Research & Ideas

  • Creating Shared Value

    January, 2011 - Harvard Business Review

    Michael Porter, Mark R. Kramer

    The capitalist system is under siege. In recent years business has been criticized as a major cause of social, environmental, and economic problems. Companies are widely thought to be prospering at the expense of their communities. Trust in business has fallen to new lows, leading government officials to set policies that undermine competitiveness and sap economic growth. Business is caught in a vicious circle. A big part of the problem lies with companies themselves, which remain trapped in an outdated, narrow approach to value creation. Focused on optimizing short-term financial performance, they overlook the greatest unmet needs in the market as well as broader influences on their long-term success. Why else would companies ignore the well-being of their customers, the depletion of natural resources vital to their businesses, the viability of suppliers, and the economic distress of the communities in which they produce and sell? It doesn't have to be this way, say Porter, of Harvard Business School, and Kramer, the managing director of the social impact advisory firm FSG.

  • Stop Holding Yourself Back

    January, 2011 - Harvard Business Review

    Anne Morriss, Robin J. Ely, Frances X. Frei

    After working with hundreds of leaders in a wide variety of organizations and in countries all over the globe, the authors found one very clear pattern: when it comes to meeting their leadership potential, many people unintentionally get in their own way. Five barriers in particular tend to keep promising managers from becoming exceptional leaders: people overemphasize personal goals, protect their public image, turn their competitors into two-dimensional enemies, go it alone instead of soliciting support and advice, and wait for permission to lead.

  • Are You a Good Boss-Or a Great One?

    January, 2011 - Harvard Business Review

    Linda Hill, Kent Lineback

    Private moments of doubt and fear come even to managers who have spent years on the job. Any number of events can trigger them: an initiative is going poorly; you get a lukewarm performance review; your new assignment is daunting. HBS professor Linda Hill and executive Kent Lineback have long studied the question of how managers grow and advance. Their experience brings them to a simple but troubling observation: Most bosses reach a certain level of proficiency and stay there-short of what they could and should be. Why? Because they stop working on themselves.

  • Unplugged : M@n@gement in Times of Economic Crisis: Insights Into Organizational Ambidexterity

    December, 2010 - M@n@gement

    Achim Schmitt, Gilbert Probst, Michael Tushman

    We constantly hear of the increasing complexity of our fast-paced, globalized world, and those who did not survive the succession of crises of the last decade could certainly attest to the difficulties of strategy making in such circumstances. Of course, our reflex when confronted with fear of the future is often to run for cover, particularly if management can get away with downsizing while blaming the crisis. But of course, this only fulfils the short-term objectives of strategy. If an organization favors short-term exploitation when crisis strikes, what will become of it in the longer term? By the same token, allocating resources to long-term exploration might incur the risk of precipitating the fall.

  • The Psychological Costs of Pay-for-Performance: Implications for Strategic Compensation

    December, 2010 - HBS Working Papers

    Ian Larkin, Francesca Gino, Lamar Pierce

    This paper posits that the psychological costs of pay-for-performance systems often dominate their benefits to firms, and proposes an integrated theory of strategic compensation.

  • The Case for Professional Boards

    December, 2010 - Harvard Business Review

    Robert Pozen

    When the world's largest financial institutions had to be rescued from insolvency in 2008, many experts laid the blame at the feet of corporate boards. But insufficient board oversight is a problem that had supposedly been solved in 2002. As the United States reeled from the blatant failures of corporate governance at Enron and WorldCom, Congress passed the famous Sarbanes-Oxley Act (SOX) to prevent such failures from happening again. The new rules looked promising. The majority of a board's directors now had to be independent. And senior executives were required to conduct annual assessments of their internal controls for review by external auditors, whose work would be further reviewed by a quasi-governmental oversight board. By the time of the financial meltdown, most major financial institutions were SOX compliant-but that didn't stop the failures. More than 80% of collapsed banks' board members were independent, as were all members of their audit, compensation, and nominating committees. All the firms evaluated their internal controls yearly, and, in 2007, their external auditors' reports showed no material weaknesses. Neither did the reviews by the quasi-governmental board. So why were the SOX reforms so ineffective? In the author's view, it's because they merely added a new layer of legal obligations for governance without improving the quality of people serving on the boards or changing their behavioral dynamics.

