Research

Abstract:  We develop a theory of trust in lending that distinguishes between reputation and trust using a model uncertainty framework. We show that trust removes the link between performance and the cost and availability of financing for lenders, but trust can be lost and is difficult to re-gain. When trust is lost, it generates discontinuities in pricing and credit availability, but banks are better able to survive such an erosion of trust than non-banks. This trust advantage for banks arises from the lower cost of funding for banks due to deposits and has novel policy relevance for the optimal size and scope of deposit insurance.

Abstract: We examine optimal financing design for R&D-intensive firms developing new drugs. When firms raise external financing using equity, they underinvest in R&D. But when the set of contracts is augmented to include more general (non-linear) payoff schemes, options combined with equity financing, this underinvestment is reduced. We then use a mechanism design approach and show that such non-linear schemes can attenuate R&D underinvestment by using a novel financing design that combines equity with put options to provide bilateral insurance to firms and investors. Investors insure firms against R&D failure and firms insure investors against high R&D payoffs not being realized. Interviews with industry experts indicate both the attractiveness and feasibility of the new financing design.

Abstract:  This study examines the link between credit supply and hospital health outcomes. We use bank stress tests as exogenous shocks to credit access for hospitals that have lending relationships with tested banks. We find that affected hospitals shift their operations to increase resource utilization following a negative credit shock but reduce the quality of their care to patients across a variety of measures, including a significant increase in risk-adjusted readmission and mortality rates. The results indicate that access to credit can affect the quality of healthcare hospitals deliver, pointing to important spillover effects of credit market frictions on health outcomes.

Abstract:  Financing frictions may create a misallocation of assets in a market, thus depressing output, productivity, and asset values. This paper empirically explores how liquidity shocks generate a reallocation effect that diminishes this misallocation. Using a unique dataset of agricultural outcomes, I explore how farmers respond to a relaxation of financial constraints through a liquidity shock unrelated to farming fundamentals, namely exogenous cash inflows caused by an expansion of hydraulic fracturing (fracking) leases. Farmers who receive positive cash flow shocks increase their land purchases, which results in a reallocation effect. Examining cross-county purchases, I find that farmers in high-productivity counties who receive cash flow shocks buy farmland in low-productivity counties. In contrast, farmers in low-productivity counties who receive positive cash flow shocks do not engage in similar behavior. Moreover, farmers increase their purchases of vacant (undeveloped) land. Average output, productivity, equipment investment, and profits all increase substantially following these positive cash flow shocks. Farmland prices also rise significantly, consistent with a cash-in-the-market pricing effect. These effects are consistent with an efficient reallocation of land towards more productive users. 

Abstract:  This paper develops a theory that generates an equilibrium relationship between product/project complexity, transparency, and trust in firms. Complexity, transparency, and the evolution of trust are all endogenous, and the equilibrium involves non-monotonic transparency. The least-trusted firms choose the lowest product complexity, remain opaque, and substitute ex ante third-party verification for information disclosure and trust. Firms with intermediate trust levels choose intermediate levels of complexity and transparency through disclosure. Among these firms, those more trusted choose more complex products and disclose less information. The most-trusted firms choose maximum complexity while remaining opaque, eschewing both verification and disclosure. This generates a cross-sectional relationship between product complexity, transparency, and trust. It also implies that firms will initially start with low product complexity and high information disclosure, and adopt increasing complexity as their reputation for trust increases.

Abstract:  We review the literature on financial intermediation in the process by which new medical therapeutics are financed, developed, and delivered. We discuss the contributing factors that lead to a key finding in the literature—underinvestment in biomedical R&D—and focus on the role that banks and other intermediaries can play in financing biomedical R&D and potentially closing this funding gap. We conclude with a discussion of the role of financial intermediation in the delivery of healthcare to patients.

Abstract:  Interventions to address social drivers of health (SDH), such as food insecurity, transportation, and housing, can reduce future health care costs but require up-front investment. Although Medicaid managed care organizations have incentives to reduce costs, volatile enrollment patterns and coverage changes may prevent them from realizing the full benefits of their SDH investments. This phenomenon results in the “wrong-pocket problem,” in which managed care organizations underinvest in SDH interventions because they cannot capture the full benefit. We propose a financial innovation, an SDH bond, to increase investments in SDH interventions. Issued by multiple managed care organizations in a Medicaid coverage region, the bond would raise immediate funds for SDH interventions that are coordinated across the organizations and delivered to all enrollees of the region. As the benefits of SDH interventions accrue and cost savings are realized, the amount managed care organizations must pay back to bond holders adjusts according to enrollment, addressing the wrong-pocket problem.

