Department of Finance and Financial Markets Group Conference to mark the 25thAnniversary of the Financial Markets Group
By John C.F. Kuong
On the 26th and 27th of January 2012 the Financial Markets Group and Department of Finance at ÐÓ°ÉÂÛ̳ organised a two-day conference to celebrate the 25th Anniversary of the foundation of the Group. Over 100 past and current members of the Group, as well as past Steering Committee members joined the founding Chairman, Sir David Walker, and the Founding Directors, Sir Mervyn King and Charles Goodhart, to recall the Group's history. The event consisted of a two day conference and a dinner.
Prior to the dinner, Christopher Polk introduced Sir David Walker and Sir Mervyn King who both spoke about the early days of the Group with candour and humour. After the dinner David Webb and Charles Goodhart discussed the early days and more recent history of the Group.
The conference involved presentations from a range of mainly past members of the Group who had travelled from all over the world to attend the event. The papers presented were selected to reflect the breadth and depth, as well as the chronology of the Group's history and mainly drew upon the contribution of some of the younger members. Over the two days nine papers were presented and at the end of the first day Charles Goodhart chaired a lively panel discussion on Financial Regulation and proposals to change the regulatory landscape.
Christopher Polk (Director of FMG) introduced the conference with a warm welcome to all the attendees. He thanked the members present for their enthusiasm shown in attending the event and nearly all offering to present papers. He noted that we could only select some of the excellent range of papers offered for presentation and remarked that the broad scope and high quality of the papers on the programme were a reflection of the success of the FMG. He concluded the opening remarks by thanking Sir David Walker, Charles Goodhart and Sir Mervyn King for their initiative in founding the FMG 25 years ago.
The first session of the conference was chaired by Dimitri Vayanos (ÐÓ°ÉÂÛ̳) with presentations by Andrea Caggese (UPF) and Guillaume Plantin (Toulouse). Andrea's paper co-authored with Anders Perez (UPF) another past member of the Group entitled 'Aggregate Implications of Financial and Labor Market Frictions' developed a general equilibrium model with both financial and labour market friction and demonstrated that the precautionary behaviour for firms and households due to uncertainty is an amplifying mechanism for financial shocks. Andrea illustrated how the mechanism works and quantified its impact through a careful calibration exercise. A lively discussion ensued as to the economic significance of the results claimed in the paper.
The second paper in this session presented by Guillaume Plantin was on 'Inequality, Tax Avoidance, and Financial Instability'. Guillaume presented a theoretical model of how the increasing returns to tax avoidance can induce risk-averse middle class agents to take on financial risks. He showed that this can lead to more extreme income distributionand went on to show that election pressure may lead incumbent politicians to encourage this kind of risk taking. Finally by interpreting the results from excessive risk-taking as financial instability, he remarked that this model demonstrated how financial instability can be affected by external factors outside the financial system.
The second session, chaired by Jean-Charles Rochet (Toulouse) included presentations by Claudia Custodio (Arizona State) and Gilles Chemla. (Imperial College London). Claudia's paper entitled 'The Declining Corporate Debt Maturity: the Impact of Asymmetric Information and New Listings', presented evidence about the general decrease in corporate debt maturity for US industrial firms from 1976 to 2008, whilst the decrease varies significantly across firms. She then provided an analysis on the potential drivers of this decrease in debt maturity and found that it is mainly driven by the shorter debt maturity of new listings. She showed that firms with higher information asymmetry are the main drivers, whereas agency costs, signalling and liquidity risk theories do not seem to have contributed to the decrease.
Gilles Chemla presented 'Equilibrium Security Design and Liquidity Creation by Privately-Informed Issuers'. The paper uses a security design framework to show how the information sensitivity of securities is co-determined with the degree of market liquidity and market mis-pricing. Having done this he showed that this inefficiency can be ameliorated by government's provision of public liquidity, which also crowds-in private liquidity.
The final session of Day One was a panel discussion on banking regulation moderated by Charles Goodhart. Charles asked each of the four panellists to give brief presentations and then opened the discussion to the audience. Each of the panellists was asked to discuss one or two principal regulatory reforms that they would make in the light of the financial crisis, to improve the workings of the financial system.
Dirk Schoenmaker (Duisenberg School of Finance) focussed on the importance of Macro-prudential regulations which he felt needed to address cross-border banking issues and problems of free-riding more effectively. Thomas Gehrig (Universitat Wien) focussed on the Basel process and in particular on the capital requirements. He argued that banks need to hold more equity and that the rules needed to reduce opportunities for strategic manipulation. He questions the economic rationale for subsidising bank debt via tax shield, in particular if bank leverage leads to financial instability and the associated social costs. Vittoria Cerasi (Universita degli Studi di Milano-Bicocca) argued that executive compensation, capital regulation and risk management are intricately linked, so when drafting regulation policy regulators should consider them together. She suggested that in order to reduce bank executives' incentive to take excessive risk, their compensation schemes need to be more aligned with stakeholders including creditors and tax payers, not just shareholders. Furthermore, the role of internal governance and in particular the role of the chief risk officer needs further evaluation. Finally, Rafael Repullo (CEMFI) offered a critical assessment of the Basel III proposals and argued that more standard economic reasoning should be incorporated in future proposals. He argued that the elephant in the room is proper economic analysis. He provided an analysis showing that the pro-cyclical effect of capital regulation has not been mitigated as banks' self-reporting on risk-weighted asset measures are subject to manipulation. Moreover the threat of regulatory capture stemming from regulators' discretion has not been addressed in the current proposal.
