENT GLODE, RICHARD C GREEN, and RICHARD LOWERY Financial Expertise as an Arms Race BART M LAMBRECHT and STEWART C MYERS A Lintner Model of Payout and Managerial Rents NICOLA CETORELLI and LINDA S GOLDBERG OCTOBER 2012 • PAGES 1565–1981 Banking Globalization and Monetary Transmission JOEL F HOUSTON, CHEN LIN, and YUE MA Regulatory Arbitrage and International Bank Flows BERNARD DUMAS and ANDREW LYASOFF Incomplete-Market Equilibria Solved Recursively on an Event Tree VICENTE CUÑAT, MIREIA GINE, and MARIA GUADALUPE The Vote Is Cast: The Effect of Corporate Governance on Shareholder Value MISCELLANEA ANNOUNCEMENTS jofi_67_5_cover 9/11/12 2:45 AM Page THE AMERICAN FINANCE ASSOCIATION Founded in 1940 Presidents of The American Finance Association OFFICERS President President Elect Vice President Executive Secretary and Treasurer Editor of the Journal of Finance SHERIDAN TITMAN, University of Texas, Austin ROBERT STAMBAUGH, University of Pennsylvania LUIGI ZINGALES, University of Chicago DUANE J SEPPI, Carnegie Mellon University KENNETH J SINGLETON, Stanford University BOARD OF DIRECTORS NICHOLAS BARBERIS MARKUS BRUNNERMEIER JOHN COCHRANE ROBERT MCDONALD LASSE PEDERSEN PAOLA SAPIENZA ANTOINETTE SCHOAR RAMAN UPPAL DIMITRI VAYANOS ANNETTE VISSING-JORGENSEN Yale University Princeton University University of Chicago Northwestern University New York University Northwestern University Massachusetts Institute of Technology London Business School London School of Economics Northwestern University THE JOURNAL OF FINANCE® Articles for The Journal of Finance must be submitted through our on-line submission system A link to the submission site can be found at http://www.afajof.org/journal/submission.asp Queries about the Journal are welcome through email (editor@jfinance.org) Style instructions for preparing manuscripts can be found in each issue of the Journal on one of the back pages and on the submission site A submission fee of $200 (for AFA members) and $250 (for non-members) must be paid by Visa, MasterCard, or American Express upon submission Members working in certain lowincome countries are permitted to pay lower fees (see AFA website for more information) The submission fee will be refunded if the editorial decision on a submission is rendered more than 100 days after receipt of the submission at the submission site Membership in the Association is available online at www.afajof.org Disclaimer: The Publisher, the American Finance Association and Editors cannot be held responsible for errors or any consequences arising from the use of information contained in this journal; the views and opinions expressed not necessarily reflect those of the Publisher, the American Finance Association and Editors, neither does the publication of advertisements constitute any endorsement by the Publisher, the American Finance Association and Editors of 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visit www.aginternetwork.org, www.healthinternetwork.org, www.oarescience.org Imprint Details: Printed in USA by The Sheridan Press Wiley’s Corporate Citizenship initiative seeks to address the environmental, social, economic, and ethical challenges faced in our business and which are important to our diverse stakeholder groups We have made a long-term commitment to standardize and improve our efforts around the world to reduce our carbon footprint Follow our progress at www.wiley.com/go/citizenship Aims and Scope: The Journal of Finance publishes leading research across all the major fields of financial research It is one of the most widely cited academic journals in finance and one of the most widely cited journals in all of economics as well Each issue of the journal reaches over 8,000 academics, finance professionals, libraries, government and financial institutions around the world Published six times a year, the Journal is the official publication of the American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics Address for Association Business: Duane Seppi, Journal of Finance, American Finance Association, Carnegie Mellon University, Tepper School of Business, 5000 Forbes Avenue, Pittsburgh, PA 15213 Email: ds64@andrew.cmu.edu Abstracting and Indexing Services: The Journal is indexed by ABI/Inform Global; Accounting Articles; Accounting and Tax Database; Expanded Academic ASAP; Business ASAP; Business Periodical Index; Business Source: Corporate; Business Source Elite; Business Source Plus; Business Source Premier; CatchWord; Corporate ResourceNet; Current Contents/Social & Behavioral Science; Current Contents Collections/ Business; e-jel; EBSCO Online; EconLit; Emerald Management Reviews; Environmental Sciences & Pollution Management; General Business File ASAP; Health and Safety Science Abstracts; InfoTrac College Edition; InfoTrac OneFile; Ingenta; International Bibliography of the Social Sciences; Journal of Economic Literature; JCR Social Sciences Edition; JSTOR; MAS Ultra/ Public Library Edition; OmniFile Full Text Mega Edition; ProQuest Accounting and Tax Database; Public Affairs Information Service International; Risk Abstracts; Safety Science & Risk Abstracts; Social Sciences Citation Index; Wilson Business Abstracts; Wilson Business Abstracts FullText; and Wilson OmniFile V Production Editor: Beetna Kim-Schissler (email: jofi@wiley.com) Advertising: For advertising information, please visit the journal’s website or contact the Journals Advertising Sales Representative, Kristin McCarthy, at kmccarthy@wiley.com ISSN 0022-1082 (Print) ISSN 1540-6261 (Online) Name Kenneth Field Chelcie C Bosland Charles L Prather John D Clark Inactive Inactive Harry G Guthmann Lewis A Froman Benjamin H Beckhart Neil H Jacoby Howard R Bowen Raymond J Saulnier Edward E Edwards Roland I Robinson Garfield V Cox Norris O Johnson Miller Upton Marshall D Ketchum Lester V Chandler James J O’Leary Paul M Van Arsdell Arthur M.Weimer Bion B Howard George T Conklin, Jr Roger F Murray George Garvy J Fred Weston Robert V Roosa Harry C Sauvain Walter E Hoadley Lawrence S Ritter Joseph Pechman Irwin Friend Sherman Maisel John Lintner Myron J Gordon Merton H Miller Term Affiliation Name 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 Carnegie Institute of Technology Brown University University of Texas University of Nebraska Northwestern University Russell Sage College Columbia University University of California, Los Angeles University of Illinois National Bureau of Economic Research Indiana University Northwestern University University of Chicago First National City Bank of New York Beloit College University of Chicago Princeton University Life Insurance Association of America University of Illinois Indiana University Northwestern University Guardian Life Ins Co of America Columbia University Federal Reserve Bank of New York University of California, Los Angeles Brown Brothers Harriman & Company Indiana University Bank of America New York University Brookings Institution University of Pennsylvania University of California, Berkeley Harvard University University of Toronto University of Chicago Alexander A Robichek Burton Malkiel Edward Kane William F Sharpe Franco Modigliani Harry Markowitz Stewart Myers James C Van Horne Fischer Black Robert Merton Richard Roll Stephen A Ross Michael J Brennan Myron S Scholes Robert H Litzenberger Michael C Jensen Mark E Rubinstein Sanford J Grossman Martin J Gruber Edwaurdo S Schwartz Hayne E Leland Edwin J Elton Hans R Stoll Franklin Allen George M Constantinides Maureen O’Hara Douglas W Diamond René M Stulz John Y Campbell Richard C Green Kenneth R French Jeremy Stein Darrell Duffie John Cochrane Raguram Rajan Sheridan Titman Term 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Affiliation Stanford University Princeton University The Ohio State University Stanford University Massachusetts Institute of Technology IBM Corporation Massachusetts Institute of Technology Stanford University Goldman Sachs & Company Massachusetts Institute of Technology University of California, Los Angeles Yale University University of California, Los Angeles Stanford University University of Pennsylvania Harvard University University of California, Berkeley University of Pennsylvania New York University University of California, Los Angeles University of California, Berkeley New York University Vanderbilt University University of Pennsylvania University of Chicago Cornell University University of Chicago The Ohio State University Harvard University Carnegie Mellon University Dartmouth College Harvard University Stanford University University of Chicago University of Chicago University of Texas, Austin Editors of American Finance and The Journal of Finance Name Term Kenneth Field Marshall D Ketchum Harold G Fraine Joel E Segall Harold G Fraine Lawrence S Ritter Dudley G Luckett Alexander A Robichek Jack M Guttentag Marshall E Blume Michael J Brennan Edwin J Elton and Martin J Gruber René M Stulz Richard C Green Robert F Stambaugh Campbell R Harvey Kenneth J Singleton 1942 August 1946–December 1955 January 1956–December 1958 January 1959–December 1960 January 1961–December 1963 January 1964–December 1966 January 1967–December 1970 January 1971–December 1973 January 1974–December 1976 January 1977–December 1979 January 1980–March 1983 March 1983–March 1988 March 1988–February 2000 March 2000–May 2003 June 2003–June 2006 July 2006–June 2012 July 2012– Affiliation Carnegie Institute of Technology University of Chicago University of Wisconsin University of Chicago University of Wisconsin New York University Iowa State University Stanford University University of Pennsylvania University of Pennsylvania University of British Columbia New York University The Ohio State University Carnegie Mellon University University of Pennsylvania Duke University Stanford University jofi_67_5_cover 9/6/12 8:27 AM Page THE AMERICAN FINANCE ASSOCIATION Founded in 1940 Presidents of The American Finance Association OFFICERS President President Elect Vice President Executive Secretary and Treasurer Editor of the Journal of Finance SHERIDAN TITMAN, University of Texas, Austin ROBERT STAMBAUGH, University of Pennsylvania LUIGI