  • Does Diversification Create Value in the Presence of External Financing Constraints? Evidence from the 2007-2009 Financial Crisis

    December, 2010 - HBS Working Papers

    Venkat Kuppuswamy, Belén Villalonga

    We show that the value of corporate diversification increased during the 2007-2009 financial crisis. Diversification gave firms both financing and investment advantages. First, conglomerates became significantly more leveraged relative to comparable focused firms. Second, conglomerates' access to internal capital markets became more valuable not just because external capital markets became more costly, but also because the efficiency of internal capital allocation increased significantly during the crisis. Our analysis provides new evidence on how the diversification discount and its drivers vary with financial constraints and economic conditions and suggests that corporate diversification can serve an important insurance function for investors.

  • A Brief Postwar History of U.S. Consumer Finance

    December, 2010 - HBS Working Papers

    Andrea Ryan, Gunnar Trumbull, Peter Tufano

    For over three centuries and throughout the globe, people have enthusiastically bought savings products that incorporate lottery elements. In lieu of paying traditional interest to all investors proportional to their balances, these Prize Linked Savings (PLS) accounts distribute periodic sizeable payments to some investors using a lottery-like drawing where an investor's chances of winning are proportional to one's account balances. This paper describes these products, provides examples of their use, argues for their potential popularity in the United States-especially to low and moderate income non-savers-and discusses the laws and regulations in the United States that largely prohibit their issuance.

  • A Note on Fairness and Redistribution

    December, 2010 - HBS Working Papers

    Rafael Di Tella, Juan Dubra

    We note some problems in Alesina and Angeletos (2005) and suggest a way to maintain the key insight of that paper, which is that a demand for fairness could lead to different economic systems such as those observed in France versus the U.S. (multiple equilibria).

  • Towards an Understanding of the Role of Standard Setters in Standard Setting

    December, 2010 - HBS Working Papers

    Karthik Ramanna, Abigail Allen

    Accounting standards promulgated by the Financial Accounting Standards Board (FASB) play an important role in the development and maintenance of capital markets worldwide, so it is important to understand how these standards come to be. Prior research has focused on the effect of corporate lobbying on the development of FASB standards, but has largely overlooked the role of the FASB members themselves. Looking at these individuals between 1973 and 2007, Harvard Business School doctoral candidate Abigail M. Allen and professor Karthik Ramanna examine how board members' professional experience, length of service on the board, and political leanings influenced accounting standards.

  • Financial Guarantors and the 2007-2009 Credit Crisis

    November, 2010 - HBS Working Papers

    Daniel Bergstresser, Randolph Cohen, Siddharth Shenai

    More than half of the municipal bonds issued between 1995 and 2009 were sold with bond insurance. During the credit crisis the perceived credit quality of the financial guarantors fell, and yields on insured bonds exceeded yields on equivalent uninsured issues. It does not appear that either property and casualty insurers or open-end municipal mutual funds were dumping insured bonds; analysis of holdings data indicates that their propensity to sell bonds was unusually low for the issues insured by troubled insurers. At least on a bond-by-bond basis, the yield inversion phenomenon is also not explained by the rapid liquidation of Tender Option Bond (TOB) programs, which disproportionately held insured issues. Finally, during the recent crisis the insured bonds have become significantly less liquid than uninsured municipal debt.

  • Wealth and Jobs: The Broken Link

    November, 2010 - Harvard Business Review

    Nitin Nohria

    This article discusses the weakening connections between business growth and job creation. The industrial economy of the 20th century ensured that growing firms would need to add workers, but the increasingly globalized and information-based economy of the early 21st century makes it possible for businesses to increase profits without adding significant numbers of employees.

  • Do Bonuses Enhance Sales Productivity? A Dynamic Structural Analysis of Bonus-Based Compensation Plans

    October, 2010 - HBS Working Papers

    Doug J. Chung, Thomas Steenburgh, K. Sudhir

    Companies generally pay their sales staff with some combination of salary, commissions, and bonuses for meeting quotas-with sales force costs averaging about 10 percent of sales revenue in the United States. This paper aims to gain insight into the most effective way to design a compensation plan, concentrating on whether bonuses boost sales productivity and whether they should be awarded quarterly or annually.