Abstract:  We review the recent literature on financing biomedical innovation, with a specific focus on the drug development process and how it may be enhanced to improve outcomes. We begin by laying out stylized facts about the structure of the drug development process and its associated costs and risks, and the evidence that the rate of discovery for life-saving treatments has declined over time, while its costs have increased. We make the argument that these structural features require drug-development (i.e., biopharmaceutical) firms to rely on external financing, while at the same time amplifying market frictions that may hinder the ability of these firms to obtain financing, especially for treatments that may have large societal value relative to the benefits going to the firms and their investors. We then provide an overview of the evidence for various types of market frictions to which these drug development firms are exposed, and discuss how these frictions affect their incentive to invest in the development of new drugs, leading to underinvestment in valuable treatments. In light of this evidence, numerous studies have proposed ways to overcome this “funding gap” problem, including the use of financial innovation. We discuss the potential of these approaches to improve outcomes.

Abstract:  Firms conducting biomedical research and development (R&D) face very high costs and risks, which makes financing difficult, creating a “funding gap” that impedes biomedical innovation. We propose and analyze a new class of simple financial instruments, Food and Drug Administration (FDA) hedges, which allow biomedical R&D investors to potentially better share the pipeline risk associated with FDA approval with the capital market. We first explain the market failure that FDA hedges can prevent to help increase investment in biomedical R&D, thus providing a microfoundation for such hedges. Then, using historical FDA approval data, we examine the pricing of FDA hedges and mechanisms under which they can be traded. Using unique data sources, we find that FDA approval risk—a major risk in biomedical R&D—has a low correlation across drug classes, as well as with other assets and the overall market. We argue that this zero-beta property of scientific FDA risk could be an additional source of gains from trade, between developers looking to offload FDA approval risk and issuers of FDA hedges looking for diversified investments. We offer a proof of concept of the feasibility of trading this type of pipeline risk by examining related securities issued around mergers and acquisitions activity in the drug industry. Our project-level data also allow us to empirically establish that R&D risk is mainly idiosyncratic, a common assumption in the literature for which we provide empirical support. Overall, our conclusion is that FDA hedges can spur biomedical innovation.

Abstract: How do innovative firms react when existing products experience negative shocks? We explore this question with detailed project-level data from drug development firms. Using FDA Public Health Advisories as idiosyncratic negative shocks to approved drugs, we examine how drug makers react through investment decisions. Following these shocks, affected firms increase R&D expenditures, driven by a higher likelihood of acquiring external innovations, rather than developing novel projects internally. Such acquisition activities are concentrated in firms with weak research pipeline. We also find that competing developers move resources away from the affected therapeutic areas. Our results show how investments in specialized commercialization capital create path dependencies and alter the direction of R&D investments.

Abstract:  The interaction between product market competition, R&D investment, and the financing choices of R&D-intensive firms on the development of innovative products is only partially understood. To motivate empirical hypotheses about this interaction, we develop a model which predicts that as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to assets in place that support existing products; (2) carry more cash; and (3) maintain less net debt. Using the Hatch-Waxman Act as an exogenous shock to competition, we provide causal evidence which supports these hypotheses through a differences-in-differences analysis that exploits differences between the biopharma industry and other industries, and heterogeneity within the biopharma industry. We also explore how these changes affect innovative output, and provide novel evidence that increased competition causes companies to increasingly ``focus'' their efforts, i.e., there is a decline in the total number of innovations, but an increase in their economic value. 

Abstract:  This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability. 

Abstract:  This paper investigates the effect of mandatory disclosure requirements for private firms on their decision to go public. Using detailed project-level data for biopharmaceutical firms, we explore the effects of a legal reform---the Food and Drug Administration Amendments Act (FDAAA)---which exogenously required that biotechnology and pharmaceutical firms publicly disclose information regarding clinical trials. Exploiting cross-sectional heterogeneity in firms' exposure to the regulation based on their internal development portfolios, we find that affected firms are significantly more likely to transition to public equity markets following the reform. We also find that firms that go public due to the increased disclosure requirements subsequently reduce the size of their project portfolios while shifting to safer investments acquired externally. We additionally explore the main hypothesis using a second empirical setting that considers a 2006 German legal reform which enhanced the enforcement of mandatory disclosure requirements for private firms. The findings are strongly consistent with the main hypothesis, helping to establish external validity of the documented phenomenon. The results suggest that private firms' general information environment and disclosure requirements influence the propensity of going public, and the nature of their subsequent project decisions. 