ZINGALES, University of Chicago DAVID H PYLE, University of California, Berkeley KENNETH J SINGLETON, Stanford University BOARD OF DIRECTORS NICHOLAS BARBERIS MARKUS BRUNNERMEIER JOHN COCHRANE ROBERT MCDONALD LASSE PEDERSEN PAOLA SAPIENZA ANTOINETTE SCHOAR RAMAN UPPAL DIMITRI VAYANOS ANNETTE VISSING-JORGENSEN Yale University Princeton University University of Chicago Northwestern University New York University Northwestern University Massachusetts Institute of Technology London Business School London School of Economics Northwestern University THE JOURNAL OF FINANCE® Articles for The Journal of Finance must be submitted through our on-line submission system A link to the submission site can be found at http://www.afajof.org/journal/submission.asp Queries about the Journal are welcome through email (editor@jfinance.org) Style instructions for preparing manuscripts can be found in each issue of the Journal on one of the back pages and on the submission site A submission fee of $200 (for AFA members) and $250 (for non-members) must be paid by Visa, MasterCard, or American Express upon submission Members working in certain lowincome countries are permitted to pay lower fees (see AFA website for more information) The submission fee will be refunded if the editorial decision on a submission is rendered more than 100 days after receipt of the submission at the submission site Membership in the Association is available online at www.afajof.org Disclaimer: The Publisher, the American Finance Association and Editors cannot be held responsible for errors or any consequences arising from the use of information contained in this journal; the views and opinions expressed not necessarily reflect those of the Publisher, the American Finance Association and Editors, neither does the publication of advertisements constitute any endorsement by the Publisher, the American Finance Association and Editors of the products advertised Copyright and Photocopying: © 2012 the American Finance Association All rights reserved No part of this publication may be reproduced, stored or transmitted in any form or by any means without the prior permission in writing from the copyright holder Authorization to photocopy items for internal and personal use is granted by the copyright holder for libraries and other users registered with their local Reproduction Rights Organisation (RRO), e.g Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the RRO This consent does not extend to other kinds of copying such as copying for general distribution, for advertising or promotional purposes, for creating new collective works or for resale Special requests should be addressed to: journalsrights@wiley.com Information for Subscribers: The Journal of Finance is published in six issues per year Institutional subscription prices for 2012 are: Print & Online FTE Small: US$418 (US), US$418 (Rest of World), €318 (Europe), £268 (UK) Print & Online FTE Medium: US$515 (US), US$515 (Rest of World), €388 (Europe), £331 (UK) Print & Online FTE Large: US$613 (US), US$613 (Rest of World), €461 (Europe), £393 (UK) Prices are exclusive of tax Asia-Pacific GST, Canadian GST and European VAT will be applied at the appropriate rates For more information on current tax rates, please go to www3.interscience.wiley.com/ aboutus/journal_ordering_and_payment.html#Tax The price includes online access to the current and all online back files to January 1st 1997, where available For other pricing options, including access information and terms and conditions, please visit www.interscience.wiley.com/journal-info Delivery Terms and Legal Title: Prices include delivery of print journals to the recipient’s address Delivery terms are Delivered Duty Unpaid (DDU); the recipient is responsible for paying any import duty or taxes Legal title passes to the customer on despatch by our distributors Back Issues: Single issues from current and recent volumes are available at the current single issue price from cs-journals@wiley.com Earlier issues may be obtained from Swets Backsets Service, P.O Box 810, 2160 SZ Lisse, The Netherlands, Tel: (+31) (0) 252 435 111, Fax: (+31) (0) 252 415 888, http://www.swets.nl/backsets Journal of Finance (ISSN 0022-1082), is published bimonthly on behalf of the American Finance Association by Wiley Subscription Services, Inc., a Wiley Company, 111 River St., Hoboken, NJ 07030-5774 Periodical Postage Paid at Hoboken, NJ and additional offices Postmaster: Send all address changes to Journal of Finance, Journal Customer Services, John Wiley & Sons Inc., 350 Main St., Malden, MA 02148-5020 Publisher: The Journal of Finance is published by Wiley Periodicals, Inc., Commerce Place, 350 Main Street, Malden, MA 02148; Tel: (781)388-8200; Fax: (781) 388-8210 Wiley Periodicals, Inc is now part of John Wiley & Sons Journal Customer Services: For ordering information, claims and any enquiry concerning your journal subscription please go to interscience.wiley.com/support or contact your nearest office Americas: Email: cs-journals@wiley.com; Tel: +1 781 388 8598 or +1 800 835 6770 (toll free in the USA & Canada) Europe, Middle East and Africa: Email: cs-journals@wiley.com; Tel: +44 (0) 1865 778315 Asia Pacific: Email: cs-journals@wiley.com; Tel: +65 6511 8000 Japan: For Japanese speaking support, Email: cs-japan@wiley.com; Tel: +65 6511 8010 or Tel (toll-free): 005 316 50 480 Further Japanese customer support is also available at www.interscience.wiley.com/support Visit our Online Customer Self-Help available in six languages at www.interscience.wiley.com/support Access to this journal is available free online within institutions in the developing world through the AGORA initiative with the FAO, the HINARI initiative with the WHO and the OARE initiative with UNEP For information, visit www.aginternetwork.org, www.healthinternetwork.org, www.oarescience.org Imprint Details: Printed in USA by The Sheridan Press Wiley’s Corporate Citizenship initiative seeks to address the environmental, social, economic, and ethical challenges faced in our business and which are important to our diverse stakeholder groups We have made a long-term commitment to standardize and improve our efforts around the world to reduce our carbon footprint Follow our progress at www.wiley.com/go/citizenship Aims and Scope: The Journal of Finance publishes leading research across all the major fields of financial research It is one of the most widely cited academic journals in finance and one of the most widely cited journals in all of economics as well Each issue of the journal reaches over 8,000 academics, finance professionals, libraries, government and financial institutions around the world Published six times a year, the Journal is the official publication of the American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics Address for Association Business: David Pyle, Journal of Finance, American Finance Association, University of California, Berkeley—Haas School of Business, 545 Student Services Building, Berkeley, CA 94720-1900 Email: pyle@haas.berkeley.edu Abstracting and Indexing Services: The Journal is indexed by ABI/Inform Global; Accounting Articles; Accounting and Tax Database; Expanded Academic ASAP; Business ASAP; Business Periodical Index; Business Source: Corporate; Business Source Elite; Business Source Plus; Business Source Premier; CatchWord; Corporate ResourceNet; Current Contents/Social & Behavioral Science; Current Contents Collections/ Business; e-jel; EBSCO Online; EconLit; Emerald Management Reviews; Environmental Sciences & Pollution Management; General Business File ASAP; Health and Safety Science Abstracts; InfoTrac College Edition; InfoTrac OneFile; Ingenta; International Bibliography of the Social Sciences; Journal of Economic Literature; JCR Social Sciences Edition; JSTOR; MAS Ultra/ Public Library Edition; OmniFile Full Text Mega Edition; ProQuest Accounting and Tax Database; Public Affairs Information Service International; Risk Abstracts; Safety Science & Risk Abstracts; Social Sciences Citation Index; Wilson Business Abstracts; Wilson Business Abstracts FullText; and Wilson OmniFile V Production Editor: Beetna Kim-Schissler (email: jofi@wiley.com) Advertising: For advertising information, please visit the journal’s website or contact the Journals Advertising Sales Representative, Kristin McCarthy, at kmccarthy@wiley.com ISSN 0022-1082 (Print) ISSN 1540-6261 (Online) Name Kenneth Field Chelcie C Bosland Charles L Prather John D Clark Inactive Inactive Harry G Guthmann Lewis A Froman Benjamin H Beckhart Neil H Jacoby Howard R Bowen Raymond J Saulnier Edward E Edwards Roland I Robinson Garfield V Cox Norris O Johnson Miller Upton Marshall D Ketchum Lester V Chandler James J O’Leary Paul M Van Arsdell Arthur M.Weimer Bion B Howard George T Conklin, Jr Roger F Murray George Garvy J Fred Weston Robert V Roosa Harry C Sauvain Walter E Hoadley Lawrence S Ritter Joseph Pechman Irwin Friend Sherman Maisel John Lintner Myron J Gordon Merton H Miller Term Affiliation Name 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 Carnegie Institute of Technology Brown University University of Texas University of Nebraska Northwestern University Russell Sage College Columbia University University of California, Los Angeles University of Illinois National Bureau of Economic Research Indiana University Northwestern University University of Chicago First National City Bank of New York Beloit College University of Chicago Princeton University Life Insurance Association of America University of Illinois Indiana University Northwestern University Guardian Life Ins Co of America Columbia University Federal Reserve Bank of New York University of California, Los Angeles Brown Brothers Harriman & Company Indiana University Bank of America New York University Brookings Institution University of Pennsylvania University of California, Berkeley Harvard University University of Toronto University of Chicago Alexander A Robichek Burton Malkiel Edward Kane William F Sharpe Franco Modigliani Harry Markowitz Stewart Myers James C Van Horne Fischer Black Robert Merton Richard Roll Stephen