WP 17/15

In “Career Risk and Market Discipline in Asset Management”, Marco Pagano, with Andrew Ellul and Annalisa Scognamiglio, investigate the role of talent and luck in the career of finance professionals using hand-collected data on 1,627 hedge fund employees. Their analysis shows that, while finance professionals experience a great acceleration in their career upon entering the hedge fund industry, they face significant career setbacks and are more likely to switch to other employers following the liquidation of the fund they work for. This “scarring effect” affects only high-ranking employees of the relevant investment companies, and only those whose funds significantly and persistently underperform compared to their respective benchmarks. Hence, the post-liquidation career slowdown appears to be related to the reputation loss of high-ranking employees in formerly underperforming funds, rather than to the disruption of their fund-specific human capital induced by liquidation. On the whole, these results reveal a new facet of market discipline in asset management, which operates via the managerial labor market: persistent under-performance followed by the fund’s liquidation exposes the managers of the fund’s parent company to a permanent setback in their subsequent career and compensation. Such labor market discipline complements the incentives arising from compensation schemes, and may partly compensate the tendency to index asset managers’ pay more to upside than to downside risk.

WP 17/14

In “Retirement in the Shadow (Banking)”, Facundo Piguillem, with Guillermo Ordoñez, investigate the extent to which the large increases in life expectancy and in shadow banking activities in the U.S. economy are intimately related. Agents resort on financial intermediaries to buy insurance against an uncertain life span after retirement. When they expect to live longer they are more prone to rely on financial intermediaries that are riskier but offer them better terms for insurance – shadow banks. The authors show that a calibrate model with an increase in the demand of safe assets for retirement needs and shadow banking that reduces the cost of financial intermediation can replicate the large increase in asset accumulation and output experienced by the United States since 1980. This approach allow them to compute a counterfactual without shadow banking and to show that the gains from 1980 to 2007 of operating with shadow banking was equal to 47% of 2007 GDP. Moreover, even assuming that shadow banking was the sole responsible for the recent crisis and the whole great recession, its cost is of the order of 16% of 2007 GDP. These results are relevant in the discussion about the regulation of the banking system. Even though avoiding shadow banks or certain financial innovations, such as securitization, may have benefits in terms of reducing the likelihood and magnitude of financial crises, it is also costly in terms of decreased output.

WP 17/13

In “The Cost of Distorted Financial Advice: Evidence from the Mortgage Market”, Luigi Guiso, Andrea Pozzi and Anton Tsoy, with Leonardo Gambacorta and Paolo Mistrulli, investigate two issues. Firstly, using data on the universe of Italian mortgages, they quantify the costs of distorted financial advice. Secondly, they assess the consequences of different policies to address the question. They show that a large fraction of borrowers are unable to make independent choices on financial decisions. This implies that there is large scope for intermediaries to supply biased advice. They estimate that the cost of distortion is significant and equivalent to an increase in the annual mortgage payment by 11% for the average household. A set of counterfactual exercises leads the authors to conclude that the gains from forcing intermediaries to provide only honest advice or from educating borrowers are sizable. Importantly, they are also unequally distributed: while the naïve gain, the sophisticated lose. This exposes financial education campaigns and policies that force undistorted advice to non-trivial political economy implementation problems.

WP 17/12

In “Asymmetric Information and Imperfect Competition in Lending Markets“, Fabiano Schivardi, with Gregory Crawford and Nicola Pavanini, analyze the interaction between imperfect competition and asymmetric information in the Italian market for small business lines of credit. By using matched firm-bank data from Italy, they estimate a structural model of firms’ demand for credit, loan use, and default, and join with it a model of bank pricing to individual firms. They find evidence of adverse selection, in the form of a positive correlation between the unobserved determinants of demand for credit and default. The authors conduct three counterfactual policy experiments to quantify the importance of adverse selection and investigate its interaction with market power. The results show that increases in adverse selection and in banks’ cost of capital cause prices to increase, demand and loan use to fall, and default to rise. Higher market power, however, mitigates these effects. Similarly, higher adverse selection mitigates and can even reverse the effects of banks’ consolidation on prices, demand probabilities, loan use, and default. These findings have several important policy implications. They confirm that both market power and adverse selection worsen lending conditions. That being said, imperfect competition moderates the effects of adverse selection and vice versa. This suggests that competition and banking policymakers should jointly consider the two factors, particularly in those contexts where either is likely to be strong. The structural estimates presented in the paper offer a quantitative assessment of the costs and benefits of market power in banking in the presence of adverse selection, thus giving a measure of the actual trade-off between competition and financial stability.

