The Journal of Finance

Presidential Address: The Corporation in Finance

Published: 07/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01745.x

RAGHURAM G. RAJAN

To produce significant net present value, an entrepreneur has to differentiate her enterprise from the ordinary. To take collaborators with her, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain control rights that will allow them to be repaid. A vibrant stock market helps the entrepreneur commit to these two transformations. The nature of firms and financing are intimately linked.

Insiders and Outsiders: The Choice between Informed and Arm's‐Length Debt

Published: 09/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04662.x

RAGHURAM G. RAJAN

While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.

Fischer Black Prize for 2003

Published: 03/21/2003   |   DOI: 10.1111/1540-6261.00533

Raghuram G. Rajan

Land and Credit: A Study of the Political Economy of Banking in the United States in the Early 20th Century

Published: 11/14/2011   |   DOI: 10.1111/j.1540-6261.2011.01694.x

RAGHURAM G. RAJAN, RODNEY RAMCHARAN

We find that, in the early 20th century, counties in the United States where the agricultural elite had disproportionately large land holdings had significantly fewer banks per capita, even correcting for state‐level effects. Moreover, credit appears to have been costlier, and access to it more limited, in these counties. The evidence suggests that elites may restrict financial development in order to limit access to finance, and they may be able to do so even in countries with well‐developed political institutions.

Liquidity Shortages and Banking Crises

Published: 03/02/2005   |   DOI: 10.1111/j.1540-6261.2005.00741.x

DOUGLAS W. DIAMOND, RAGHURAM G. RAJAN

We show in this article that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or contractual links between banks, we argue that bank failures can shrink the common pool of liquidity, creating, or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity and solvency problems interact and can cause each other, making it hard to determine the cause of a crisis. We propose a robust sequence of intervention.

What Do We Know about Capital Structure? Some Evidence from International Data

Published: 12/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05184.x

RAGHURAM G. RAJAN, LUIGI ZINGALES

We investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G‐7 countries. We find that factors identified by previous studies as correlated in the cross‐section with firm leverage in the United States, are similarly correlated in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved.

Does Distance Still Matter? The Information Revolution in Small Business Lending

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00505

Mitchell A. Petersen, Raghuram G. Rajan

The distance between small firms and their lenders is increasing, and they are communicating in more impersonal ways. After documenting these systematic changes, we demonstrate they do not arise from small firms locating differently, consolidation in the banking industry, or biases in the sample. Instead, improvements in lender productivity appear to explain our findings. We also find distant firms no longer have to be the highest quality credits, indicating they have greater access to credit. The evidence indicates there has been substantial development of the financial sector, even in areas such as small business lending.

The Benefits of Lending Relationships: Evidence from Small Business Data

Published: 03/01/1994   |   DOI: 10.1111/j.1540-6261.1994.tb04418.x

MITCHELL A. PETERSEN, RAGHURAM G. RAJAN

This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. We find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.

A Theory of Bank Capital

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00296

Douglas W. Diamond, Raghuram G. Rajan

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.

Going the Extra Mile: Distant Lending and Credit Cycles

Published: 02/07/2022   |   DOI: 10.1111/jofi.13114

JOÃO GRANJA, CHRISTIAN LEUZ, RAGHURAM G. RAJAN

The average distance of U.S. banks from their small corporate borrowers increased before the global financial crisis, especially for banks in competitive counties. Small distant loans are harder to make, so loan quality deteriorated. Surprisingly, such lending intensified as the Fed raised interest rates from 2004. Why? We show that banks' responses to higher rates led bank deposits to shift into competitive counties. Short‐horizon bank management recycled these inflows into risky loans to distant uncompetitive counties. Thus, rate hikes, competition, and managerial short‐termism explain why inflows “burned a hole” in banks' pockets and, more generally, increased risky lending.

Pledgeability, Industry Liquidity, and Financing Cycles

Published: 07/04/2019   |   DOI: 10.1111/jofi.12831

DOUGLAS W. DIAMOND, YUNZHI HU, RAGHURAM G. RAJAN

Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm's current access to finance.

The Internal Governance of Firms

Published: 05/23/2011   |   DOI: 10.1111/j.1540-6261.2011.01649.x

VIRAL V. ACHARYA, STEWART C. MYERS, RAGHURAM G. RAJAN

We develop a model of internal governance where the self‐serving actions of top management are limited by the potential reaction of subordinates. Internal governance can mitigate agency problems and ensure that firms have substantial value, even with little or no external governance by investors. External governance, even if crude and uninformed, can complement internal governance and improve efficiency. This leads to a theory of investment and dividend policy, in which dividends are paid by self‐interested CEOs to maintain a balance between internal and external control.