Abstract:  This study investigates whether a private firm's decision to go public affects the IPO decisions of its competitors. Using detailed data from the drug development industry, we identify a private firm's direct competitors at a precise level through a novel approach using similarity in drug development projects based on disease targets. The analysis shows that a private firm is significantly more likely to go public after observing the recent IPO of a direct competitor, and this effect is distinct from "hot" market effects or other common shocks. Furthermore, our effects are centered on firms that operate in more competitive areas. We additionally explore peer effects in private firm funding propensities more broadly, such as through venture capital or being acquired, and find results consistent with a competitive channel. 

Abstract: This paper examines how the firm's choice of investment horizon interacts with rent-seeking by privately-informed, multi-tasking managers and the labor market. There are two main results. First, managers prefer longer-horizon projects that permit them to extract higher rents from firms, so short-termism involves lower agency costs and is value-maximizing for some firms. Second, when firms compete for managers, firms practicing short-termism attract better managerial talent when talent is unobservable, but larger firms that invest in long-horizon projects hire more talented managers when talent is revealed.

Abstract: What is the effect of cash injections during financial crises? Exploiting county-level variation arising from random weather shocks during the 1980s Farm Debt Crisis, we analyze and measure the effect of local cash flow shocks on the real and financial sector. We show that such cash flow shocks have significant impact on a host of economic outcomes, including land values, loan delinquency rates, and the probability of bank failure. Further, we measure how cash injections affect local labor markets, analyzing the impact on employment and wages both within and outside of the sector receiving a positive cash flow shock. Estimates of the effect of local cash flow shocks on county income levels during the financial crisis yield a multiplier of 1.63. 

Abstract: Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary’s credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary’s credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets. 

Abstract:  Thanks to a combination of scientific advances and economic incentives, the development of therapeutics to treat rare or orphan diseases has grown dramatically in recent years. With the advent of Food and Drug Administration–approved gene therapies and the promise of gene editing, many experts believe we are at an inflection point in dealing with these afflictions. In this article, the authors propose to document this inflection point by measuring the risk and reward of investing in the orphan drug industry. They construct a stock market index of 39 publicly traded companies that specialize in developing drugs for orphan diseases and compare the financial performance of this index, which they call ORF, to the broader biopharmaceutical industry and the overall stock market from 2000 to 2015. Although the authors report that ORF underperformed other biopharma companies and the overall stock market in the early 2000s, its performance has improved over time: from 2010 to 2015, ORF returned 608%, far exceeding the 317%, 320%, and 305% returns of the S&P, NASDAQ, and NYSE ARCA Biotech indexes, respectively, and the 83% of the S&P 500. ORF does have higher volatility than the other indexes but still outperforms even on a risk-adjusted basis, with a Sharpe ratio of 1.24 versus Sharpe ratios of 1.17, 1.14, and 1.05, respectively, for the other three biotech indexes and 0.71 for the S&P 500. However, ORF has a market beta of 1.16, which suggests significant correlation to the aggregate stock market and less diversification benefits than traditional pharmaceutical investments. 

Abstract:  Uncertainty surrounding the risk and reward of investments in biopharmaceutical companies poses a challenge to those interested in funding such enterprises. Using data on publicly traded stocks, we track the performance of 1,066 biopharmaceutical companies from 1930 to 2015—the most comprehensive financial analysis of this sector to date. Our systematic exploration of methods for distinguishing biotech and pharmaceutical companies yields a dynamic, more accurate classification method. We find that the performance of the biotech sector is exquisitely sensitive to the presence of a few outlier companies, and confirm that nearly all biotech companies are loss-making enterprises, exhibiting high stock volatility. In contrast, since 2000, pharmaceutical companies have become increasingly profitable, with risk-adjusted returns consistently outperforming the market. The performance of all biopharmaceutical companies is subject not only to factors arising from their drug pipelines (idiosyncratic risk), but also from general economic conditions (systematic risk). The risk associated with returns has profound implications both for patterns of investment and for funding innovation in biomedical R&D. 

Abstract:  This paper explores the relationship between a firm's legal contracting environment and its innovation incentives. Using granular data from the pharmaceutical industry, we examine a contracting mechanism through which incumbents maintain market power: "pay-for-delay'' agreements to delay the market entry of competitors. Exploiting a shock where such contracts become legally tenuous, we find that affected incumbents subsequently increase their innovation activity  across a variety of project-level measures. Exploring the nature of this innovation, we also find that it is more "impactful’’ from a scientific and commercial standpoint. The results provide novel evidence that restricting the contracting space can boost innovation at the firm level. However, at the extensive margin we find a reduction in innovation by new entrants in response to increased competition, suggesting a nuanced effect on aggregate innovation. 