A Ross Michael J Brennan Myron S Scholes Robert H Litzenberger Michael C Jensen Mark E Rubinstein Sanford J Grossman Martin J Gruber Edwaurdo S Schwartz Hayne E Leland Edwin J Elton Hans R Stoll Franklin Allen George M Constantinides Maureen O’Hara Douglas W Diamond René M Stulz John Y Campbell Richard C Green Kenneth R French Jeremy Stein Darrell Duffie John Cochrane Raguram Rajan Sheridan Titman Term 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Affiliation Stanford University Princeton University The Ohio State University Stanford University Massachusetts Institute of Technology IBM Corporation Massachusetts Institute of Technology Stanford University Goldman Sachs & Company Massachusetts Institute of Technology University of California, Los Angeles Yale University University of California, Los Angeles Stanford University University of Pennsylvania Harvard University University of California, Berkeley University of Pennsylvania New York University University of California, Los Angeles University of California, Berkeley New York University Vanderbilt University University of Pennsylvania University of Chicago Cornell University University of Chicago The Ohio State University Harvard University Carnegie Mellon University Dartmouth College Harvard University Stanford University University of Chicago University of Chicago University of Texas, Austin Editors of American Finance and The Journal of Finance Name Term Kenneth Field Marshall D Ketchum Harold G Fraine Joel E Segall Harold G Fraine Lawrence S Ritter Dudley G Luckett Alexander A Robichek Jack M Guttentag Marshall E Blume Michael J Brennan Edwin J Elton and Martin J Gruber René M Stulz Richard C Green Robert F Stambaugh Campbell R Harvey Kenneth J Singleton 1942 August 1946–December 1955 January 1956–December 1958 January 1959–December 1960 January 1961–December 1963 January 1964–December 1966 January 1967–December 1970 January 1971–December 1973 January 1974–December 1976 January 1977–December 1979 January 1980–March 1983 March 1983–March 1988 March 1988–February 2000 March 2000–May 2003 June 2003–June 2006 July 2006–June 2012 July 2012– Affiliation Carnegie Institute of Technology University of Chicago University of Wisconsin University of Chicago University of Wisconsin New York University Iowa State University Stanford University University of Pennsylvania University of Pennsylvania University of British Columbia New York University The Ohio State University Carnegie Mellon University University of Pennsylvania Duke University Stanford University Vol 67 October 2012 Editor KENNETH J SINGLETON Stanford University No Co-Editors BRUNO BIAIS Toulouse School of Economics MICHAEL R ROBERTS University of Pennsylvania Associate Editors VIRAL ACHARYA New York University DANIEL PARAVISINI London School of Economics NICHOLAS C BARBERIS Yale University CHRISTINE A PARLOUR University of California, Berkeley NITTAI K BERGMAN Massachusetts Institute of Technology ´ L˘ UBOS˘ PASTOR University of Chicago PHILIP BOND University of Minnesota ALON BRAV Duke University DAVID A CHAPMAN Boston College MIKHAIL CHERNOV London School of Economics JENNIFER S CONRAD University of North Carolina GREGORY DUFFEE Johns Hopkins University ADLAI FISHER University of British Columbia THIERRY FOUCAULT HEC, Paris NICOLAE GAˆ RLEANU University of California, Berkeley ALEXANDER GUEMBEL Toulouse School of Economics WEI JIANG Columbia University CHRISTIAN T LUNDBLAD University of North Carolina HANNO LUSTIG University of California, Los Angeles RONI MICHAELY Cornell University DAVID K MUSTO University of Pennsylvania STEFAN NAGEL Stanford University MITCHELL A PETERSEN Northwestern University CHRISTOPHER POLK London School of Economics JOSHUA RAUH Stanford University DAVID T ROBINSON Duke University JEAN-CHARLES ROCHET University of Zurich PAOLA SAPIENZA Northwestern University ANTOINETTE SCHOAR Massachusetts Institute of Technology PHILIP E STRAHAN Boston College DAVID THESMAR HEC, Paris STIJN VAN NIEUWERBURGH New York University ANNETTE VISSING-JORGENSEN Northwestern University ANDREW WINTON University of Minnesota Business Manager DUANE SEPPI Carnegie Mellon University Assistant Editor WENDY WASHBURN HELP DESK The Latest Information Our World Wide Web Site For the latest information about the journal, about our annual meeting, or about other announcements of interest to our membership, consult our web site at http://www.afajof.org Subscription Questions or Problems Address Changes Journal Customer Services: For ordering information, claims and any enquiry concerning your journal subscription please go to www.wileycustomerhelp.com/ask or contact your nearest office Americas: Email: cs-journals@wiley.com; Tel: +1 781 388 8598 or +1 800 835 6770 (toll free in the USA & Canada) Europe, Middle East and Africa: Email: cs-journals@wiley.com; Tel: +44 (0) 1865 778315 Asia Pacific: Email: cs-journals@wiley.com; Tel: +65 6511 8000 Japan: For Japanese speaking support, Email: cs-japan@wiley.com; Tel: +65 6511 8010 or Tel (toll-free): 005 316 50 480 Visit our Online Customer Get-Help available in languages at www wileycustomerhelp.com Permissions to Reprint Materials from the Journal of Finance C 2012 The American Finance Association All rights reserved With the exception of fair dealing for the purposes of research or private study, or criticism or review, no part of this publication may be reproduced, stored or transmitted in any form or by any means without the prior permission in writing from the copyright holder Authorization to photocopy items for internal and personal use is granted by the copyright holder for libraries and other users of the Copyright Clearance 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University of California, Berkeley—Haas School of Business, 545 Student Services Building, Berkeley, CA 94720-1900 Telephone and Fax: (510) 642-2397; email: pyle@haas.berkeley.edu Volume 67 CONTENTS for OCTOBER 2012 No ARTICLES The Supply-Side Determinants of Loan Contract Strictness JUSTIN MURFIN 1565 Dynamic CEO Compensation ALEX EDMANS, XAVIER GABAIX, TOMASZ SADZIK, and YULIY SANNIKOV 1603 Are Banks Still Special When There Is a Secondary Market for Loans? AMAR GANDE and ANTHONY SAUNDERS 1649 Financial Flexibility, Bank Capital Flows, and Asset Prices CHRISTINE A PARLOUR, RICHARD STANTON, and JOHAN WALDEN Financial Expertise as an Arms Race VINCENT GLODE, RICHARD C GREEN, and RICHARD LOWERY A Lintner Model of Payout and Managerial Rents BART M LAMBRECHT and STEWART C MYERS Banking Globalization and Monetary Transmission NICOLA CETORELLI and LINDA S GOLDBERG 1685 1723 1761 1811 Regulatory Arbitrage and International Bank Flows JOEL F HOUSTON, CHEN LIN, and YUE MA 1845 Incomplete-Market Equilibria Solved Recursively on an Event Tree BERNARD DUMAS and ANDREW LYASOFF 1897 The Vote Is Cast: The Effect of Corporate Governance on Shareholder Value VICENTE CUN˜ AT, MIREIA GINE, and MARIA GUADALUPE 1943 MISCELLANEA 1979 ANNOUNCEMENTS 1981 THE JOURNAL OF FINANCE • VOL LXVII, NO • OCTOBER 2012 The Supply-Side Determinants of Loan Contract Strictness JUSTIN MURFIN∗ ABSTRACT Using a measure of contract strictness based on the probability of a covenant violation, I investigate how lender-specific shocks impact the strictness of the loan contract that a borrower receives Banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions from the current borrower The effects persist after controlling for bank capitalization, although bank equity compression is also associated with tighter contracts The evidence suggests that recent defaults inform the lender’s perception of its own screening ability, thereby impacting its contracting behavior JUST AS CREDIT VOLUMES have swung wildly over the past several years, the terms of loan contracts issued have been equally fickle Financial covenants requiring borrowers to maintain financial ratios within predetermined ranges were abandoned en masse during the easy credit period from 2002 to 2006 In the aftermath of 2008’s financial crisis, contracts swung the other way, with financial trip wires set such that lenders receive contingent control rights for even modest borrower deterioration Meanwhile, the effects of binding covenants on borrowers are substantial, ranging from limited access to otherwise committed credit facilities (Sufi (2009)) to increased lender influence over the real and financial decisions of the firm (Beneish and Press (1993), Chava and Roberts (2008), Nini, Smith, and Sufi (2009, 2011), Roberts and Sufi (2009a,b)).1 What drives variation in the strictness of the equilibrium loan contract? To date, the literature has focused primarily on the role of borrower characteristics in determining the degree of contingent control lenders receive Smith and ∗ Murfin is with Yale University I am particularly grateful to my dissertation chair, Manju Puri, for guidance and support This paper also benefited greatly from the suggestions of Mitchell Petersen (the acting Editor), two anonymous referees, Ravi Bansal, Alon Brav, Murillo Campello, Scott Dyreng, Simon Gervais, John Graham, Kenneth Jones, Andrew Karolyi, Felix Meschke, Adriano Rampini, David Robinson, Phil Strahan, Anjan Thakor, Vish Viswanathan, Andrew Winton, and seminar participants at Cornell University, Duke University, Drexel University, Kansas University, Notre Dame, NYU, University of Illinois, University of Utah, University of Virginia, Washington University, Yale University, the WFA, the NBER, and the FDIC Center for Financial Research I acknowledge financial support from the FDIC Center for Financial Research Firm investment, capital structure, cash management, merger activity, and even personnel have been linked to lender–borrower renegotiations following covenant violations 1565 1566 The Journal of Finance R Warner’s (1979, P 121) seminal discussion of covenants concludes that “there is a unique optimal set of financial contracts which maximize the value of the firm,” attributing covenant choice to the particular features of a given project The theory and evidence presented since strongly suggest that, on average, riskier firms receive contracts