  • Reversing the Null: Regulation, Deregulation, and the Power of Ideas

    October, 2010 (revised) - HBS Working Papers

    David Moss

    It has been said that deregulation was an important source of the recent financial crisis. It may be more accurate, however, to say that a deregulatory mindset was an important source of the crisis-a mindset that, to a very significant extent, grew out of profound changes in academic thinking about the role of government. As scholars of political economy quietly shifted their focus from market failure to government failure over the second half of the twentieth century, they set the stage for a revolution in both government and markets, the full ramifications of which are still only beginning to be understood. This intellectual sea-change generated some positive effects, but also some negative ones, including (it seems) an excessively negative impression of the capacity of government to address problems in the marketplace. Today, as we consider the need for new regulation, particularly in the wake of the financial crisis, another fundamental shift in academic thinking about the role of government may be required-involving nothing less than a reversal of the prevailing null hypothesis in the study of political economy.

  • Making Savers Winners: An Overview of Prize-Linked Savings Products

    October, 2010 - NBER Working Papers

    Melissa Schettini Kearney, Peter Tufano, Jonathan Guryan, and Erik Hurst

    For over three centuries and throughout the globe, people have enthusiastically bought savings products that incorporate lottery elements. In lieu of paying traditional interest to all investors proportional to their balances, these Prize Linked Savings (PLS) accounts distribute periodic sizeable payments to some investors using a lottery-like drawing where an investor's chances of winning are proportional to one's account balances. This paper describes these products, provides examples of their use, argues for their potential popularity in the United States-especially to low and moderate income non-savers-and discusses the laws and regulations in the United States that largely prohibit their issuance.

  • Crashes and Collateralized Lending

    September, 2010 - HBS Working Papers

    Jakub W. Jurek, Erik Stafford

    This paper develops a parsimonious static model for characterizing financing terms in collateralized lending markets. We characterize the systematic risk exposures for a variety of securities and develop a simple indifference-pricing framework to value the systematic crash risk exposure of the collateral. We then apply Modigliani and Miller's (1958) Proposition Two (MM) to split the cost of bearing this risk between the borrower and lender, resulting in a schedule of haircuts and financing rates. The model produces comparative statics and time-series dynamics that are consistent with the empirical features of repo market data, including the credit crisis of 2007-2008.

  • How Did Increased Competition Affect Credit Ratings?

    September, 2010 - HBS Working Papers

    Bo Becker and Todd Milbourn

    The credit rating industry has historically been dominated by just two agencies, Moody's and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how, in fact, increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower-quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.

  • Making the Numbers? 'Short Termism' & the Puzzle of Only Occasional Disaster

    September, 2010 - HBS Working Papers

    Nelson P. Repenning, Rebecca Henderson

    Much recent work in strategy and popular discussion suggests that an excessive focus on "managing the numbers"-delivering quarterly earnings at the expense of longer-term investments-makes it difficult for firms to make the investments necessary to build competitive advantage. "Short termism" has been blamed for everything from the decline of the U.S. automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that can reconcile these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm's capability is close to a critical "tipping threshold." When the firm operates above this threshold, managing earnings smoothes revenue with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage. This piece has also been highlighted in HBS Working Knowledge.

  • Building a Better America-One Wealth Quintile at a Time

    September, 2010 - Forthcoming in Perspectives on Psychological Science

    Michael I. Norton, Dan Ariely

    Disagreements about the optimal level of wealth inequality underlie policy debates ranging from taxation to welfare. We attempt to insert the desires of "regular" Americans into these debates by asking a nationally representative online panel to estimate the current distribution of wealth in the United States and to "build a better America" by constructing distributions with their ideal level of inequality. First, respondents dramatically underestimated the current level of wealth inequality. Second, respondents constructed ideal wealth distributions that were far more equitable than even their erroneously low estimates of the actual distribution. Most important from a policy perspective, we observed a surprising level of consensus: all demographic groups-even those not usually associated with wealth redistribution such as Republicans and the wealthy-desired a more equal distribution of wealth than the status quo.

  • Using What We Know: Turning Organizational Knowledge into Team Performance

    August, 2010 - HBS Working Papers

    Bradley R. Staats, Melissa A. Valentine, Amy C. Edmondson

    An organization's captured (and codified) knowledge--white papers, case studies, documented processes--should help project teams perform better, but does it? Existing research has not answered the question, even as U.S. companies alone spend billions annually on knowledge management programs. Looking at large-scale, objective data from Indian software developer Wipro, researchers Bradley R. Staats, Melissa A. Valentine, and Amy C. Edmondson found that team use of an organization's captured knowledge enhanced productivity, especially for teams that were geographically diverse, relatively low in experience, or performing complex work.

