Sergey Chernenko

Working Papers

Bank Capital and the Growth of Private Credit

with Robert Ialenti and  David Scharfstein

Abstract: This paper examines whether regulatory arbitrage can explain the growth of private credit. We find that business development companies (BDCs) --- closed-end funds that provide a significant share of nonbank loans to middle market firms --- are very well capitalized according to bank capital frameworks. They have average capital ratios of about 33% and excess capital in severely stressed scenarios. Thus, private credit has not grown because nonbank financial intermediaries have to hold less capital than banks. Instead, we argue that banks find lending to BDCs to facilitate their middle market lending more attractive than making loans to middle market lending. This is, in part, because overcollateralized loans to BDCs and other nonbank financial intermediaries get relatively favorable capital treatment, enabling banks to exploit their low-cost funding. It is also attractive because the loans are relatively large and thus less costly to originate, underwrite, and service than a portfolio of middle market loans.  

The Limits of Algorithmic Measures of Race in Studies of Outcome Disparities

with David Scharfstein

Abstract: We show that the use of algorithms to predict race has significant limitations in measuring and understanding the sources of racial disparities in finance, economics, and other contexts. First, we derive theoretically the direction and magnitude of measurement bias in estimates of unconditional disparities that use predicted instead of actual race. If their prediction errors were random, existing algorithms such as BIFSG (Voicu, 2018) would underestimate disparities in credit access for Black borrowers by 30–50%. In practice, the algorithms are systematically biased toward identifying minority borrowers who are likely to experience worse outcomes. Second, we show that in many applications the accuracy of predicted race is illusory, as many empirical methodologies call for the inclusion of location fixed effects and comparison of white and minority individuals within a given geography. As a result, estimates of conditional disparities can be dramatically underestimated, in some of our analyses, by up to 60%. While underestimating conditional disparities, predicted race overstates the importance of location in explaining disparities. Finally, because algorithm accuracy can vary across subsamples, predicted race can under- or overestimate interaction effects meant to measure cross-sectional variation in disparities.

Applications or Approvals: What Drives Racial Disparities in the Paycheck Protection Program?

with Nathan Kaplan, Asani Sarkar, and David Scharfstein

Abstract: We use the 2020 Small Business Credit Survey to study the sources of racial disparities in use of the Paycheck Protection Program (PPP). Black-owned firms are 8.9 percentage points less likely than observably similar white-owned firms to receive PPP loans.  About 55\% of this take-up disparity is attributable to a disparity in application propensity, while the remainder is attributable to a disparity in approval rates. The finding in prior research that Black-owned PPP recipients are less likely than white-owned recipients to borrow from banks and more likely to borrow from fintech lenders is driven entirely by application behavior. Conditional on applying for a PPP loan, Black-owned firms are 9.9 percentage points less likely than white-owned firms to apply to banks and 7.8 percentage points more likely to apply to fintechs. However, they face similar average approval disparities at banks (7.4 percentage points) and fintechs (8.4 percentage points). Sorting by Black-owned firms away from banks and toward fintechs is significantly stronger in more racially biased counties, and the bank approval disparity is also larger in more racially biased counties. Neither differences in PPP demand nor differences in eligibility rates are able to explain any of our findings. Racial disparities in program awareness and in the burden of application requirements (e.g., submitting all required documentation) both appear to be important drivers of application disparities, and the latter also helps to explain both bank and fintech approval disparities.

Flow-Induced Trading: Evidence from the Daily Trading of Municipal Bond Mutual Funds

with Viet-Dung Doan

Abstract: We use novel data on the daily flows, trading, and cash buffers of open-end municipal bond mutual funds to study the dynamics of trading in response to fund flows. We document a much stronger short-term reliance on cash buffers than would be suggested by monthly regressions. When trading in response to fund flows, funds also tilt their trading to slightly more liquid bonds. Propensity to sell in response to outflows is affected strongly by market conditions: it decreases with the average markup and increases with the expectations of future aggregate outflows. We use our daily data to estimate flow-induced sales during the early stages of the COVID-19 pandemic if all funds started with the 10% highly liquid assets buffer proposed by the SEC. Cumulative aggregate sales by the sample funds would have been only 18% lower.