with stricter covenants (see Berlin and Mester (1992), Billett, King, and Mauer (2007), Rauh and Sufi (2010), Demiroglu and James (2010), among others) Instead, this paper examines the previously unexplored supply side of the borrower–lender nexus I ask, holding borrower risk fixed, how lenders impact the strictness of the equilibrium contract and what factors influence changing lender preferences for contingent control While there is a substantial collection of research documenting the ways in which various shocks to lenders influence credit availability (Bernanke and Gertler (1995), Peek and Rosengren (1997), Kang and Stulz (2000), Paravisini (2008), Lin and Paravisini (2011), for example), to date no paper that I am aware of has considered the effects of supply-side factors on the state-contingent nature of credit that banks offer In particular, I focus on the recent default experience of the lender as a potential shock to its contracting tendencies.2 This choice is motivated by a number of recent papers that strongly suggest that defaults to lender loan portfolios affect lending behavior at the defaulted-upon banks Chava and Purnanandam (2011), for example, provide evidence that banks with exposure to the 1998 Russian sovereign default subsequently cut back lending to their borrowers Berger and Udell (2004) link overall loan portfolio performance to the tightening of bank credit standards and lending volumes Finally, Gopalan, Nanda, and Yerramilli (2011) show that individual corporate defaults affect lead arranger activity in the syndicated loan market Taken together, these papers suggest that variation in lender default experience may provide a plausible source of supply-side variation in lender contracting choice as well As the basis of my analysis, I develop a new measure of loan contract strictness that approximates the probability that the lender will receive contingent control via a covenant violation Applying this new strictness measure to DealScan loan data, I find that banks tend to write tighter contracts than their peers after having suffered defaults to their own loan portfolios, holding constant borrower risk and controlling for time effects This result is robust to a number of alternative specifications In particular, by considering only defaults occurring in unrelated industries and/or in distinct geographic areas from the current borrower, I rule out the possibility that a default by one borrower informs undiversified lenders about the risk of other potential borrowers The evidence would suggest, for example, that a default by a high tech firm in California impacts the contract offered to a mining company in West Virginia by way of their common lender These lender effects are economically large For the average borrower, a one-standard-deviation increase in defaults to a lender’s portfolio induces contract tightening roughly equivalent to what a Defaults refer to payment defaults and not technical defaults on the contract such as covenant violations The Supply-Side Determinants of Loan Contract Strictness 1567 borrower could expect to receive following a downgrade in its own long-term debt rating What drives lenders to tighten contracts? I explore two distinct hypotheses The first hypothesis is that tightening is a result of depletion of bank capital mechanically associated with borrower defaults If capital shocks influence a lender’s contracts but are also correlated with recent defaults, then any analysis that excludes capital may suffer from an omitted variable bias In addition to investigating bank capital effects, I consider a second hypothesis, namely, that banks use recent defaults to update beliefs regarding their own screening ability The theoretical predictions as to how a lender’s contracts might be influenced by its capital position are mixed On the one hand, limited liability for bank shareholders may induce gambling when the bank is undercapitalized As a result, banks may write looser contracts with larger losses in bad states of the world in exchange for higher interest rates in good state of the world.3 Alternatively, the large costs associated with recapitalization may cause thinly capitalized banks to hedge against insolvency, writing tighter contracts as insurance in the event of borrower distress.4 Including bank capital controls in the benchmark specification helps shed light on the effect of capital on contracts, while simultaneously providing sharper inference on the effect of lender portfolio defaults The inclusion of controls for bank capital yields two noteworthy results First, the effect of recent lender default experience on contract terms persists, even after controlling for lender capitalization levels and changes Second, after partialling out the independent effect of defaults, bank capitalization seems to provide a second channel through which contract terms are influenced by lender effects Well-capitalized banks tend to write looser contracts, controlling for borrower risk, while contractions in bank equity are associated with stricter contracts The direction of the effect is consistent with undercapitalized banks behaving more conservatively to protect their remaining capital, or alternatively, with lenders who write risky contracts requiring additional capital cushion The evidence that defaults induce lenders to tighten their loan contracts, independent of their capital position, suggests that contract strictness may depend on information content in the defaults Yet, if the prior tests have adequately controlled for borrower characteristics and macroeconomic risk, then the information content in defaults must pertain to the lender itself I explore one particular variant of this lender learning hypothesis that banks find defaults to their own portfolios informative about their ability to screen risky borrowers A large number of defaults, for example, may lead bank managers to update their beliefs regarding the effectiveness of credit scoring models, the abilities of their loan officers, or the adequacy of bank policies Conditional on Bradley and Roberts (2004) find evidence of a trade-off between covenants and interest rates Zhang (2009), for example, shows that stricter covenants improve recovery rates in the event of borrower default 1568 The Journal of Finance R poor borrower screening, the bank may reasonably write stricter contracts to compensate for their uncertainty regarding borrower risk Tighter covenants provide the lender with the option to restructure contracts or reduce credit availability as information about borrower risk is revealed, effectively substituting stronger ex post monitoring for weaker ex ante screening If defaults inform the lender about its own screening ability, then defaults on the most recently originated loans will be the most informative In contrast, the performance of loans originated in the distant past (or “legacy loans”) will be made less meaningful by employee turnover and institutional changes to credit policy that occur over time Consistent with these predictions, I find that banks are considerably more sensitive to defaults on recently originated loans than to defaults on older and less informative legacy loans Of course, in the syndicated loan market, defaults may also inform participant banks about the lead arranger’s screening ability (see, e.g., Gopalan, Nanda, and Yerramilli (2011)) Because loan participants rely upon the lead arranger to vouch for the borrower’s creditworthiness, they may require tighter contracts from the lead arranger to compensate for reputational damage due to defaults Drucker and Puri (2009), for example, show that lenders use tighter covenants as a substitute for reputation in the secondary loan market Yet I find that covenants in bilateral loans (loans not intended to be sold to other banks by the lender) are equally, if not more, sensitive to the lender’s recent default experience than are covenants in syndicated loans, indicating that the importance of the lender’s reputation in the secondary loan market may be limited In the final section of the paper, I address the question of why borrowers accept stricter contracts and the resulting increased lender intervention when their own risk is unchanged Going back to Smith and Warner’s claim that “there is a unique optimal set of financial contracts which maximize the value of the firm,” one would expect that, in a frictionless bank market, unaffected lenders would step in to provide the borrower’s “optimal” contract As a result, contracts that deviate from this idealized contract will not be observed by the econometrician Bank–borrower relationships, however, are sticky In practice, borrowers are often best served by a small, close-knit circle of relationship banks and not by a perfectly competitive mass of investors Petersen and Rajan (1994, 1995) argue that smaller bank groups provide lenders the opportunity to collect rents from future business, thereby facilitating upfront borrower-specific investments required to resolve information asymmetries Empirically, attempts to increase the breadth of lender relationships increase the price and reduce the availability of credit (Petersen and Rajan (1994, 1995), Cole (1998)) Yet dependence on a smaller group of lenders is a double-edged sword Evidence from Slovin, Sushka, and Polonchek’s (1993) event study around Continental Illinois Bank’s failure and subsequent rescue suggested that borrowers without other bank relationships or access to bond markets were more exposed to their lender’s risk Detragiache, Garella, and Guiso (2000) also argue that The Vote Is Cast 1963 0.01 0.008 Diff in excess returns between Pass and Fail in [-5;+5] interval 0.006 0.004 0.002 -11 -9 -7 -5 -3 -1 11 13 15 17 19 21 23 25 27 29 -0.002 Day relaƟve to meeƟng date -0.004 -0.006 Figure Day-by-day difference in excess returns, vote share in [−5;+5] interval The yaxis measures the difference in daily excess returns between proposals that pass by a close margin [up to +5%] and proposals that are rejected by a close margin [up to −5%] The x-axis shows the different days before and after the vote (date is the day when the vote is passed) Table V Column displays the effect of passing a proposal on the meeting date (t), the day after (t + 1), and over the t + to t + period We find that most of the effect (1.3% abnormal return) is on the day of the vote, when the surprise around the threshold occurs The following days yield an additional return of 1.2%, suggesting that there is no reversal of the effect While this 1.2% is not statistically significant, the total cumulative effect after week (2.4%) is significant at the 10% level Given the difference in precision between the two estimates, throughout the paper we favor the 1.3% 1-day return as our more conservative but more precisely estimated coefficient of the market response to passing a proposal Column shows similar results using a different model to compute the daily abnormal returns (a standard one-factor market model instead of the three-factor Fama–French with momentum that we use in the rest of the analysis) Overall, we find that, most of the effect on prices occurs on the day of the vote In column 3, we further explore what happens on that day by allowing for a more flexible specification of the effect of the number of votes on daily returns (recall that the model in expression (7) sums over the votes of the day to aggregate over all the different outcomes) Here, we allow for different dummy variables for the number of proposals that passed, with a maximum of six proposals passing in a given meeting day We find that the effect is monotonically increasing and approximately linear in the number of proposals Therefore, the linearity assumption in the model in Section II.B.2 seems appropriate (the effect of passing one proposal is 1.3%, similar to our baseline estimate; passing two proposals yields a 2.2% abnormal return; three and four proposals yield 1964 The Journal of Finance R Table V Abnormal Returns of Passing Governance Proposals This table presents the effect of passing a proposal on abnormal returns on the meeting date (t) and on the day after (t+1) and the cumulative effect from t+2 to t+7 The dependent variable in columns 1, 3, and is abnormal returns computed using the Fama–French and momentum factors (FFM) from Carhart (1997); in columns and it is abnormal returns computed using the market model (MM) In column 6, it is a dummy variable for whether abnormal returns are positive or negative Column allows for six different dummy variables to capture the number of proposals (one to six) that passed at the meeting Columns 4, 5, and allow for a separate effect of antitakeover proposals (labeled as G-index proposals) and “Other” governance proposals The specification in all columns is given by equation (7) All columns control for year fixed effects, firm-meeting fixed effects, and distance-to-the-election effects; standard errors in parentheses are clustered by firm Significance at the 10%, 5%, and 1% levels is indicated by ∗ , ∗∗ , and ∗∗∗ , respectively Abnormal Returns FFM (1) Day of vote, t One day later, t+1 Days t+2 to t+7 MM (2) 0.002 (0.004) 0.010 (0.006) 11,884 0.002 2,377 0.013∗∗ (0.005) 0.022∗∗ (0.010) 0.046∗∗∗ (0.017) 0.046∗∗ (0.022) 0.071∗∗ (0.030) 0.115∗∗∗ (0.031) 11,884 0.002 2,377 Two votes passed Three votes passed Four votes passed Five votes passed Six votes passed Observations R2 Number of firm-meetings 11,884 0.005 2,377 FFM (4) G-index FFM (3) 0.013∗∗ 0.014∗∗∗ (0.005) (0.005) 0.002 0.004 (0.004) (0.004) 0.010 0.007 (0.006) (0.007) Day of vote, t One vote passed Abnormal Returns G-index versus Other MM (5) G-index 0.014∗∗ 0.013∗ (0.007) (0.007) One day later, t+1 −0.001 0.000 (0.006) (0.006) Days t+2 to t+7 0.011 0.010 (0.009) (0.009) Other Other Day of vote, t 0.009 0.012∗∗ (0.006) (0.006) One day later, t+1 0.007 0.011∗ (0.005) (0.005) Days t+2 to t+7 0.004 −0.000 (0.008) (0.010) Day of vote, t 11,884 0.005 2,377 11,884 0.007 2,377 Positive Ret (6) G-index 0.156∗∗ (0.070) 0.074 (0.073) 0.064 (0.073) Other 0.002 (0.113) 0.173 (0.110) −0.113 (0.106) 11,884 0.007 2,377 a total of 4.6% returns, etc.) The effect is significant even when a single proposal is passed, that is, there is no critical number of successful proposals in a meeting necessary to obtain substantial returns Columns and allow for a different effect of the two kinds of proposals: the set of antitakeover provisions included in the G-index and the set of Other proposals Among these Other (non-G-index) proposals, the ones that fall more frequently around the discontinuity are proposals to increase board independence from management and proposals to expense stock options (see the Appendix) We find that most of the effect is driven by antitakeover proposals— in particular, by proposals to repeal a classified board and to eliminate poison The Vote Is Cast 1965 pills This is partly because there are more G-index proposals that fall around the discontinuity, so we can estimate them more precisely This also reflects the fact that G-index proposals are thought to have a potentially greater impact in insulating managers to pursue their private goals However, we also find positive, albeit somewhat smaller and less precisely estimated, effects of other kinds of proposals, which have received less attention in the literature Finally, we replace abnormal returns with a dummy variable that indicates whether the returns were positive or negative This estimate ignores the magnitude of abnormal returns but is less sensitive to the presence of outliers Column shows that, on the day of the vote, G-index proposals that passed by a small margin were 16% more likely to lead to a positive abnormal return than those that failed by a small margin In sum, we find that there is a significant 1.3% average price reaction to proposals that pass by a small margin relative to those that fail by a small margin.18 We argue that the regression discontinuity design allows us to obtain a causal estimate that is not driven by omitted variables or unobserved firm characteristics In Section IV.C below, we study the long-term effects of these votes to assess the evidence on different possible explanations for the positive price reaction A.2 Heterogeneous Effects of Governance Proposals The previous section provides an estimate of the average effect of passing a governance proposal However, it is likely that firms with different characteristics may have different quantitative responses to passing a governance proposal In this section, we study whether the effect of passing a governance proposal is different in different types of firms and when governance provisions matter more One would expect that firms with large institutional shareholders (who are among the most active ones) might respond differently from firms with low institutional ownership Column of Table VI reproduces the analysis of Table V, restricting the sample to firms with above-median concentration of the top five institutional owners We find that they respond more to passing a provision than firms with more dispersed ownership In particular, column of Table VI shows that passing a G-index shareholder proposal in concentrated-ownership firms elicits a 2.1% abnormal return on the day of the meeting, with a further cumulative return of 2.1% in the days after the meeting The cumulative effect after week in firms with concentrated ownership is 1.76 times the effect for the whole sample This may reflect that these firms are more closely monitored and therefore the proposal is more likely to be implemented It may also reflect that the value of these provisions is higher for these firms, suggesting that governance proposals and monitoring are complements In column 2, we 18 This is a large and significant effect, in contrast with the generally small or insignificant results found when using the mailing date as an event study (see Gillan and Starks (2000), Thomas and Cotter (2007)) 1966 The Journal of Finance R Table VI Abnormal Returns and Firm Heterogeneity This table presents the effect of passing a proposal on abnormal returns on the meeting date (t) and on the day after (t+1) and the cumulative effect from t+2 to t+7 for different subsamples of firms The dependent variables in all columns are abnormal returns computed using the Fama–French and momentum factors from Carhart (1997) Column includes firms with above-median ownership concentration (percentage controlled by the top five institutional owners); column includes firms with 10 or more antitakeover provisions (above-median G-index) before the meeting; column includes firms with above-median R&D/assets Columns to allow for a separate effect of antitakeover proposals (labeled as G-index proposals) and Other governance proposals Column uses the whole sample and allows for a separate effect of proposals by individual and institutional/activist shareholders The specification in all columns is given by equation (7) All columns control for year fixed effects, firm-meeting fixed effects, and distance-to-the-election effects; standard errors in parentheses are clustered by firm Significance at the 10%, 5%, and 1% levels is indicated by ∗ , ∗∗ , and ∗∗∗ , respectively G-index versus Other High Ownership Active Concentration Sharehold (1) (2) Day of vote, t G-index One day later, t+1 G-index Days t+2 to t+7 G-index Day of vote, t Other One day later, t+1 Other Days t+2 to t+7 Other Observations R2 Number of firm-meetings 0.021∗∗ (0.010) 0.002 (0.008) 0.019∗ (0.010) 0.009 (0.008) 0.012∗ (0.007) 0.004 (0.011) 5,919 0.016 1,184 0.025∗∗ (0.010) 0.004 (0.007) 0.010 (0.011) 0.012 (0.009) 0.015∗ (0.008) −0.008 (0.012) 2,579 0.046 516 Proponents High G-Index (3) High R&D (4) Activist Proponent (5) 0.019∗∗ (0.009) 0.001 (0.007) 0.023∗∗ (0.011) 0.018∗ (0.010) 0.005 (0.010) 0.005 (0.013) Institutional 0.010 (0.010) 0.008 (0.011) 0.008 (0.015) 5,704 0.012 1,141 0.008 (0.009) 0.012 (0.008) −0.006 (0.012) 4,320 0.017 864 Individuals Institutional Institutional Individuals Individuals 0.021∗∗ (0.008) 0.007 (0.006) 0.015∗∗ (0.008) 0.008 (0.007) −0.001 (0.006) 0.005 (0.010) 11,819 0.005 2,364 restrict the sample to firms that have been exposed to some degree of activist shareholder pressure