  • Multinational Firms, Labor Market Discrimination, and the Capture of Competitive Advantage by Exploiting the Social Divide

    August, 2010 - HBS Working Papers

    Jordan Siegel, Lynn Pyun, B.Y. Cheon

    Women and ethnic minorities are frequently discriminated against in the labor markets of both developed and emerging economies, particularly in opportunities for management positions. Multinationals entering such markets must decide whether to aggressively hire and promote the excluded group, thus reaping the benefits of their underutilized talent, or conform to local practice and avoid provoking some bigoted policymakers, executives, purchasers, and/or supply agents. The authors find that multinationals gain significant competitive opportunities by scanning the host-market social landscape, identifying social schisms in the labor market, and exploiting such schisms by actively hiring and promoting members of the excluded group to positions of management responsibility.

  • Venture Capital Investment in the Clean Energy Sector

    August, 2010 - HBS Working Papers

    Shikhar Ghosh, Ramana Nanda

    We examine the extent to which venture capital is adequately positioned for the rapid commercialization of clean energy technologies in the U.S. While there are several startups in clean energy that are well-suited to the traditional venture capital investment model, our analysis highlights a number of structural challenges related to venture capital (VC) investment in the sector that is particularly acute for startups involved in the production of clean energy.

  • Financing Risk and Bubbles of Innovation

    July, 2010 - HBS Working Papers

    Ramana Nanda, Matthew Rhodes-Kropf

    Investors in risky startups who stage their investments face financing risk-that is, the risk that later-stage investors will not fund the startup, even if the fundamentals of the firm are still sound. This paper show that financing risk is part of a rational equilibrium where investors can flip from investing to not investing in certain sectors of the economy. We further demonstrate that financing risk has the greatest impact on firms with the most real option value. Hence, the mix of projects funded and type of investors who are active varies with the level of financing risk in the economy. We also highlight that some extremely novel technologies may in fact need "hot" financial markets to get through the initial period of diffusion. The work underscores that financial markets may play a much larger and under-studied role in creating and magnifying bubbles of innovation in the real economy.

  • Business Model Innovation and Competitive Imitation

    July, 2010 - HBS Working Papers

    Ramon Casadesus-Masanell, Feng Zhu

    This paper examines the desirability, or lack thereof, of business model innovations when they cannot be protected, opening the door to competitive imitation.

  • Leniency in Private Regulatory Enforcement: The Role of Organizational Scope and Governance

    July, 2010 - HBS Working Papers

    Lamar Pierce, Michael W. Toffel

    Profit-seeking firms can present efficiency improvements when performing functions traditionally relegated to government. Yet these potential cost efficiencies from market competition are often offset by poor enforcement quality resulting from moral hazard, which can be particularly onerous when outsourcing enforcement of government regulation. In this paper, we argue that the considerable moral hazard of private regulatory enforcement can be mitigated by the scope of organizations' product/service portfolios and by private governance mechanisms. These organizational characteristics affect the stringency of enforcement through reputation and customer loyalty, differential impacts of government sanctions, and standardization and internal monitoring of operations. We test our theory in the context of vehicle emissions testing in a state in which the government has outsourced inspection and enforcement to private sector establishments. Analyzing millions of emissions tests, we find empirical support for our hypotheses that particular forms of firm governance and product portfolios can mitigate moral hazard.

  • Surviving the Global Financial Crisis: Foreign Direct Investment and Establishment Performance

    June, 2010 - HBS Working Papers

    Laura Alfaro, Maggie Chen

    This paper examines the differential response of establishments to the global financial crisis, with particular emphasis on the role of foreign direct investment (FDI) in determining micro economic performance. Using a new worldwide dataset that reports the activities of more than 12 million establishments before and after 2008, we investigate how multinationals around the world responded to the crisis relative to local firms. We explore three distinct channels through which FDI affects establishment performance: (i) production linkages, (ii) financial linkages, and (iii) multinational networks. Our analysis shows that while multinational-owned establishments performed, on average, better than their local competitors, there is considerable heterogeneity in the role of FDI. First, multinationals located in countries that experienced sharper declines in aggregate output, demand, and credit conditions displayed a greater advantage over local firms. Multinationals headquartered in countries with a greater incidence of the crisis, in contrast, fared less satisfactorily abroad. Second, multinationals that engaged in activities with vertical production linkages or stronger financial constraints exhibited particularly better responses compared to local firms. Finally, being part of a larger multinational network also led to superior economic performance.

