Research Summary
Research Summary
Overview
By: Boris Vallee
Description
Professor Vallée focuses on financial innovation, investigating it from different angles. This research thread has led him to relate the methods and insights of corporate finance and banking with those of other subfields, including household finance, public finance, political economy, and industrial organization. To analyze the scope and use of innovative financial products, he has constructed new data sets and original variables, an approach that has led him to interact with practitioners, hand-collect data, and conduct text-based analysis.
Financial Complexity
A frequently debated consequence of financial innovation is the increasing complexity of financial instruments. Professor Vallée and his co-author have studied the retail market for structured financial products, such as an instrument that provides capital protection and returns based on an underlying index. By performing a text analysis of the term sheets of the 55,000 such products issued in Europe since 2002 and constructing three indexes measuring complexity, he has found a steady increase in complexity, with no significant decline after the recent financial crisis. Further, Professor Vallée’s analysis shows that banks with the least sophisticated clients use complex instruments most prominently, and that financial complexity increases when competition intensifies.
Financial Institutions and Contingent Capital
In light of the concern about high leverage of financial institutions, Professor Vallée has researched the market reaction and economic performance following the exercise of contingent capital options, which convert debt into equity, embedded in some specific bank-issued capital instruments. During the financial crisis, European banks massively triggered option features of hybrid bonds they had issued in response to regulatory capital requirements in order to reduce their debt burden. This episode constitutes the first real-world experiment on the use of contingent capital features. Professor Vallée finds that these trigger events are positively received by credit markets; stockholder reaction is more mixed, depending on the type of resulting debt relief and leverage. Moreover, banks that obtain regulatory debt relief by using this option exhibit higher economic performance than similar banks that do not. These findings point to the possible constructive role of innovative debt instruments as an effective solution to the dilemma of bank capital regulation.
Innovative Borrowing Instruments in Public Finance
Professor Vallée and his research collaborator have examined toxic loans as borrowing instruments used by local governments to hide debt cost for their own strategic advantage. While politicians often argue that banks “fool” them with complex products, Professor Vallée’s findings support a different explanation. Using proprietary data, he shows that politicians strategically use risky borrowing instruments to increase their chances of re-election. For instance, toxic loans are utilized significantly more often by highly indebted local governments and in politically contested areas.
Financial Complexity
A frequently debated consequence of financial innovation is the increasing complexity of financial instruments. Professor Vallée and his co-author have studied the retail market for structured financial products, such as an instrument that provides capital protection and returns based on an underlying index. By performing a text analysis of the term sheets of the 55,000 such products issued in Europe since 2002 and constructing three indexes measuring complexity, he has found a steady increase in complexity, with no significant decline after the recent financial crisis. Further, Professor Vallée’s analysis shows that banks with the least sophisticated clients use complex instruments most prominently, and that financial complexity increases when competition intensifies.
Financial Institutions and Contingent Capital
In light of the concern about high leverage of financial institutions, Professor Vallée has researched the market reaction and economic performance following the exercise of contingent capital options, which convert debt into equity, embedded in some specific bank-issued capital instruments. During the financial crisis, European banks massively triggered option features of hybrid bonds they had issued in response to regulatory capital requirements in order to reduce their debt burden. This episode constitutes the first real-world experiment on the use of contingent capital features. Professor Vallée finds that these trigger events are positively received by credit markets; stockholder reaction is more mixed, depending on the type of resulting debt relief and leverage. Moreover, banks that obtain regulatory debt relief by using this option exhibit higher economic performance than similar banks that do not. These findings point to the possible constructive role of innovative debt instruments as an effective solution to the dilemma of bank capital regulation.
Innovative Borrowing Instruments in Public Finance
Professor Vallée and his research collaborator have examined toxic loans as borrowing instruments used by local governments to hide debt cost for their own strategic advantage. While politicians often argue that banks “fool” them with complex products, Professor Vallée’s findings support a different explanation. Using proprietary data, he shows that politicians strategically use risky borrowing instruments to increase their chances of re-election. For instance, toxic loans are utilized significantly more often by highly indebted local governments and in politically contested areas.