We proxy for shareholder pressure using the number of prior shareholder proposals (i.e., had two or more shareholder-sponsored proposals in the previous two meetings) and find that, in those firms, the effect of passing a G-index proposal is quite high at 2.5% on the day of the meeting We also analyze whether the identity of the proponent is related to the price response to passing a proposal Some proposals are introduced by wellestablished activist funds or institutional shareholders, while others are put forth by individuals We might expect larger effects for institutional activists’ proposals if they more accurately reflect the needs of the firm and are also more likely to be implemented Column separately evaluates the effect of passing for proposals by two different groups of proponents: proposals by individuals The Vote Is Cast 1967 (which constitute around 50% of the sample) and proposals by institutional activists (these include pension funds, investment funds, companies, and other institutional shareholders) We find that institutional activists’ proposals have higher effects, with an abnormal return of 2.1% on the day of the vote and a further 2.2% over the following days For individual proponents, the cumulative effect after week is just 1.1%, and it is not statistically different from zero It is also important to determine if there is a critical number of provisions that shield the firm against external discipline The value of removing an antitakeover provision may be different in firms with many provisions in place relative to those with few, which are already relatively unprotected Column shows the effect of passing a proposal for firms with more than 10 (median) G-index provisions in place on the day of the meeting We find that those firms benefit more from the removal of takeover barriers In particular, passing a G-index shareholder proposal yields a 1.9% abnormal return on the day of the vote and a further 2.4% abnormal return over the following days The cumulative effect after week is 6.6%, that is, 2.64 times the effect for the whole sample Antitakeover provisions seem to be more effective when bundled together with many others In contrast, when firms are already relatively unprotected from takeovers, dropping a further provision has a more modest impact on governance The previous analysis shows that, on average, passing a proposal that improves shareholder rights increases shareholder value However, it is possible that excessive shareholder rights could lead managers to focus excessively on the short run at the expense of the long run (Stein (1988)) If this were the case, firms in which long-run investments are important might respond negatively to these governance proposals We proxy for the long-term nature of firms’ investment by their R&D expenditures Column estimates our basic model for firms with an above-median R&D-to-assets ratio prior to the meeting We find that the effect for these firms (1.8%) is, if anything, larger than the result for the whole sample (1.3%), indicating that there is no different response regarding this dimension of long-run investments The change in abnormal returns due to changes in the governance structure is also positive for these firms The regression discontinuity estimate is the weighted average effect across all firms and proposals, where more weight is given to those votes in which a close election was expected (Lee and Lemieux (2010)) In our case, as we mention earlier, the elimination of staggered boards and poison pills represents 68% of G-index proposals falling around the discontinuity, implying that those proposals have a bigger weight in the identification In terms of how much one can extrapolate the results of our analysis to other firms, one must take into account the fact that, within listed firms, those that are larger, less profitable, and have a higher level of institutional ownership tend to be targeted by shareholder proposals more often (Karpoff, Malatesta, and Walkling (1996), 1968 The Journal of Finance R Romano (2001)).19 However, within the set of firms that are the target of a proposal, we know from Section III that there are no systematic differences between firms on either side of the threshold, which means there is no evidence of selection into treatment A.3 Implementation and the Probability of Passing Future Proposals Ertimur, Ferri, and Stubben (2010) show that the average probability that a proposal that passes will be implemented is 31.1% For proposals that are closer to the threshold, the probability of implementation after passing increases by 20.7%.20 While data on whether each proposal in our sample was implemented are not publicly available, we know how the value of the G-index changes over time for most firms in our sample The G-index is the number of antitakeover provisions in place at a point in time We can evaluate how it responds to the passage of a provision at the discontinuity This serves as a proxy for the net effect on implementation of passing a proposal that incorporates not only the direct effect of passing the particular issue voted on, but also effects on other proposals being passed and implemented—both contemporaneously and in the future Column of Table VII shows the effect of passing a governance proposal on the G-index The index is available only every years Hence, the first coefficient is the effect on the first year available after the focal meeting (this can be between and years after the meeting, depending on when the vote occurred relative to the G-index years), and the second coefficient is years later, etc We find that the probability of implementation increases discretely around the discontinuity Thus, proposals that pass by a small margin are substantially more likely to be implemented relative to those that fail Passing a proposal reduces the G-index by 0.313, which we interpret as a 31.3% probability of removing an antitakeover provision within years That number grows in subsequent years, and within years the probability is 50% This indicates, among other things, that when a proposal is passed but not implemented, shareholders are likely to propose it again.21 19 In the Internet Appendix, we display firm characteristics across different samples We see that the sample of firms with close-call votes is relatively similar to the S&P 1500: book-tomarket, return on equity, and cash flow over assets are not statistically different While differences in return on assets and capital expenditures are statistically significant, they are economically small, at 0.8% and 0.3%, respectively In addition, in the Internet Appendix we show that firms with observations around the discontinuity are not “extreme” observations, but rather firms with average characteristics in terms of institutional ownership and Tobin’s Q 20 They estimate that the probability of implementation from proposals that obtain 50% to 60% of the vote in favor is 23.9% The probability that a proposal that failed will be implemented is 3.2% We obtain 20.7% as the difference between the two See Table I, panel D and footnote in Ertimur, Ferri, and Stubben (2010) 21 Passing a governance proposal in a given meeting is also likely to affect the probability of submitting and passing other proposals in the future In an earlier version, we estimate these dynamic effects in our data and find that passing G-index proposals makes it more likely that other proposals will be passed in the future (unreported) The Vote Is Cast 1969 Table VII Effect of Passing a Governance Proposal on the G-index Column shows the effect of passing a governance proposal on the number of antitakeover provisions in place at the firm (the G-index) The index is provided by Riskmetrics every years The first coefficient (Year of vote, t) is the effect of passing a proposal on the G-index for the first year available in Riskmetrics that is at least months after the meeting; the second coefficient is the effect years after that, etc Column allows for six different dummy variables to capture the number of proposals (one to six) that passed at the meeting The specification in all columns is given by equation (7) All columns control for year fixed effects, firm-meeting fixed effects, and distance-to-the-election effects; standard errors are clustered by firm Significance at the 10%, 5%, and 1% levels is indicated by ∗ , ∗∗ , and ∗∗∗ , respectively G-index Year of vote, t Two years later, t+2 Four years later, t+4 Six years later, t+6 (1) (2) −0.313∗∗∗ (0.102) −0.329∗∗ (0.150) −0.503∗∗ (0.229) −0.507 (0.389) −0.329∗∗ (0.149) −0.505∗∗ (0.228) −0.511 (0.389) Year of vote, t One vote passed −0.336∗∗∗ (0.108) −0.581∗∗∗ (0.217) −0.744∗∗ (0.318) −1.828∗∗∗ (0.589) −2.393∗∗∗ (0.562) Two votes passed Three votes passed Four votes passed Five votes passed Observations R2 Number of firm-meetings 9,386 0.044 2,198 9,386 0.045 2,198 B The Value of a Governance Proposal In the previous section, we find that passing a provision increased shareholders’ returns on the day of the vote by 1.3% This is our estimate of Z, as defined in Section I.B However, the observed abnormal return does not fully reflect the value from implementation; rather, it corresponds to the change in the expectation of the proposal being implemented and the additional effect on the submission and implementation of future governance proposals In order to recover the actual value of a proposal (W ) using expression (2), we need to know (i) the probability that the provision will be implemented if passed, and (ii) the probability that other proposals will be passed and implemented in the future 1970 The Journal of Finance R We use the G-index results from Table VII as a proxy for implementation to estimate the value of the proposal to the firm We show that passing a proposal reduces the number of G-index provisions by 0.31 We also find that years later, the probability of passing and implementing is p 1.6% higher ( pt+2 =0.329−0.313), and years after that, it is 17.4% higher p ( pt+4 =0.503−0.329), etc With these probabilities in hand and assuming a discount rate of 5%, we can use expression (1) to recover the value of a provision to the firm We estimate that one provision generates an increase of 2.8% in market value This is a lower bound for the effect of implementing a governance proposal that only takes into account the 1-day market reaction Using the less conservative 1-week cumulative returns as our estimate for the market response (2.4%) would imply a value of implementing one proposal of up to 5.1% Solving for Z in expression (1), one can also show that two-thirds of the effect is due to contemporaneous factors and one-third to dynamic considerations.22 A 2.8% increase in shareholder value per provision translates into approximately U.S.