Measuring the Perceived Liquidity of the Corporate Bond Market

with Adi Sunderam

Abstract: We develop a novel measure of market liquidity that does not depend on transaction or quote data: the strength of the cross-sectional relationship between mutual fund cash holdings and flow volatility. Our measure captures funds' expectations of future liquidity and can be applied in settings where transactions are rare, or data are not available. We show that municipal bonds and syndicated loans are perceived to be twice and five times as illiquid as corporate bonds respectively. The perceived liquidity of speculative-grade and Rule 144A bonds is significantly lower than investment-grade bonds and deteriorated significantly following the 2008-9 financial crisis.  

Internet appendix

Forced Sales and Dealer Choice in OTC Markets

with Viet-Dung Doan

Abstract: Using novel trade-level data, we study how municipal bond mutual funds trade in response to daily flows. When forced to sell bonds to satisfy redemptions, funds prearrange fewer trades, sell more liquid bonds, and trade with more central dealers, who offer faster execution. Funds are especially likely to turn to more central dealers when trading lower rated bonds, when funds have low cash buffers, and when trading after periods of aggregate outflows. More central dealers charge higher markups when funds demand fast execution. 

Mutual Fund Liquidity Creation

with Viet-Dung Doan

Abstract:  We develop a novel measure of the dollar value of liquidity created by open-end mutual funds. Our measure compares the costs investors would have incurred had they traded on their own in response to liquidity shocks with the actual costs incurred by open-end mutual funds when trading to satisfy investor redemptions. Applying this measure to municipal bond mutual funds, we show that during the 2008-2017 period the average fund provides liquidity services worth 1.80 cents per dollar of gross redemptions or 50 basis points of fund assets per year. The aggregate value of liquidity services provided during this period was $14-22 billion. We decompose liquidity creation into three components: 1) flow netting, 2) liquidity management, and 3) trade execution, and explore the cross-sectional and time-series variation in liquidity creation.

Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds

with Adi Sunderam

Joint winner of the ESRB research prize in memory of Ieke van den Burg, 2016.

Abstract: We study liquidity transformation in mutual funds using a novel data set on their cash holdings. To provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. We provide evidence suggesting that mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in.

Presentation at the NBER Conference on New Developments in Long-Term Asset Management

Presentation at the First ESRB Annual Conference 

Publications

Racial Disparities in the Paycheck Protection Program

with David Scharfstein

accepted at the Journal of Financial Economics

Abstract: Consistent with contemporaneous research, we document that minority-owned firms were more likely than observationally similar white-owned firms to receive PPP loans from nonbank lenders than from banks. However, we show that this substitution to nonbanks was only partial, resulting in significantly lower PPP take-up by minority-owned

firms, particularly Black-owned ones. Location and firm characteristics explain about two-thirds of the 25pp disparity in PPP take-up by Black-owned firms. While there was greater substitution to nonbanks in more racially biased locations, overall take-up was still lower in those locations. Access to professional help with applications facilitated use of nonbanks and mitigated disparities.

Internet appendix

Why Do Firms Borrow Directly from Nonbanks?

with Isil Erel and Robert Prilmeier

Review of Financial Studies 35(11): 4902–4947

Abstract: Analyzing hand-collected credit agreements data for a random sample of middle-market firms during 2010-2015, we find that a third of all loans is extended directly by nonbank financial intermediaries. Nonbanks lend to less profitable and more levered firms that undergo larger changes in size around loan origination. The probability of borrowing from a nonbank jumps by 34% as EBITDA falls below zero, an effect that is largely due to bank regulation. Controlling for firm and loan characteristics, nonbank loans carry 190 basis points higher interest rates, suggesting that access to funding, rather than prices, is why firms borrow from nonbanks.