Charles Goodhart concluded the panel discussion with three remarks. First, he believed the key problem in the Basel discussion of capital requirement is that there is no common understanding of what the appropriate capital buffer should be to absorb negative shocks and to mitigate risk-taking incentives of bank executives. Second, there is no effective mechanism to impose penalties on banks which reach minimum requirements. He concurred with Rafael that the Basel proposals would benefit from more rigorous economic scrutiny and requested economists to do more work and engage more actively in advisory capacities.
Day two opened with a session chaired by Patrick Bolton (Columbia University) and presentations by Fausto Panunzi (Bocconi), Christian Hellwig (Toulouse University) and Jan Bena (University of British Columbia). Fausto's paper on 'Legal Investor Protection and Takeovers', co-authored with Mike Burkart (Stockholm School of Economics), Denis Gromb (INSEAD) and Holger Mueller (NYU Stern School of Business), pointed out that the link between legal investor protection and efficiency has been studied before but little attention has been given to its effects on takeovers. He showed that in a multi-bidders context, strong Legal Investor Protection (LIP) facilitates efficient takeovers to take place, as LIP limits post-merger private benefit extraction by the bidder, thus allowing bidders to borrow more so that the outcome of the bidding contest is more likely to be determined by the efficiency gains of the merger, rather than the initial funding capacity of bidders. With this effect of LIP on funding capacity, he also provided an analysis of the optimal allocation of voting rights and sales of controlling blocks.
In the same session Christian Hellwig presented 'A Theory of Asset Prices based on Heterogeneous Information'. In this theoretical paper, he showed that noisy aggregation of dispersed information can result in a systematic departure of asset prices from the fundamental value arising from the dividend process, as the asset price depends upon the information of the marginal trader. He further showed that the sign of the departure depends upon whether the securities are exposed to upside or downside risks and this information friction can generate excess price variability and low return predictability. By applying this result, he illustrated how the classic Modigliani-Miller Theorem fails in general and security originators can maximise profits by selling equity and debt to different markets with different information frictions.
The final paper in this session was presented by Jan Bena who presented his work on 'Corporate Innovation Activity and Expected Returns'. The paper studies the impact of innovation on asset pricing. He first documented that firms with high relative shares of patents have lower expected returns than less innovative ones, as the innovation leaders tend to have a smaller loading on common risk factors (0.9 market beta verses 1.4). He then provided a theoretical model in a real option framework to show that when firms invest sequentially, the more technologically efficient firm is the leader and always has a lower common risk factor loading than the follower, as is consistent with the evidence.
The final session of the conference was chaired by Andrew Patton (Duke) and focussed on financial econometrics, with presentations by Enrique Sentana (CEMFI) and Dennis Kristensen (UCL). In his presentation entitled 'A Unifying Approach to the Empirical Evaluation of Asset Pricing Models', Enrique stated that the two main approaches in testing linear factor pricing model, namely regression and Stochastic Discount Factor (SDF) methods, typically yield different estimation results. In this paper he showed that single-step regression methods such as Continuously Updated General Method of Moments (CU-GMM), in contrast to standard two-step or iterated GMM procedures, can produce numerically identical values for the price of risk, pricing errors, Jensen's alphas and over-identifying restriction tests. Thus he argued that there is effectively a single method to empirically evaluate asset pricing models.
In the final presentation of the conference Dennis Kristensen presented his paper 'Smooth Filtering and Estimation of Stochastic Volatility Models Using High-Frequency Data'. The paper was motivated by the fact that dynamic stochastic models are widely used in economics but sometimes the state variables are not observable. Hence, estimating the likelihood of unobserved latent state variables is important but not easy. In this paper he proposed a novel Sequential Monte Carlo (SMC) method for maximum likelihood estimation (MLE) of dynamic latent variable models (DLVM). As opposed to traditional SMC algorithms, this novel method delivers a smooth likelihood approximation and thus allows MLE. He also reported an application of this new algorithm to continuous-time stochastic volatility models.
The conference concluded with a short vote of thanks and closing remarks from Patrick Bolton and final closure by Christopher Polk.
This event was generously sponsored by the ÐÓ°ÉÂÛ̳ Annual Fund and the Department of Finance