$600 million for the average firm in the sample (average market value is U.S.$22,400 million in 1996 U.S dollars) This is an economically sizeable effect, especially when we consider the fact that firms often drop several provisions in subsequent meetings Dropping 2.5 provisions (one standard deviation of the G-index in the sample) translates into a nonnegligible predicted increase in market value of 7% These estimates can be benchmarked against the 8.5% annualized return that Gompers, Ishii, and Metrick (2003) report when going long on the democratic portfolio and short on the dictatorship portfolio over the 1990 to 1998 period Their result requires the strong assumption that the value of good governance was not fully understood in 1990 (otherwise the initial prices of both portfolios should have already reflected the value of governance) and that it was at least partially discovered during this period, either explicitly or implicitly, by observing the performance of different firms Even under the assumption that the importance of antitakeover provisions was fully discovered between 1990 and 1998, using our results we would have only predicted an annualized return between 2.6% and 4.3%.23 C Long-Run Effects of Governance In this final section, we evaluate the effect of passing a governance proposal on long-term firm outcomes Evaluating these real effects is important for determining why the firm’s market value increases following an improvement in shareholder rights and, in particular, following the removal of antitakeover 22 The abnormal return of 1.3% on the day of the vote can be decomposed, using equation (1), into 0.86% due to changes in governance within year of the vote and 0.44% due to subsequent changes 23 The difference in average provisions between both portfolios is 9.4 The 2.6% return is obtained using our preferred (most conservative) estimate of 2.8% per provision This implies a 26.3% return over years The 4.3% is obtained using the full weekly returns with an implied value of a provision of 5.15% The Vote Is Cast 1971 provisions The increase in market value could simply reflect that the increased probability of a takeover may lead to a takeover premium It could also result from an improvement in internal governance and managerial discipline.24 This would be the case if weak shareholder rights provided substantial protective power to standing managers (e.g., by insulating them from the takeover market), causing additional agency costs in the form of inefficient investments, reduced operational efficiency, and/or private benefits All regressions in Table VIII use the empirical model in expression (7) to estimate the effect of passing a governance proposal on a number of long-term outcomes and to distinguish between the effects of antitakeover and Other proposals.25 Columns 1, 2, and examine, respectively, whether the number of acquisitions made by a firm, the growth of capital expenditures, and the bookto-market ratio change significantly in the years following the improvement in shareholder rights.26 One way in which improved governance can affect performance is through the reduction in unnecessary acquisitions, investments, and capital-expenditures growth We compute the number and value of firm acquisitions from the SDC database, which records all transactions of at least 5% of market value We find that removing an antitakeover provision reduces the number of acquisitions made in the years following the vote (column 1) This effect is long-lived and exhibits interesting dynamics The number falls by 0.03 the year after the vote, 0.17 two years later, and 0.18 three years later (only this last coefficient is significant though).27 Column shows that the growth of capital expenditures also seems to decline after a vote to eliminate G-index provisions These results suggest a less aggressive growth policy for better-governed firms and give support to empire building, excessive size, and free cash flow problems as manifestations of poor governance For other types of provisions the effect is reversed, and capital expenditures actually increase a few years after the vote, but this is subject to the limitations of the data for those proposals at long durations mentioned earlier Finally, we find some long-term performance improvements following these exogenous changes in governance Column of Table VIII shows that the book-to-market ratio of the 24 We tested directly (unreported) whether the proposals had an effect on the probability of being taken over using firm delisting information from CRSP Firms that pass more proposals are more likely to be acquired but we find no significant difference around the discontinuity in takeover probabilities However, conclusively establishing this result would require a separate analysis given the relatively low frequency of such events and given that the endogenous change in manager behavior will reduce observed takeover probabilities 25 To avoid the effect of outliers, for each column of Table VIII we restrict the sample to firmvotes that not have any observation in the top or bottom 5% of the distribution of the dependent variable The results are not sensitive to this particular outlier cutoff but are sensitive to the inclusion of outliers 26 Since we are looking at effects up to years after the vote, we cannot estimate the long-run effects for proposals at the end of the sample This is particularly problematic for Other proposals because they are more frequent toward the end of the sample Our very demanding identification in terms of data requirements (fixed effects, clustering, discontinuity) is bound to yield larger standard errors 27 We find a similar pattern for the value of these acquisitions (see the Internet Appendix) 1972 The Journal of Finance R Table VIII Long-Run Effects of Governance Proposals This table presents the effect of passing a governance proposal on firm long-term outcomes The specification in all columns is given by equation (7) All columns allow for a separate effect of antitakeover proposals (labeled as G-index proposals) and Other governance proposals The dependent variables are: the number of acquisitions in column 1, the growth rate of capital expenditures in column 2, and book-to-market value of the firm in column See notes to Table II for further sources and definitions Standard errors in parentheses are clustered by firm Significance at the 10%, 5%, and 1% levels is indicated by ∗ , ∗∗ , and ∗∗∗ , respectively Year of meeting, t G-index One year later, t+1 G-index Two years later, t+2 G-index Three years later, t+3 G-index Four years later, t+4 G-index Year of meeting, t Other One year later, t+1 Other Two years later, t+2 Other Three years later, t+3 Other Four years later, t+4 Other Observations R2 Number of firm-meetings 1,797 Acquisitions Count (1) Capex Growth (2) Book-to-Market (3) −0.00102 (0.120) −0.0305 (0.102) −0.166 (0.109) −0.180∗ (0.108) 0.166 (0.134) 0.0384 (0.122) 0.135 (0.132) 0.316 (0.223) 0.248 (0.214) 0.500∗∗ (0.253) 11,384 0.022 1,524 −0.0797 (0.0541) −0.117∗∗ (0.0577) −0.0411 (0.0664) −0.00382 (0.0671) −0.0922 (0.0648) 0.114 (0.0832) 0.0161 (0.106) 0.157 (0.103) 0.464∗∗∗ (0.144) 0.664∗∗ (0.257) 6,501 0.027 1,817 −0.0172 (0.0270) −0.0255 (0.0337) −0.0648∗ (0.0342) −0.0970∗∗∗ (0.0362) −0.0941∗∗ (0.0419) −0.0607∗∗ (0.0254) −0.107∗∗ (0.0436) 0.00972 (0.0724) −0.0266 (0.0447) 0.0444 (0.101) 9,120 0.024 firm falls significantly as a result of passing the governance proposals (both G-index and Other) Given that the abnormal returns seem to be linear in the number of provisions passed (Table V, column 3), we also check whether the real effects reported in this section also follow a linear pattern The results (reported in the Internet Appendix) show a linear pattern of real effects This is further evidence that links both effects The Internet Appendix provides additional long-term results Overall, we find that, as a result of the removal of antitakeover provisions, acquisitions and capital expenditures fall and firm valuation increases in the long-run, which provides evidence of dynamic effects of governance well beyond the year the proposal passed In contrast, there is little effect on earnings (see also the Internet Appendix) Although some of these effects are imprecisely estimated, this suggests that the abnormal returns that we identify in The Vote Is Cast 1973 earlier sections as a result of governance improvements lead to actual changes in managers’ actions Furthermore, if one is willing to interpret the marginal acquisitions and capital expenditures as value-destroying and a way in which managers extract private benefits (e.g., through empire building), then our evidence suggests that corporate governance proposals that remove antitakeover provisions increase shareholder value through disciplining management and a reduction in agency costs V Conclusion In this paper, we present novel evidence on the causal effect of corporate governance provisions on firms’ market value and long-term performance We adapt the regression discontinuity design to the analysis of event studies and apply it to the outcomes of votes on governance proposals in shareholder meetings Firms that pass a proposal by a close margin are ex ante similar to those that reject it by a close margin Hence, passing a provision is “locally” exogenous, leading to a discrete increase in the probability of implementation This approach provides a causal estimate and overcomes the endogeneity