WP 17/11

In “Weighted-average least squares estimation of generalized linear models”, Franco Peracchi, with Giuseppe De Luca and Jan R. Magnus, extend the weighted-average least square (WALS) approach to deal with uncertainty about the specification of the linear predictor in the wide class of generalized linear models (GLMs). This class includes a variety of nonlinear models for discrete and categorical outcomes, such as logit, probit, and Poisson regression models. In addition to developing the asymptotic theory for the WALS estimator of GLMs, the authors also investigate its finite-sample properties through a Monte Carlo experiment, the design of which is based on a real empirical example, namely the analysis of attrition in the first two waves of the Survey of Health, Ageing and Retirement in Europe (SHARE).

WP 17/10

In “Talent Discovery, Layoff Risk and Unemployment Insurance“, Marco Pagano, with Luca Picariello, analyze how to provide insurance against layoff risk in talent-intensive industries. In these industries workers’ talent is particularly important as their technology does not rely on the ability to perform routine tasks efficiently, but rather on qualities such as imagination, creativity, and education as well. Workers would like to insure against the losses they might incur should their talent be worse than expected. In principle this risk could be privately insurable by firms committing to giving generous severance pay to laid-off employees. However, firms could provide such an insurance scheme only if workers were not free to switch to other employers once their talent were discovered, otherwise they would lose the more talented employees and be left with the low-performing ones. Therefore, in presence of ex-post competition for talent, workers are left to bear the layoff risk arising from the talent discovery process. The authors show that in this situation risk-averse workers try to mitigate such risk by choosing to work for firms whose projects convey little information about employees’ quality, thus inducing a less efficient allocation of talent. In this context public unemployment insurance corrects this inefficiency, enhancing employment in talent-sensitive industries and investment in education by employees. The model predicts that the generosity of unemployment insurance is positively correlated with the share of workers employed in talent-sensitive firms, which is consistent with international and US evidence.

WP 17/09

In “Strategic Entry and Potential Competition: Evidence from Compressed Gas Fuel Retail“, Andrea Pozzi, with Giulia Pavan and Gabriele Rovigatti, study how competition affects the incentives to preempt entry. It is well known that in markets with expanding demand or declining costs entry occurs inefficiently early if there are too many potential entrants rather than a single one. However there is lack of both theoretical analysis and empirical evidence on whether a higher number of firms potentially able to enter the market further exacerbates such inefficiency. The authors exploit a shift in regulation in the retail fuel industry in Italy that allows both to identify the potential entrants in each geographical market and to create exogenous variation in their number. They find that areas with more potential entrants witness significant earlier entry than similar areas with fewer competitors. Evidence is provided to tie this result with an underlying preemption race whose intensity raises with the number of potential entrants.

WP 17/08

In “From Weber to Kafka: Political Instability and the Rise of an Inefficient Bureaucracy“, Luigi Guiso and Claudio Michelacci, with Gabriele Gratton and Massimo Morelli, propose a simple dynamic model which relies on a two-way relationship between legislation and bureaucratic performance: too many laws mechanically jam up the bureaucracy; at the same time, an inefficient bureaucracy gives incentives to politicians to sponsor laws in order to gain the reputation of capable reformers, leading naturally to the possibility of multiple steady states. On the one hand a country may end up in a Weberian steady state characterized by efficient bureaucracy and economic prosperity, on the other hand it may end up in a Kafkian one characterized by inefficient bureaucracy and stagnation. The authors show that a surge in political instability that results in short legislatures, strong public pressure for reforms, or short-lived technocratic governments tends to cause an excessive production of new laws, which can determine a permanent shift to a Kafkian steady state. Italy’s experience since the early 1990s fits some features of the model well: the sharp increase in political instability due to the end of Cold War induced a sharp increase in legislative activism, accompanied by a deterioration in bureaucratic efficiency and poor economic performance. By using micro level data for Italian MPs, the authors also provide evidence that, when political instability is high, politicians signal their competence through legislative activism, which leads to overproduction of laws and norms.

WP 17/07

In “Local Crowding Out in China“, Marco Pagano, with Yi Huang and Ugo Panizza, claim that in China, between 2006 and 2013, massive local public debt issuance crowded out the investment of private firms by tightening their funding constraints, but it did not affect state-owned firms. The authors establish this result using a novel, purpose-built dataset for Chinese local public debt. They find that the investment of private firms is inverserly correlated with city-level public debt, and this result is stronger for private firms that depend more heavily on external funding. Moreover, in cities where public debt is high, private firms’ investment is more sensitive to internal cash flow, also when cash-flow sensitivity is estimated jointly with the probability of being credit-constrained.

