Hello all,

With the start of the new season, we bring you this year’s second newsletter, featuring the publication of the second issue of the RF for 2025, which includes nine articles. Below, you’ll find their summaries and abstracts.

Before we dive in, we’re pleased to welcome Olivier Darmouni, James Vickery, Ansgar Walther, and Michael Weber as Associate Editors of the Review of Finance. Their three-year terms began on 1 March 2025, and we look forward to their contributions to the journal.

Happy reading!

Volume 29, Issue 2, March 2025

ARTICLES

• What drives commodity price variation? (Editor's Choice)
  by Meng Han, Lammertjan Dam, Walter Pohl
• Corporate governance, meritocracy, and careers
  by Marco Pagano and Luca Picariello
• Supervisory cooperation and regulatory arbitrage
  by Thorsten Beck, Consuelo Silva-Buston, Wolf Wagner
• Bank regulation, investment, and capital requirements under adverse selection
  by Thomas J Rivera
• A good sketch is better than a long speech: evaluate delinquency risk through real-time video analysis
  by Xiangyu Chang, Lili Dai, Lingbing Feng, Jianlei Han, Jing Shi, Bohui Zhang
• Saving externality: when depositing too much breaks the bank
  by Agnese Leonello, Caterina Mendicino, Ettore Panetti, Davide Porcellacchia
• How do corporate tax hikes affect investment allocation within multinationals?
  by Antonio De Vito, Martin Jacob, Dirk Schindler, Guosong Xu
• Do salient climatic risks affect shareholder voting?
  by Eliezer M Fich and Guosong Xu
• Blockbuster or bust? Silver screen effect and stock returns
  by Sanghyun Hong and Xiaopeng Wei

For the full issue, please visit Issue 2 of Volume 29 on our website.

Final note: In this issue, we also have the correction to Margin constraints and asset prices, originally published in Volume 1, 2025.

What drives commodity price variation? (Editor's choice)

Authors: Meng Han, Lammertjan Dam, Walter Pohl

In financial markets, price variation generally reflects variation in discount rates rather than in expected cash flows, a pattern observed in many asset markets. An open question is whether this logic applies to commodity markets.

We show that commodity markets differ significantly from other asset markets. Commodity prices can still be viewed as reflecting the discounted value of future cash flows; however, prices strongly predict cash flows instead. This makes commodity prices much closer to the classical textbook view of price changes reflecting cash flow news.

From the point of view of a consumer of a commodity, it may seem peculiar to talk about the role of discount rates versus cash flows. If you operate an airline, a barrel of oil is purely a one-time cash outlay, and the only question is whether to determine the price now or later (i.e. whether to buy it on the spot or futures market). However, for an investor, commodities play a different role. Investors can trade commodities in both spot and futures markets to profit from price differences. Spot and futures prices do not move together perfectly, and the difference can be a reflection of news about the profitability of investing in this market, or how heavily investors discount. Experience in other markets suggests that the discount rate should dominate. It does not.

To explore this, we consider a trading strategy that turns a single commodity unit into an infinite series of cash flows. By repeatedly selling the unit and buying it again using futures contracts, the investor can collect the cash equivalent of net convenience yields. By net present value logic, the price of the commodity should equal the discounted sum of these yields, with price changes reflecting changes in expected yields, discount rates, or both.

We then apply a linearized present value model to commodity prices, similar to the Campbell-Shiller decomposition used for stocks. For equities, this model can reveal whether price-dividend ratios vary to predict future returns, dividend growth, or bubbles. However, applying this model to commodities is challenging because net convenience yields, the commodity equivalent of dividends, can be negative, complicating the log-linearization. To address this, we use the neglog transformation to generalize the Campbell-Shiller framework for negative yields. This approach preserves the economic meaning of negative yields.

With this generalized model, we explore the relationships between commodity price volatility, returns, and yield growth using an index for 23 commodities from 1959 to 2024. The figure highlights the main findings, with on the left the current yield-to-price ratio (percentage net convenience yield) versus the following 5-year cumulative return; and on the right the price-to-yield ratio versus the following 5-year cumulative net convenience yield growth. We find strong predictability patterns in both returns and yield growth (correlation 43% and 61% respectively). Higher commodity prices predict higher expected net convenience yields and lower expected returns, with yield growth being more predictable than returns. Over the long run, however, variation in commodity prices is primarily driven (about 90%) by expected yield growth.