problems that have affected the literature thus far Our empirical strategy allows us to recover an estimate of the effect of governance even if, prior to the vote, the market had already incorporated the probability of passing the shareholder proposal into stock prices This is because proposals that fell around the majority threshold were, ex ante, the most uncertain, in which case investors could not perfectly predict whether they would pass It is for these proposals that we are able to observe a price reaction This strategy allows us to interpret our results as causal, overcoming the limitations of the existing literature We show that, on average, the market reacts to the passage of a governancerelated shareholder proposal with positive abnormal returns of around 1.3% on the day of the vote This reflects an increase in market value of 2.8% per implemented proposal We identify some heterogeneity of this reaction, with the effect being more pronounced among firms with concentrated ownership, high preexisting antitakeover provisions, high R&D expenditures, and stronger shareholder pressure, and for proposals made by institutional shareholders rather than by individuals However, while positive, the magnitude of our estimated effects is between one-third and one-half of the estimates in Gompers, Ishii, and Metrick (2003) Firm behavior also changes with new governance structures Dropping antitakeover provisions leads to lower investments and fewer acquisitions Finally, the long-term performance of the firm, measured using Tobin’s Q or bookto-market ratios, improves after or years when antitakeover provisions are dropped; nevertheless, we find modest results with respect to return on equity Our analysis also uncovers interesting dynamic effects Passing a governance proposal affects the chance of dropping a provision both now and in the future In terms of shareholder returns, two-thirds of the effect is associated with contemporaneous provision changes and one-third with future ones The real 1974 The Journal of Finance R effects associated with governance changes are also dynamic, with some effects materializing up to years after a proposal passes As a whole, our results suggest that changing the internal corporate governance in targeted firms is rewarded by the market—with more pronounced effects for proposals to remove antitakeover provisions These changes also yield performance improvements in the long run The evidence indicates that the channels behind these improvements include more conservative investment and acquisition policies A better understanding of the effect of governance provisions and the magnitude of the agency problem is crucial to guiding the public debate on the adequacy of implementing and regulating corporate governance Our results provide causal evidence that the value of improving governance inside firms is sizeable Our results also shed light on the potential role of shareholder activism in improving the governance of firms and creating value In particular, our evidence suggests that shareholder activism and improved democracy inside firms can have large positive effects on shareholder value Appendix Description of All Shareholder Proposals (Rismetrics 1997 to 2007) Discontinuity Type Description Proposal Audit Limit consulting by auditors Shareholder approval of auditors Rotate auditor Board Separate chairman/CEO Majority independent directors Commit to/report on board diversity Limit director tenure Independent nominating committee Increase key committee independence Allow union/employee reps on the board Increase compensation committee independence Minimum director stock ownership Independent compensation committee Lead director Shareholder advisory committee Increase audit committee independence Create nominating committee Observations Mean Vote For # –5, +5 # –10, 10 59 224 89 60 20.1 48.0 5.3 28.2 26.1 16.7 2 15 5 33 54 24 6.3 25.7 2 15 19.0 0 11 7.7 0 10 35.1 7.6 0 18.8 0 4 24.4 10.2 19.5 0 0 24.7 0 Frequ 68 520 (Continued) The Vote Is Cast 1975 Appendix—Continued Discontinuity Type Description Proposal Compensation Link pay to performance/ recoup bonuses Award performance-based stock options Expense stock options Link executive pay to social criteria Disclose executive compensation Advisory vote on compensation Misc compensation Cap executive pay Add performance criteria to equity-based awards Restrict director compensation Approve/disclose/limit SERPs Pay directors in stock Restrict nonemployee director pensions Pension fund surplus reporting Require equity awards to be held No repricing underwater stock option Approve executive compensation Hire independent compensation consultant G-Index Repeal classified board G Delay G Other Redeem or vote poison pill G Voting Cumulative voting G Protection Vote on future golden parachutes Eliminate supermajority G Voting provision Remove antitakeover G Other provisions & other Confidential voting G Voting G Delay Shareholders may call special meeting G Protection Compensation plans G Other Adopt antigreenmail G Protection Maximum director liability G Voting Require only majority vote Observations Mean Vote For # –5, +5 # –10, 10 371 16.0 12 21 114 23.6 17 112 109 50.1 8.2 39 68 59 11.5 53 41.5 14 33 42 35 31 25.6 8.0 34.4 10 12 29 9.6 0 24 35.6 23 14 11.8 31.1 0 14 33.6 12 27.5 0 11 31.6 4 31.3 39.9 549 355 273 152 57.5 57.7 31.5 44.4 116 77 22 19 219 132 49 56 109 62.7 16 32 42 41.4 39 25 52.7 56.5 16 3 18.7 30.7 15.5 50.1 0 0 Frequ 1,061 1,558 (Continued) 1976 The Journal of Finance R Appendix—Continued Discontinuity Type Description Proposal Other Study sell company Miscellanea Double board nominees Change annual meeting location Reincorporate to U.S state Change annual meeting date Affirm political nonpartisanship Vote on targeted share placement Issue postmeeting report Opt out of state takeover statute Disclose prior government service Improve postmeeting report Restore preemptive rights Nominee statement in proxy Majority vote to elect directors Majority vote shareholder committee No discretionary voting Counting shareholder votes Equal access to proxy Voting Observations Mean Vote For # –5, +5 # –10, 10 162 138 43 20 15.8 14.5 8.1 6.0 0 0 15 12 25.5 4.4 0 7.2 0 42.4 3 5.5 46.6 0 3.2 0 6.6 0 1 27.5 9.1 0 0 206 45.9 56 115 128 15.9 11 14.8 15.4 22.0 0 0 Frequ 416 356 REFERENCES Agrawal, Ashwini K., 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Secured Number of participants Number of lead arrangers Mean 2 2,0 20 3,5 15.27 1 8,3 05 0.12 2 0,0 91 3.07 10th 50th 1 1,9 93.31 0.13 10. 77 51.71 0.03 0.28 599.86 0.12 1.28 8,2 68.60 0.23 6.04 SD 90th 2 2,7 89 0.43 0.50 0.00 0.00 1.00 9,8 13 1 5,0 55 12.87 3.62 3.67 4.67 8.00 0.97 13.00 2.83 17.00 6.55 2 0,9 42 2 2,7 75 2 2,7 89 2 2,7 89 2 2,7 89 49.06 349.08 0.49 6.65 1.18 289.52 1,0 16.78 0.50 9.02 0.52 12.00 10. 00 0.00 1.00... update their beliefs regarding the abilities of their loan officers, the adequacy of bank policies and procedures, or the effectiveness of credit scoring models at identifying borrower risk Udell (1989 ), for example, finds evidence that banks monitor the continuing quality and performance of their loan portfolio (the so-called loan review function) as a means to monitor the performance of their loan officers... between the observed ratio and the minimum allowable ratio (or the negative of the difference in the case of a maximum ratio ), both taken in natural logs for the following reported covenants: minimum EBITDA to debt, current ratio, quick ratio, tangible net worth, total net worth, EBITDA, fixed charge coverage, interest coverage, maximum debt to equity, debt to tangible net worth, and capital expenditure These... secured, the log of deal maturity (in months ), the log of deal amount, and the log of the number of bank participants, although The Supply-Side Determinants of Loan Contract Strictness 1581 Table III Contract Strictness and Recent Defaults Panels A and B present borrower fixed effects regressions of loan strictness as described in Section I (ranging from zero to 100 ), on the number of defaults in the. .. repeat the analysis with two alternative measures, namely, the number of financial covenants and, for loans with a net worth or tangible net worth covenant, the slack of that covenant at the time of issuance scaled by total assets Neither measure does well in comparison The number of financial covenants is not significant in any of the specifications The slack of the net worth covenant has the correct... collateral, and number of participants, as well as time dummies Following Nini, Smith, and Sufi’s suggestion, I only consider new violations, excluding violations in which the borrower had a prior violation in any of the subsequent four quarters.12 The results, presented in Table I, confirm that the new measure has a strong association with the probability of a violation For the sake of comparison, I repeat... papers provide varied measures of covenant strictness that reflect 1570 The Journal of Finance R this sentiment (see, e.g ., Bradley and Roberts (2004 ), Billett, King, and Mauer (2007 ), Drucker and Puri (2009 ), Dyreng (2009 ), Demiroglu and James (2 010) ) My goal is to provide a measure that captures the intuitive properties from each of these Four desirable properties of any strictness measure jump out... the level of the ultimate parent (see below) Note that these choices are not critical to the main result of the paper, which can be reproduced by treating each bank office as a separate lender or, alternatively, by aggregating all wholly owned subsidiaries under the ultimate parent 14 The Internet Appendix is available on the Journal of Finance website at http://www afajof.org/supplements.asp The Supply-Side... Finally, I also report the characteristics of lead lenders for the sample loans Lenders have average (median) total assets of $589.79 billion ($450.56 billion ), mean (median) capitalization of 7.51% (7.77% ), 15 For the subsample of DealScan loans reporting both mandate and closing dates, the timing is only slightly longer, with a mean (median) time in market of 89 (63) days 1578 The Journal of Finance