The program on corporate finance.

• Author: Baker, Malcolm
• Position: Program Report

Narrowly interpreted, corporate finance is the study of the investment and financing policies of corporations. Because corporations are at the center of economic activity, the causes and consequences of corporate finance--and hence the research activities of the program--touch almost every aspect of micro- and macroeconomics, allowing the center of gravity to shift from the narrow concerns of corporate managers.

The NBER Program on Corporate Finance recently completed its 25th year. In his first program report, the founding director, Robert Vishny, described corporate finance as "institutionally oriented, with research often driven by issues of current importance" and the program's empirical studies as "motivated by relevant, applied theory." (1) Back then, the takeover and restructuring wave of the late 1980s was salient; soon afterwards, in the mid-1990s, it was cross-country comparisons of legal systems, governance, enforcement, and financial development, often with implications for emerging institutions in the transitional economies of Eastern Europe and the former Soviet Union. The phenomena were studied with firm-level, market, and institutional data, and with then-novel empirical technologies. Notably, these included event studies and the quasi-experimental analysis of colonial legal origins. The applied theoretical lens was, for the most part, agency problems arising from the separation of ownership and control.

The influence of "issues of current importance" remains as apparent now as in the program's first report. The defining moment for corporate finance over the past decade has been the financial crisis of 2008. Broadly speaking, our program's research has found its greatest impact in exploring the role of credit cycles, the fragility of financial institutions, the behavior of households, and the associated macroeconomic consequences. A boom and bust in credit conditions, stretched bank balance sheets, and contagious defaults in the mortgage market were the proximate causes of the crisis, and the consequences were macroeconomic. So, credit markets, financial institutions, and household finance, including their macroeconomic and regulatory implications, are the current centers of activity among NBER researchers in corporate finance. Traditional topics of corporate investment and financing are receiving less attention. In some ways, this brings the program--which emerged from the NBER Financial Markets and Monetary Economics program, which was founded in the late 1970s and divided into Asset Pricing, Corporate Finance, and Monetary Economics in 1991--back to its roots.

New empirical tools also have emerged. Techniques have been imported from labor economics and other fields. For example, NBER researchers exploit discontinuities in policy, which generate fruitful natural experiments, and design randomized controlled trials in partnership with firms, government agencies, and nongovernmental organizations. The rising demand for empirical rigor in identifying policy-relevant causal mechanisms has meant a microempirical shift, with the study of household financial products, for example, serving as an auspicious lamppost. At the same time, structural estimation of theoretical models is often used to tease out the macroeconomic implications of microempirical insights.

The program's empirical studies are grounded in a wider range of "relevant, applied theory." The seminal work of Merton Miller and Franco Modigliani, approaching its 60th anniversary, continues to be the organizing framework for understanding the market imperfections that allow finance to create or destroy value: whether in firms, as the authors originally intended, or more broadly in households, financial institutions, and the macroeconomy. Agency and information problems remain central imperfections, with a recent focus on conflicts of interest along the chain from savers to household borrowers; so do the costs of financial distress, fire sales, and the fragility of shortterm financing, experienced on a systemic scale with the 2008 failure of Lehman Brothers.

In a new trend, affiliates of the program have become increasingly attentive to behavioral factors, frequently delving into the role of bias in households, managers, investors, and, ultimately, markets. Traditional theoretical lenses and new behavioral ones are at the forefront of research that could help mitigate the effect of the past crisis and inform macroprudential regulation for lowering the probability of a sequel. In that sense, the organizing frameworks and the research output of the NBER Program on Corporate Finance have proven robust, relevant, and sometimes central in fields that are outside the program's narrow mandate.

In particular, corporate finance has played a key role in enhancing traditional macro models, some of which were narrowly focused on a single policy instrument. Tweaking the federal funds rate without completely understanding its mechanism proved effective when the global economic engine required routine maintenance. But the economic breakdown of the financial crisis revealed limitations of the New Keynesian models. Without an explicit modeling of the financial sector, these models were less useful for restarting the engine. In contrast, the corporate finance toolkit proved essential in analyzing the alphabet soup of the Troubled Asset Relief Program (TARP), Quantitative Easing (QE), Home Affordable Refinance Program (HARP), and many other regulatory interventions.

