The Journal of Finance

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.

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.

Fischer Black Prize for 2003

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

Raghuram G. Rajan

Analyst Following of Initial Public Offerings

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb04811.x

RAGHURAM RAJAN, HENRI SERVAES

We examine data on analyst following for a sample of initial public offerings completed between 1975 and 1987 to see how they relate to three well‐documented IPO anomalies. We find that higher underpricing leads to increased analyst following. Analysts are overoptimistic about the earnings potential and long term growth prospects of recent IPOs. More firms complete IPOs when analysts are particularly optimistic about the growth prospects of recent IPOs. In the long run, IPOs have better stock performance when analysts ascribe low growth potential rather than high growth potential. These results suggest that the anomalies may be partially driven by overoptimism.

Covenants and Collateral as Incentives to Monitor

Published: 09/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb04052.x

RAGHURAM RAJAN, ANDREW WINTON

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.

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, Liquidity Everywhere, Not a Drop to Use: Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity

Published: 07/05/2024   |   DOI: 10.1111/jofi.13370

VIRAL V. ACHARYA, RAGHURAM RAJAN

Central bank balance sheet expansion, through actions like quantitative easing, is run through commercial banks. While this increases liquid central bank reserves held on commercial bank balance sheets, demandable uninsured deposits issued to finance the reserves also increase. Subsequent shrinkage in the central bank balance sheet may entail shrinkage in bank‐held reserves without a commensurate reduction in deposit claims. Furthermore, during episodes of liquidity stress, when many claims on liquidity are called, surplus banks may hoard reserves. As a result, central bank balance sheet expansion may create less additional liquidity than typically thought, and indeed, may increase the probability and severity of episodes of liquidity stress.

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.

The Decline of Secured Debt

Published: 12/18/2023   |   DOI: 10.1111/jofi.13308

EFRAIM BENMELECH, NITISH KUMAR, RAGHURAM RAJAN

The share of secured debt issued (as a fraction of total corporate debt) declined steadily in the United States over the twentieth century. This stems partly from financial development giving creditors greater confidence that high‐quality borrowers will respect their claims even if creditors do not obtain security upfront. Consequently, such borrowers prefer retaining financial flexibility by not giving security up front. Instead, security is given contingently—when a firm approaches distress. This also explains why, superimposed on the secular decline, the share of secured debt issued is countercyclical.

The Cost of Diversity: The Diversification Discount and Inefficient Investment

Published: 03/31/2007   |   DOI: 10.1111/0022-1082.00200

Raghuram Rajan, Henri Servaes, Luigi Zingales

We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversified firm. The model predicts that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities. When diversity in resources and opportunities increases, however, resources can flow toward the most inefficient division, leading to more inefficient investment and less valuable firms. We test these predictions on a panel of diversified U.S. firms during the period from 1980 to 1993 and find evidence consistent with them.

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.

Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit‐taking

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00415

Anil K. Kashyap, Raghuram Rajan, Jeremy C. Stein

What ties together the traditional commercial banking activities of deposit‐taking and lending? We argue that since banks often lend via commitments, their lending and deposit‐taking may be two manifestations of one primitive function: the provision of liquidity on demand. There will be synergies between the two activities to the extent that both require banks to hold large balances of liquid assets: If deposit withdrawals and commitment takedowns are imperfectly correlated, the two activities can share the costs of the liquid‐asset stockpile. We develop this idea with a simple model, and use a variety of data to test the model empirically.