  • Financial Innovation and Financial Fragility

    June, 2010 - NBER Working Paper Series

    Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny

    A standard model of financial innovation is presented, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

  • Cyclicality of Credit Supply: Firm Level Evidence

    June, 2010 - HBS Working Papers

    Bo Becker, Victoria Ivashina

    The effect of bank loan supply through the business cycle using firm-level data from 1990 to 2009 is studied. The paper addresses two of the main empirical challenges in identifying the effects of bank credit supply. First, it focuses on firms' choice between two close forms of external financing: bank debt and public bonds. By conditioning the sample of firms raising new debt, a demand explanation for the drop in bank borrowing can be ruled out . Second, by doing the analysis at the firm level, how the composition of firms raising finance varies through time is directly addressed. We find strong evidence of substitution from bank loans to bonds at times characterized by tight lending standards, high levels of non-performing loans to bank equity, low bank share prices, and tight monetary policy. To illustrate our point, in the last half of 2007, 36% of all debt issues were bank loans. However, relative loan issuance fell to 8% by the first half of 2009, the lowest level in the period from 1990 to 2009. Although the bank-to-bond substitution can only be measured for larger firms (which have access to bond markets), this confirms that the substitution has strong predictive power for lending volume by small and unrated firms.

  • Innovations in Governance

    April, 2010 - NBER Working Paper Series

    Raymond Fisman, Eric Werker

    A standard model of financial innovation is presented, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

  • Just Say No to Wall Street: Putting a Stop to the Earnings Game

    April, 2010 - HBS Working Papers

    Michael C. Jensen, Joseph Fuller

    Putting an end to the ""earnings game"" requires that CEOs reclaim the initiative by avoiding earnings guidance and managing expectations in such a way that their stocks trade reasonably close to their intrinsic value. In place of earnings forecasts, management should provide information about the company's strategic goals and main value drivers. They should also discuss the risks associated with the strategies and management's plans to deal with them. Using the experiences of several companies, the authors illustrate the dangers of conforming to market pressures for unrealistic growth targets. They argue that an overvalued stock, by encouraging overpriced acquisitions and other risky, value-destroying bets, can be as damaging to the long-run health of a company as an undervalued stock.

  • Who Selected Adjustable Rate Mortgages? Evidence from the 1989-2007 Surveys of Consumer Finances

    March, 2010 - HBS Working Papers

    Daniel Bergstresser, John Beshears

    The authors find evidence that households selecting adjustable rate mortgages (ARMs) during the recent decade were disproportionately those who were less suspicious or who may have had difficulty understanding complicated ARM features that became commonplace prior to the financial crisis.

  • The Economic Crisis and Medical Care Usage

    March, 2010 - HBS Working Papers

    Annamaria Lusardi, Daniel Schneider, Peter Tufano

    A unique, nationally representative cross-national dataset is used to document the reduction in individuals' usage of routine non-emergency medical care in the midst of the economic crisis. A substantially larger fraction of Americans have reduced medical care than have individuals in Great Britain, Canada, France, and Germany, all countries with universal health care systems. At the national level, reductions in medical care are related to the degree to which individuals must pay for it, and within countries are strongly associated with exogenous shocks to wealth and employment.

  • Coming Clean and Cleaning Up: Is Voluntary Self-Reporting a Signal of Effective Self-Policing

    March, 2010 (revised) - HBS Working Papers

    Michael Toffel, Jodi L. Short

    Administrative agencies are increasingly establishing voluntary self-reporting programs both as an investigative tool and to encourage regulated firms to police themselves. Effective self-policing is critical to contemporary regulatory designs that rely heavily on regulated entities to monitor and assure their own regulatory compliance. We investigate whether self-reporting, or the voluntary disclosure of legal violations, can reliably signal effective self-policing efforts that might warrant a reduction in regulatory scrutiny. We find voluntary disclosure to be associated with improvements in regulatory compliance and environmental performance, indicating that self-reporting is associated with effective self-policing. In addition, we find evidence that regulators subsequently reduced scrutiny of voluntary disclosers, which suggests that self-reporting can help regulators economize government enforcement resources and develop cooperative relationships with firms that are committed to self-policing.