Abstract:  We build a novel structural growth model that features a dynamic agency conflict and knowledge spillovers to assess how labor mobility affects economic growth. Our calibration to US data targets responses of employee turnover and firms’ intangible investment rates to variation in workers’ outside option values that are identified by state-level changes in degrees of non-compete enforcement. Counterfactual analysis finds that the current degree of restrictions across states on labor mobility are close to being growth maximizing.

Abstract:  This paper examines the effect of legal bankruptcy protection on small businesses. Using granular agricultural microdata, we use a regression discontinuity design to exploit farm eligibility for a unique bankruptcy code for farms known as Chapter 12. We find that farmers that qualify for this protection take on additional debt, but do not face a higher cost of debt, consistent with Chapter 12 eligibility increasing the demand for debt. Exploring a variety of outcomes, we find that farms with enhanced bankruptcy protection make relatively more investments, and are more productive across various measures. This translates to greater farm production, sales, and profitability. Overall, our results suggest that the enhanced bankruptcy protection improves ex ante outcomes and is efficiency-enhancing. We also show that the bankruptcy protection has a positive spillover on farmer household consumption.

Abstract:  We examine the effect of increased healthcare costs on local economic conditions. We use private equity buyouts of hospital systems as a shock to the healthcare costs faced by firms in affected areas. We provide evidence that private equity buyouts of hospital systems result in higher healthcare insurance premiums paid by firms, and such rises in premiums lead to higher business bankruptcies, an increase in business loan volume, slower employment and establishment growth, and reduced innovative output. The effects are more pronounced in areas with less competitive hospital markets, higher labor intensity, and fewer insurers providing coverage. 

Abstract:  This paper theoretically examines innovation investment incentives by firms facing labor market frictions. A firm can choose the degree of innovation of its projects: non-innovative (exploitative) investments that continue existing ideas, incrementally innovative investments, or truly novel innovations that involve uncertain technologies. In an optimal contracting setting with moral hazard, unknown managerial talent, and asymmetric information about project quality, there are two main results. First, constrained-efficient contracts generate rents for managers that represent agency costs for firms, and these vary across different project types. Second, labor market frictions have a non-monotonic effect on the innovation choice. Innovation occurs when there are both low and high labor market frictions, with incremental innovation occurring with low labor frictions and uncertain novel innovation occurring with high labor frictions. Exploitative investments occur when there are intermediate degrees of labor market frictions.

Abstract:  In this essay, I discuss the recent research agenda of Robert C. Merton on the topic of trust and its key role in the financial system. I begin by defining what trust is, and describing how the notion of trust fits in with his previous work on the Functional Perspective in finance. I then lay out the arguments for why trust is essential for understanding the proper functioning of the financial system. Following this, I review our joint work on trust and lending, where we formalize these notions in a model that theoretically distinguishes between trust and reputation, and provide new insights on how trust may affect the future evolution of the financial system. I conclude with a discussion of how joining this framework of trust with the Functional Perspective can be used to explore broader implications related to information disclosure, liquidity, and firms’ choices between transparency and opacity. This has implications for the post-crisis debate on the desirability of opaque financial institutions to enhance the liquidity of moneylike debt claims.

Abstract:  It has been suggested that firms with foreign operations stockpile large amounts of cash, primarily in their foreign subsidiaries, because bringing the cash home involves paying a repatriation tax on foreign income. This implies that the stock market should value foreign-held cash less than domestically-held cash. But this effect may be moderated by the impact of investment opportunities abroad that would provide an outlet for the foreign cash and affect how the market values it. This paper empirically examines the difference between the market values of on-balance-sheet cash held domestically and that held abroad by US firms, and the impact of the interaction of the repatriation tax and investment opportunities on this difference. The results show that shareholders assign a higher value to cash held abroad than to cash held domestically, and that the marginal value of foreign-held cash is substantially higher than that of domestic cash for US firms with better foreign investment opportunities. This suggests that the effect of the differential investment opportunities for foreign and domestic cash swamps the repatriation-tax disadvantage of foreign cash. As further evidence, this paper also examines the effect of the exogenous shock provided by the tax repatriation holiday in 2004, and finds that firms with better investment opportunities abroad experienced lower abnormal returns following the passage of that legislation.