Working Paper: NBER ID: w23419
Authors: Elias Albagli; Christian Hellwig; Aleh Tsyvinski
Abstract: We analyze the firm-level and aggregate consequences of equity market imperfections in the form of noisy information aggregation for corporate risk-taking and investment. Market imperfections cause controlling shareholders to invest too much in upside risks and too little in downside risks in an attempt to capture market rents. In partial equilibrium, these inefficiencies are particularly severe if upside risks are coupled with near constant returns to scale. In general equilibrium, the shareholders’ collective attempts to boost shareholder value of individual firms leads to a novel pecuniary externality that amplifies investment distortions with downside risks but offsets distortions with upside risks, thereby overturning the results from the partial equilibrium analysis. We consider policy interventions to correct the distortions, and show that in general equilibrium such interventions disrupt the financial market’s allocational role. We analyze extensions of our model to excess leverage, agency conflicts between shareholders and managers, negative welfare effects of transparency, excess sensitivity of investment to stock prices, and dynamically inconsistent firm behavior.
Keywords: equity market imperfections; shareholder incentives; corporate risk-taking; investment distortions; regulatory interventions
JEL Codes: D21; E22; G1; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Policy interventions (D78) | Correcting distortions (C51) |
| Policy interventions (D78) | Disrupting allocational role of financial markets (G19) |
| Equity market imperfections (D52) | Controlling shareholders invest excessively in upside risks (G34) |
| Equity market imperfections (D52) | Controlling shareholders underinvest in downside risks (G34) |
| Controlling shareholders invest excessively in upside risks (G34) | Socially inefficient outcomes (D61) |
| Controlling shareholders underinvest in downside risks (G34) | Socially inefficient outcomes (D61) |
| Collective attempts of shareholders to maximize individual firm value (L21) | Novel pecuniary externality (D62) |
| Novel pecuniary externality (D62) | Amplified investment distortions associated with downside risks (G31) |
| Novel pecuniary externality (D62) | Mitigated investment distortions linked to upside risks (H32) |
| Equity market imperfections (D52) | Significant implications for investment decisions (G11) |
| Equity market imperfections (D52) | Significant implications for aggregate welfare (D69) |