  • Location Strategies for Agglomeration Economies

    February, 2010 - HBS Working Papers

    Juan Alcácer, Wilbur Chung

    Locations thick with similar economic activity expose firms to pools of skilled labor, specialized suppliers, and potential inter-firm knowledge spillovers that can provide firms with opportunities for competitive advantage. While certainly attractive, the lure of these agglomeration economies varies. Some firms should be wary of aiding their competitors by co-locating with them, for example, because each "agglomeration economy" differs in how readily competitors can leverage contributions made by others. HBS professor Juan Alcácer and Wilbur Chung of the University of Maryland develop a framework to better understand how firms respond to agglomeration economies. This publication has also been profiled in Harvard Business School Working Knowledge. Click here to read.

  • Accelerating Innovation In Energy: Insights from Multiple Sectors

    February, 2010 - HBS Working Papers

    Rebecca Henderson, Richard G. Newell

    How should the energy sector best respond to the threat of climate change? Henderson and co-author Richard Newell describe why accelerating innovation in energy could play an important role in shaping an effective response. This publication has also been profiled in Harvard Business School Working Knowledge. Click here to read.

  • Integrity: A Positive Model That Incorporates the Normative Phenomena of Morality, Ethics, and Legality-Abridged

    February, 2010 - HBS Working Papers

    Michael C. Jensen, Werner H. Erhard, Steve Zaffron

    The financial crisis of 2008-2009 has revealed that our broad model of corporate governance is broken, independent of the shortcomings in the regulatory system. Managers and boards of directors in scores of systemically important firms failed to protect employees, customers, or shareholders and placed the global financial system at risk. This paper assert that the root cause of the crisis can be found in five related systems: incentives, risk management and control, accounting, human capital, and culture. The worst firms had lethal combinations of strong incentives, weak control and risk management, flawed internal and external accounting, low skill and/or low integrity people, and corrosive cultures. Piecemeal attempts to fix elements of corporate governance will fail. The problem, to illustrate, is not just the structure of compensation. Nor will increasing required capital prevent problems at companies with strong incentives and weak controls. We may need a new kind of external agency for systemically risky firms that would take a holistic look at the five systems to identify weaknesses, make recommendations to managers and boards, and set regulatory policies, including assessing charges for insuring against losses. Without such a comprehensive assessment and improvement plan, boards cannot do their jobs, and the system will remain as subject to calamitous events as it was before the crisis.

  • Private Equity and Industry Performance

    December 2009 - HBS Working Papers

    Shai Bernstein, Josh Lerner, Morten Sørensen, and Per Strömberg

    In response to the global financial crisis that began in 2007, governments worldwide are rethinking their approach to regulating financial institutions. Among the financial institutions that have fallen under the gaze of regulators have been private equity (PE) funds. There are many open questions regarding the economic impact of PE funds, many of which cannot be definitively answered until the aftermath of the buyout boom of the mid-2000s can be fully assessed. HBS professor Josh Lerner and coauthors address one of these open questions, by examining the impact of PE investments across 20 industries in 26 major nations between 1991 and 2007. This publication has also been profiled in Harvard Business School Working Knowledge. Click here to read.

  • Management and the Financial Crisis (We have Met the Enemy and He Is Us…)

    November 2009 - HBS Working Papers

    William Sahlman

    The financial crisis of 2008-2009 has revealed that our broad model of corporate governance is broken, independent of the shortcomings in the regulatory system. Managers and boards of directors in scores of systemically important firms failed to protect employees, customers, or shareholders and placed the global financial system at risk. This paper assert that the root cause of the crisis can be found in five related systems: incentives, risk management and control, accounting, human capital, and culture. The worst firms had lethal combinations of strong incentives, weak control and risk management, flawed internal and external accounting, low skill and/or low integrity people, and corrosive cultures. Piecemeal attempts to fix elements of corporate governance will fail. The problem, to illustrate, is not just the structure of compensation. Nor will increasing required capital prevent problems at companies with strong incentives and weak controls. We may need a new kind of external agency for systemically risky firms that would take a holistic look at the five systems to identify weaknesses, make recommendations to managers and boards, and set regulatory policies, including assessing charges for insuring against losses. Without such a comprehensive assessment and improvement plan, boards cannot do their jobs, and the system will remain as subject to calamitous events as it was before the crisis.