Mutual Funds as Venture Capitalists? Evidence from Unicorns

with Josh Lerner and Yao Zeng

Review of Financial Studies 34(5): 2362-2410

Abstract: “Founder-friendly” venture financings and nontraditional venture investors have both flourished over the past decade. Using detailed contract data, we study open-end mutual funds investing in private venture-backed firms. We posit that conflicts between early-stage venture investors and liquidity-constrained later-stage ones influence the classic agency problems affecting entrepreneurs and investors. We find that mutual funds with more stable funding are more likely to invest in private firms and that financing rounds with mutual fund participation have stronger redemption, stronger IPO-related rights, and less board representation. These findings are consistent with our conceptual framework.

Internet appendix with SAS code to extract mutual fund holdings of unicorns from CRSP Mutual Fund Database. Note that starting around September 2018, T. Rowe Price funds stopped reporting holdings of private securities to commercial data providers such as CRSP and Morningstar. These holdings continue to be reported in the funds' SEC filings.

Do Fire Sales Create Externalities?

with Adi Sunderam

Journal of Financial Economics 135(3): 602-628

Abstract: We develop three novel measures of the incentives of equity mutual funds to internalize the price impact of their trading. We show that mutual funds with stronger incentives to internalize their price impact accommodate inflows and outflows by adjusting their cash buffers instead of trading in portfolio securities. As a result, stocks held by these funds have lower volatility, and flows out of these funds have smaller spillover effects on other funds holding the same securities. Our results provide evidence of meaningful fire sale externalities in the equity mutual fund industry.

Internet appendix

The Front Men of Wall Street: The Role of CDO Collateral Managers in the CDO Boom and Bust

Journal of Finance 72(5): 1893-1936

Abstract: I study the incentives of the collateral managers who selected securities for ABS CDOs—securitizations that figured prominently in the financial crisis. Specialized managers that did not have other businesses that could suffer negative reputational consequences invested in low quality securities underwritten by the CDO's arranger. These securities perform significantly worse than observationally similar securities. Managers that invested in these securities were rewarded with additional collateral management assignments. Diversified managers that did assemble CDOs suffered negative reputational consequences during the crisis: institutional investors withdrew from their mutual funds. Overall, the results are consistent with a quid pro quo between the collateral managers and CDO underwriters.

Internet Appendix reporting the number of deals and their IRR for each collateral manager in the data 

Who Neglects Risk? Investor Experience and the Credit Boom

with Sam Hanson and Adi Sunderam

Journal of Financial Economics 122(2): 248-269

Abstract: Many have argued that overoptimistic thinking on the part of lenders helps fuel credit booms. We use new micro-data on mutual funds’ holdings of securitizations to examine which investors are susceptible to such boom-time thinking. We show that firsthand experience plays a key role in shaping investors’ beliefs. During the 2003-2007 mortgage boom, inexperienced fund managers loaded up on securitizations linked to nonprime mortgages, accumulating twice the holdings of more seasoned managers. Moreover, inexperienced managers who personally experienced severe or recent adverse investment outcomes behaved more like seasoned managers. Training and institutional memory can serve as partial substitutes for personal experience.

Frictions in Shadow Banking: Evidence from the Lending Behavior of Money Market Mutual Funds

with Adi Sunderam

Review of Financial Studies 27(6): 1717-1750

Abstract: We document frictions in money market mutual fund lending that lead to the transmission of distress across borrowers. Using novel security-level holdings data, we show that funds exposed to Eurozone banks suffered large outflows in mid-2011. These outflows had significant spillovers: non-European issuers relying on such funds raised less short-term debt financing. Issuer characteristics do not explain the results: holding fixed the issuer, funds with higher Eurozone exposure cut lending more. Due to credit market frictions, funds with low Eurozone exposure provided substitute financing only to issuers they had pre-existing relationships with, even though issuers are large, highly rated firms.