This program report moves from small to large, from individuals to institutions to markets, and their influence on the macroeconomy. Regulation perhaps deserves a separate section, but I have opted instead to embed the discussion of regulatory analysis in context throughout. Each topic could fill an entire report, and there are far too many papers to mention. I will cite only a few recent NBER working papers in each area, with my sincere apologies to those I have missed, to earlier foundational work, and to related work outside of the program.

Individuals

The Corporate Finance program now places more emphasis on individual actors than it did in the past. These include household borrowers, who account for the majority of bank loans in the form of mortgages and credit card balances; household savers and investors, who provide bank and corporate funding; household financial advisers, who provide guidance; and, of course, corporate managers, but with a focus not just on their function in allocating capital, but also on their identities and beliefs.

Starting with borrowers, Hong Ru and Antoinette Schoar show how credit card companies use a combination of salient teaser interest rates and back-end fees located in the fine print to design solicitations to appeal to unsophisticated households. (2) Ex ante contract design of this type can have ex post consequences: Benjamin Keys, Tomasz Piskorski, Amit Seru, and Vincent Yao show how households respond to resets in adjustable mortgage rates, with the newfound liquidity lowering default, increasing new car consumption financed with auto debt, as shown in Figure 1, and, for credit-constrained households, reducing high-cost credit card debt. (3) This suggests a channel for transmission of monetary policy.

Moving to savers, Adriano Rampini and S. Viswanathan develop a theory of household risk management that helps to explain why poorer households bear the brunt of macroeconomic fluctuations, and perhaps also helps explain their demand for safe securities. (4) Safety may be in the eye of the beholder: Nicola Gennaioli, Andrei Shleifer, and Vishny; and Pedro Bordalo, Gennaioli, and Shleifer, emphasize the possibility that savers and investors neglect subtle risks, leading to the manufacture and sale of securities that load up on subtle, unappreciated risks, deliver the illusion of safety, and eventually undermine the stability of the financial system as previously neglected risks are revealed. (5) Consistent with risk neglect, Jeffrey Wurgler and I; Rudiger Fahlenbrach, Robert Prilmeier, and Rene Stulz; as well as Matthew Baron and Wei Xiong find that higher risk and less well-capitalized banks with faster loan growth earn lower average returns. (6)

Households also invest in risky securities. Here, the salience of past returns replaces apparent safety and risk neglect. Bordalo, Gennaioli, and Shleifer (7) develop a model built on Daniel Kahneman and Amos Tversky's (8) representativeness heuristic to illustrate how investors extrapolate recent history. Itzhak Ben-David, Justin Birru, and Viktor Prokopenya, (9) in retail foreign exchange markets, and Robin Greenwood and Shleifer, (10) in investor expectations data, provide corroborating evidence. Investors increase risk-taking in response to their own past performance, despite the fact that past performance is not predictive: Surveys of investor expectations are both positively correlated with past returns and negatively correlated with future returns and ex ante proxies for future returns, such as the dividend-price ratio. Extrapolative expectations are a plausible driver of credit- and equity-market-driven business cycles.

In principle, financial advisers should help unsophisticated households navigate borrowing, saving, and investing decisions. However, Sendhil Mullainathan, Markus Noeth, and Schoar show that advisers tend not to de-bias their clients; instead they endorse return-chasing behavior and steer clients toward funds with high fees. (11) Mark Egan, Gregor Matvos, and Seru go further, documenting a high rate of misconduct among financial advisers. (12) Even when fired from their institutions, sanctioned advisers are reemployed at high rates by firms that disproportionately serve unsophisticated retail clients.

The lack of sound professional advice points to the potential importance of financial literacy education; decision support with mandated presentation of relevant facts and...