  • The End of Chimerica

    November 2009 - HBS Working Papers

    Niall Ferguson, Moritz Schularick

    For the better part of the past decade, the world economy has been dominated by a world economic order that combined Chinese export-led development with U.S. over-consumption. The financial crisis of 2007-2009 likely marks the beginning of the end of the Chimerican relationship. In this paper we look at this era as economic historians, trying to set events in a longer-term perspective. In some ways China's economic model in the decade 1998-2007 was similar to the one adopted by West Germany and Japan after World War II. Trade surpluses with the U.S. played a major role in propelling growth. But there were two key differences. First, the scale of Chinese currency intervention was without precedent, as were the resulting distortions of the world economy. Second, the Chinese have so far resisted the kind of currency appreciation to which West Germany and Japan consented. We conclude that Chimerica cannot persist for much longer in its present form. As in the 1970s, sizeable changes in exchange rates are needed to rebalance the world economy. A continuation of Chimerica at a time of dollar devaluation would give rise to new and dangerous distortions in the global economy.

  • Banking Deregulations, Financing Constraints and Firm Entry Size

    October 2009 - HBS Working Papers

    William Kerr, Ramana Nanda

    This paper examines the effect of U.S. branch banking deregulations on the entry size of new firms using micro-data from the U.S. Census Bureau. It finds that the average entry size for startups did not change following the deregulations. However, among firms that survived at least four years, a greater proportion of firms entered either at their maximum size or closer to the maximum size in the first year. The magnitude of these effects was small compared to the much larger changes in entry rates of small firms following the reforms. The results highlight that this large-scale entry at the extensive margin can obscure the more subtle intensive margin effects of changes in financing constraints.

  • Systemic Risk and the Refinancing Ratchet Effect

    September 2009 - HBS Working Papers

    Amir E.Khandani, Andrew W. Lo, Robert C. Merton

    The confluence of three trends in the U.S. residential housing market-rising home prices, declining interest rates, and near-frictionless refinancing opportunities-led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a "ratchet" effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages.

  • Anger and Regulation

    August 2009 - NBER Working Paper Series

    Rafael Di Tella, Juan Dubra

    This paper proposes a model where voters experience an emotional cost when they observe a firm that has displayed insufficient concern for other people's welfare (altruism) in the process of making high profits. The main result is that, as competition decreases, the set of parameters for which such pooling equilibria exist beomes smaller and firms are more likely to anger consumers.

  • Understanding Inflation-Indexed Bond Markets

    June 2009 - NBER Working Paper Series

    John Y. Campbell, Robert J. Shiller, Luis M. Viceira

    This paper explores the history of inflation-indexed bond markets in the U.S. and the U.K. It documents a massive decline in long-term real interest rates from the 1990s until 2008, followed by a sudden spike in these rates during the financial crisis of 2008. Breakeven inflation rates, calculated from inflation-indexed and nominal government bond yields, stabilized until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments in the fall of 2008. Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds, that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing going forward, even though they have offered high returns over the past decade.

  • Informed and Interconnected: A Manifesto for Smarter Cities

    June 2009 - HBS Working Papers

    Rosabeth Moss Kanter, Stanley S. Litow

    The need for a fresh approach to U.S. communities is more urgent than ever because of the biggest global economic crisis since the Great Depression. Through examination of the barriers to solving urban problems (and the ways they reinforce each other), this paper offers a new approach to community transformation which calls for leaders to use technology to inform and connect people. But technology alone is not the answer. Realization of the vision requires leaders to invest in the tools, guide their use, and pave the way for transformation. Perhaps the urgency of the current economic crisis can provide the impetus to overcome resistance to change and turn problems into an opportunity to reduce costs, improve services to communities, and make our cities smarter.

  • Don't Just Survive-Thrive: Leading Innovation in Good Times and Bad.

    April 2009 - HBS Working Papers

    Lynda Applegate, J. Bruce Harreld

    Battered by contracting markets and frozen credit, many businesses today are fighting for survival. Indeed, the current global financial crisis provides a mandate for restructuring. But survival is not the end goal. In fact, cost cutting and restructuring are simply the first steps in repositioning and leading a company and industry through the crisis and in defining how business will be conducted in the future. This paper describes how IBM managed to, not just survive the crisis it faced in the early 1990s, but to reposition the company to lead the industry. The powerful lesson from the IBM story is that innovation is not a side business to running the real business.

  • Securing Jobs or the New Protectionism?: Taxing the Overseas Activities of Multinational Firms.

    March 2009 - HBS Working Papers

    Mihir Desai

    Tax policy toward American multinational firms would appear to be approaching a crossroads. The presumed linkages between domestic employment conditions and the growth of foreign operations by American firms have led to calls for increased taxation on foreign operations-the so-called "end to tax breaks for companies that ship our jobs overseas." At the same time, the current tax regime employed by the U.S. is being abandoned by the two remaining large capital exporters-the U.K. and Japan-that had maintained similar regimes. The conundrum facing policymakers is how to reconcile mounting pressures for increased tax burdens on foreign activity with the increasing exceptionalism of American policy.

