Output & Impact: Finance
In the nearly 100 years of the Carlson School's existence, its faculty has produced an unending stream of groundbreaking research, pushing against boundaries in both academia and in the business world at large. Discover notable examples from the Finance Department.
Solving a debt security puzzle
“The Determinants of Credit Spread Changes” (Journal of Finance, 2001) by Professor and C. Arthur Williams, Jr./Minnesota Insurance Industry Chair Robert Goldstein, J. Spencer Martin, and Pierre Collin-Dufresne established an important puzzle in the world of debt securities. “My co-authors and I noticed that the empirical work on corporate bonds focused on their yields. This focus made sense because yields capture how much interest firms are paying to borrow money,” Goldstein says. “However the findings of these empirical papers were a bit ‘boring’ because changes in corporate yields are mostly driven by changes in treasury yields. When we decided to focus on credit spreads rather than on yields—credit spreads equal the difference between corporate yields and treasury yields—we discovered they had a life of their own.”
Goldstein then examined whether changes in credit spreads could be explained by changes in those factors that theory predicts should explain them, such as changes in firm value. “We found that although these predicted factors did in fact help explain spread changes, a large fraction went unexplained,” he says. “The unexplained part across firms was highly correlated. There was a corporate-bond specific factor that was driving spreads in the aggregate economy that could not be explained by the standard model.”
This research emphasized that the standard frictionless, arbitrage-free models that academics usually focus on are a bit naïve. Goldstein says this became obvious during the Great Recession when the yields of corporate bonds rose sharply, well above the “fair cost” for taking on default-risk that could be determined from credit default swap (CDS) spreads. “Since the financial crisis, the fact that assets can move far away from their fundamental value during times of financial distress has become an important part of the literature,” he says. Since publication, Goldstein’s work has been cited 1,680 times by other researchers.
Pecking at the pecking order theory
Professor Murray Frank is best known for two papers that examine what drives firms’ choice of capital structure—their mix of financing, especially debt and equity. This is one of the most important topics in corporate finance, and it has been the subject of fierce debate for many years. The main debate is which of two paradigms dominates firms’ choice of capital structure.
“In the late 1990s, the finance textbooks taught that capital structure was largely determined by firms balancing tax benefits of debt against bankruptcy costs—an idea called the tradeoff theory,” Frank says. “But when professors were asked what they believed, most of them seemed to believe an alternative theory called ‘the pecking order theory.’ According to this alternative idea, firms ignore taxes and bankruptcy costs, and instead follow a financing hierarchy—first retained earnings, then debt, and only in extreme cases use equity finance.”
Murray found the pecking order theory too simplistic to really be a good description. In “Testing the Pecking Order Theory of Capital Structure” (Journal of Financial Economics, 2003), he and Vidhan Goyal found that the evidence for this view was much weaker than previously thought, and most smaller firms actually issue far more net equity than they issue net debt.
“We were able to show that the pecking order theory was not a good description of the financial choices of most firms,” Murray says. “We then did several follow-up studies to determine which factors seem to be empirically important. This had a significant impact on how the finance profession views the pecking order theory.”
One follow-up study, “Capital Structure Decisions: Which Factors are Reliably Important?” (Financial Management, 2009), took a comprehensive look at which firm characteristics have consistent effects on firms’ choice of capital structure, in particular their leverage (debt/value) ratio.
“It is now generally accepted that the hypothesized hierarchy is too simplistic, and things like taxes, bankruptcy costs, market conditions, and so forth matter more to firms when choosing their financing,” Murray says. “The old finance textbooks actually provided a better account of real firm decisions than most finance professors had realized. Many studies in recent years have built on the factors that Vidhan and I identified as being empirically important. More recent theoretical developments have also tended to build on the tradeoff theory as the foundation.”
A bank by any other name is still a firm
“The Theory of Bank Risk Taking and Competition Revisited” (Journal of Finance, 2005) by Professor and Banking Industry of Minnesota Chair John Boyd and Gianni De Nicolo ended up overturning conventional wisdom and has had a tremendous impact on financial policy. Until this paper was written, many banking researchers and regulators thought that increased competition among banks would lead to greater risk of bank failures, or “financial fragility.” Boyd showed that this need not be the case. Under some circumstances, greater competition makes banks safer because it gives their borrowers incentive to pursue safer strategies.
“Our research was built on an old idea, except that it had never been applied to banking before,” Boyd says. “A lot of people think banks are totally special, but they are not. They are a firm like any other firm trying to make money. Why should they be different from anyone else?”
Since this work was published, a great deal of applied research has looked to see which effect—greater fragility or greater safety—dominates in reality. The evidence is that sometimes, Boyd’s effect dominates, and sometimes it does not, leading people to consider other institutional or regulatory structures. Although this finding that “life is complicated” is not very sexy, Boyd’s research did a lot to dissuade policy makers from assuming that one size fits all.
“Our results turned conventional thinking around,” Boyd says. “What was widely believed in the literature was wrong. This research changed the way everyone looks at banking.”
Discover the impact of research taking place across the Carlson School:
Output & Impact: Accounting
Output & Impact: Information and Decision Sciences
Output & Impact: Marketing
Output & Impact: Strategic Management and Entrepreneurship
Output & Impact: Supply Chain and Operations
Output & Impact: Work and Organizations