The Real Consequences of Market Segmentation

with Adi Sunderam

Review of Financial Studies 25(7): 2041-2070

Review of Financial Studies Young Researcher Prize, 2012.

Abstract: We study the real effects of market segmentation due to credit ratings by using a matched sample of firms just above and just below the investment-grade cutoff. These firms have similar observables, including average investment rates. However, flows into high-yield mutual funds have an economically significant effect on the issuance and investment of the speculative-grade firms relative to their matches, especially for firms likely to be financially constrained. The effect is associated with the discrete change in label from investment- to speculative-grade, not with changes in continuous measures of credit quality. We do not find similar effects at other rating boundaries.

Agency Costs, Mispricing, and Ownership Structure

with C. Fritz Foley and Robin Greenwood

Financial Management 41: 885-914

2nd place Pearson Prize for the best paper published in Financial Management between Autumn 2012 and Autumn 2014 

Abstract: Standard theories of ownership assume insiders ultimately bear all agency costs and therefore act to minimize conflicts of interest. However, overvalued equity can offset these costs and induce listings associated with higher agency costs. We explore this possibility by examining a sample of public listings of Japanese subsidiaries. Subsidiaries in which the parent sells a larger stake and subsidiaries with greater scope for expropriation by the parent firm are more overpriced at listing, and minority shareholders fare poorly after listing as mispricing corrects. Parent firms often repurchase subsidiaries at large discounts to valuations at the time of listing and experience positive abnormal returns when repurchases are announced.

The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps

with Michael Faulkender

Journal of Financial and Quantitative Analysis 46: 1727-1754

Abstract: Existing cross-sectional findings on nonfinancial firms’ use of derivatives that are usually interpreted as the result of hedging may alternatively be due to speculation. Panel data examinations can distinguish between derivatives practices that endure over time and are therefore more likely to result from hedging, and those that are more transient, thus more consistent with speculation. Our decomposition results indicate that hedging of interest rate risk is concentrated among high-investment firms, consistent with costly external finance. Simultaneously, firms appear to use interest rate swaps to manage earnings and to speculate when their executive compensation contracts are more performance sensitive.

Trading Activity and Macroeconomic Announcements in High-Frequency Exchange Rate Data

with Alain P. Chaboud and Jonathan H. Wright

Journal of the European Economic Association 6: 589-596

Abstract: This article introduces a new high-frequency data set that includes global trading volume and prices over five years in the spot euro-dollar and dollar-yen currency pairs. Studying the effects of US macroeconomic data releases, we show that spikes in trading volume tend to occur even when announcements are in line with market expectations, in sharp contrast to the price response. There is some evidence that the volume after announcements is negatively related to the ex ante dispersion of market expectations, contrary to the standard theoretical prediction. At very high frequency, we find evidence that much of the immediate jump in prices in reaction to an announcement occurs before the surge in volume.

Order Flow andExchange Rate Dynamics in Electronic Brokerage System Data

with David W. Berger, Alain P. Chaboud, Edward Horowka, and Jonathan H. Wright

Journal of International Economics 75: 93-109

Abstract: We analyze the association between order flow and exchange rates using a new dataset representing a majority of global interdealer transactions in the two most-traded currency pairs at the one minute frequency over a six-year time period. This long span of high-frequency data allows us to gain new insights about the joint behavior of these series. We first confirm the presence of a substantial association between interdealer order flow and exchange rate returns at horizons ranging from 1 min to two weeks, but find that the association is substantially weaker at longer horizons. We study the time-variation of the association between exchange rate returns and order flow both intradaily and over the long term, and show that the relationship appears to be stronger when market liquidity is lower. Overall, our study supports the view that liquidity effects play an important role in the relationship between order flow and exchange rate changes. This by no means rules out a role for order flow as a channel by which fundamental information is transmitted to the market, as we show that our findings are quite consistent with a recent model by Bacchetta and Van Wincoop (2006: Can information heterogeneity explain the exchange rate determination puzzle? American Economic Review, 96, pp. 552–576.) that combines both liquidity and information effects.