  • Debt Literacy, Financial Experiences, and Overindebtedness.

    March 2009 - NBER Working Paper (purchase or subscription required)

    Peter Tufano, Annamaria Lusardi

    This paper analyzes a national sample of Americans with respect to their debt literacy, financial experiences, and their judgments about the extent of their indebtedness.

  • When Does Domestic Saving Matter for Economic Growth?

    January 2009 - HBS Working Papers

    Philippe Aghion, Diego Comin, Peter Howitt, and Isabel Tecu

    The researchers begin with a simply stated question: Can a country grow faster by saving more? Long-run growth theories imply that a country can grow faster by investing more in human or physical capital or in R&D, but that a country with access to international capital markets cannot grow faster by saving more. Domestic saving is therefore not considered an important ingredient in the growth process because investment can be financed by foreign saving. From the point of view of standard growth theory, the positive cross-country correlation between saving and growth that many commentators have noted appears puzzling. This publication has also been recently profiled in Harvard Business School Working Knowledge. Click here to read.

  • An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System

    January 2009 - HBS Working Papers

    David Moss

    The magnitude of the current financial crisis reflects the failure of an economic and regulatory philosophy that had proved increasingly influential in policy circles over the past three decades. This paper suggests (1) that contrary to the prevailing wisdom, New Deal policies (including federal deposit insurance and bank supervision) worked to stabilize the financial system; (2) that the financial catastrophe of 2007-2009 was not an accident, but rather a mistake, driven by a deregulatory mindset that took 50 years of post-New Deal financial stability for granted; and (3) that the dramatic federal response to the current financial crisis has created a new reality, in which virtually all systemically significant financial institutions now enjoy an implicit guarantee from the federal government that will continue to exist (and continue to generate moral hazard) long after the immediate crisis passes. Click here to read.

  • Fear of Rejection? Tiered Certification and Transparency

    October 2008 - HBS Working Papers

    Emmanuel Farhi, Josh Lerner, and Jean Tirole

    The sub-prime crisis has thrown a harsh spotlight on the practices of securities underwriters, which provided too many complex securities that proved to ultimately have little value. Certifiers such as rating agencies, journals, standard setting bodies, and providers of standardized tests play an increasingly important role in the market economies. Yet as scrutiny of rating agencies in the aftermath of the sub-prime crisis has shown, these organizations have complex incentive structures and may adopt problematic approaches. On an explicit level, all major rating agencies follow a well-defined process, whose end product is the publication of a rating based on an objective analysis. But firms have been historically able to get rating agencies not to disclose ratings that displease them. This publication has also been recently profiled in Harvard Business School Working Knowledge. Click here to read.

  • The Economics of Structured Finance

    October 2008 - HBS Working Papers

    Joshua Coval, Jakub W. Jurek and Erik Stafford

    The authors examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. This publication has also been recently profiled in Harvard Business School Working Knowledge. Click here to read.

  • Reputation and Competition: Evidence From the Credit Rating Industry

    October 2008 - HBS Working Papers

    Bo Becker and Todd Milbourn

    Fair and accurate credit ratings arguably play an important role in the financial system. In an environment absent free entry of rating agencies, the provision of quality ratings is at least partially sustained by the reputational concerns of the rating agencies. The economically significant entry of a third agency into a market that was previously best described as a duopoly provides a unique experiment to examine the effect of increased competition on the disciplining effects of reputation. Using a variety of data sources, the authors find that competition leads to more issuer-friendly and less informative ratings.

  • Economic Catastrophe Bonds

    April 2008 - Harvard Business School Working Papers

    Joshua D. Coval and Erik Stafford

    The central insight of asset pricing is that a security's value depends on both its distribution of payoffs across economic states and state prices. In fixed income markets, many investors focus exclusively on estimates of expected payoffs, such as credit ratings, without considering the state of the economy in which default is likely to occur. Such investors are likely to be attracted to securities whose payoffs resemble those of economic catastrophe bonds - bonds that default only under severe economic conditions. This paper shows that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation than alternatives with comparable payoff profiles. It also argues that this difference arises from the willingness of rating agencies to certify structured products with a low default likelihood as safe and from a large supply of investors who view them as such.

Faculty Interests