WP 17/06

In “Corporate Leverage and Employees’ Rights in Bankruptcy“, Marco Pagano, with Andrew Ellul, investigate how corporate leverage responds to employees’ legal protection in bankruptcy depending on whether leverage is chosen to curtail workers’ bargaining power (strategic debt model) or is driven by credit constraints (credit constraints model). In particular they test if and to what extent workers’ effect on leverage depends on the protection afforded under bankruptcy law to employees’ versus creditors’ claims, and specifically on their relative seniority in liquidation and the balance of their rights in restructuring. Using newly collected cross-country data on employees’ rights in corporate bankruptcy, the authors estimate the impact of such rights on firms’ capital structure, applying triple-diff strategies that exploit time-series, cross-country and firm-level variation. The estimates show that leverage increases more substantially in response to rises in corporate property values or in profitability at firms where employees have strong seniority in liquidation and weak rights in restructuring, thus giving empirical support to the strategic debt model.

WP 17/05

In “Short-run effects of lower productivity growth. A twist on the secular stagnation hypothesis“, Jean-Paul L’Huillier, with Olivier Blanchard and Guido Lorenzoni, offer a novel explanation of the weak GDP growth observed in the U.S. in the current decade. In their view, while the effects of the legacies of the past (i.e. a weak financial system and fiscal consolidation) have been fading away, expectations about future potential growth have become much less optimistic leading to a temporarily weaker demand. Regression and simulation results suggest that downward revisions of productivity growth may have decreased demand by 0.5% to 1% a year since 2012. If this explanation is correct, it has important policy implications. In particular, as this adjustment comes to an end, demand will pick up and interest rates will increase substantially, more than currently anticipated by financial markets.

WP 17/04

In “Credit Misallocation During the European Financial Crisis“, Fabiano Schivardi, with Enrico Sette and Guido Tabellini, address the question of whether banks with low capital extend excessive credit to weak firms, and whether this matters for aggregate efficiency and economic growth. Using a unique data set that covers almost all bank-firm relationships in Italy during the period 2004-2013, they find that undercapitalized banks were more reluctant to cut credit to non-viable firms. Credit misallocation increased the failure rate of healthy firms and reduced that of non-viable firms. Nevertheless, the negative effects of credit misallocation on the growth rate of healthier firms were negligible. These results show that while banks with low capital can be an important source of aggregate inefficiency in the medium run, they cannot be blamed for having aggravated or prolonged the recession induced by the European financial crisis.

WP 17/03

In “Demand and Supply of Populism“, Luigi Guiso, Helios Herrera, Massimo Morelli and Tommaso Sonno study the determinants of the demand and supply of populism in Europe by making use of individual level data from multiple waves of the European Social Survey. Regarding the demand side, they find that lower income, financial distress and higher economic insecurity, due to exposure to globalization and competition from immigrants, drive the populist vote. Economic insecurity also has an indirect effect on populist voting because it lowers the trust in incumbents. All these variables induce voters to either abstain from voting or, if they do participate, to vote more for populist parties. Aggregating all effects, the authors show that strong negative economic shocks (such as the 2008 crisis still ongoing in several countries) and the collapse of trust in traditional parties they induce, boost the demand for populist policies. Regarding the supply, the paper shows that the same economic variables also caused the entry of populist parties in the political arena. In response to the consensus the populist parties have gained, traditional parties have gradually shifted their platforms towards more populist oriented policies.

WP 17/02

In “Firm-Related Risk and Precautionary Saving Response“, Luigi Guiso, Andreas Fagereng and Luigi Pistaferri , develop a strategy that allows them to simultaneously identify the strength of the precautionary motive and the degree of self-insurance of labor income risk. To address endogeneity problems, they use Norwegian administrative data to identify a credible instrument for consumption risk, that is the variance of firm-specific shocks. At the same time, they provide a framework for studying the precautionary saving response of structural changes in wage insurance provided by the firm. They find a strong precautionary motive, a partial ability to self-insure labor income risk and a large reduction of precautionary savings in response to firm adoption of high powered wage contracts.

WP 17/01

In “Ambiguous Policy Announcements“, Claudio Michelacci and Luigi Paciello study the effects of monetary policy announcements in a New Keynesian model, where ambiguity-averse households with heterogeneous net financial wealth use a worst-case criterion to assess the credibility of the announcements. In this framework, an announcement of a future monetary tightening is always contractionary, while an announcement of a future loosening is less expansionary than under full credibility, and it can even be contractionary if the inequality in wealth is sufficiently pronounced. This occurs because wealthy creditor households are more prone to believe the announcement of loosening than poor, indebted households. Hence there is a fall in perceived aggregate wealth, which, if large enough, can cause a contraction in aggregate demand. To assess the relevance of this mechanism the authors analyze the start of the ECB’s practice of offering forward guidance in July 2013. They show that households’ inflation expectations have responded in accordance with the theory. Calibrating their model to match the entire distribution of European households’ net financial wealth, they find that forward guidance is contractionary, and particularly so when households do not feel liable for the public debt.