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Corporate governance, meritocracy, and careers

Authors: Marco Pagano and Luca Picariello

This paper explores the impact of corporate governance standards on firms’ hiring and promotion policies, focusing on meritocracy versus power retention by entrepreneurs. Effective corporate governance can influence firms to adopt meritocratic practices, promoting skilled employees based on merit rather than favoritism. This alignment between corporate governance and merit-based policies improves firm productivity and attracts high-skill workers, which benefits not only the individual firm but also the broader economy by enhancing workforce skill levels and job-market alignment.

The authors propose a model in which entrepreneurs may choose non-meritocratic promotions to retain control, despite the cost of reduced efficiency and profitability. External financiers anticipate these costs and offer less favorable terms to firms that prioritize power retention over merit. Similarly, high-skill workers prefer meritocratic firms, as these companies provide better promotion and pay prospects. Consequently, firms that follow meritocratic principles are more likely to attract skilled labor, which increases both their individual productivity and overall market efficiency.

The paper shows that the labor market features a unique sorting equilibrium, where skilled employees gravitate toward firms with strong corporate governance standards and merit-based advancement, while firms with weaker governance attract unskilled workers. The better are corporate governance standards, the greater is the number of firms with meritocratic promotions, and therefore the larger is the number of workers whose career advancement rests on merit. The evidence shown in Figure 1 is consistent with the model’s prediction that governance standards should correlate with meritocratic practices: in countries with strong corporate governance (as measured by the World Bank’s Protection Minority Investors score) firms prioritize merit in promotions (based on an index built from the WEF Global Competitiveness report).

However, meritocratic promotion requires firms to offer higher incentive pay to motivate skilled managers, which can limit the profitability of merit-based promotions in the presence of severe agency problems. Offering incentive pay to skilled managers has an ambiguous effect on workers’ skill acquisition: higher pay upon promotion increases their incentives to acquire skills, but raises the cost of promoting skilled workers, thus reducing the fraction of meritocratic firms and thereby the promotion probability for skilled workers. As a result, the severity of managerial moral hazard may turn out to either increase or decrease the equilibrium fraction of skilled workers in the economy.

The model predicts that moderate improvements in governance standards only benefit firms where entrepreneurs place sufficiently low value on private benefits of control, while they damage entrepreneurs that value such benefits greatly. Hence, such reforms do not generate Pareto improvements. In contrast, extreme reforms enforcing universal merit-based promotions could lead to a Pareto improvement by aligning all firms with efficient practices. As a result, drastic governance reforms might gain broader political support than moderate ones.

Overall, the paper argues that corporate governance standards play a role in shaping not only firm-level meritocracy but also broader social welfare, productivity, and skill acquisition patterns.

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Supervisory cooperation and regulatory arbitrage

Authors: Thorsten Beck, Consuelo Silva-Buston, Wolf Wagner

While bank supervisors frequently cooperate across countries, novel data on 268 cooperation agreements reveal that such cooperation falls short of covering the global operations of large banking groups. We show that this causes material regulatory arbitrage: banking groups allocate lending activities and risk into third-country subsidiaries when cooperation agreements cover their operations in other countries. The average distortion in a country’s foreign lending caused by regulatory arbitrage is 21 percent, with the effect being magnified in the presence of a weak supervisory framework. Taken together, our results indicate that incompleteness in cooperation substantially diminishes its global effectiveness.

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Bank regulation, investment, and capital requirements under adverse selection

Authors: Thomas J Rivera

This article studies the optimal design of bank capital regulations when capital markets are subject to adverse selection. I show how the implementation of capital requirements can eliminate the information frictions that make raising capital costly by screening banks to reveal their private information to the market. The optimal regulations induce information revelation via recapitalization programs when the banking sector is weak and pool the banks’ private information via uniform capital requirements otherwise. Optimal capital requirements are linked to the securities issued to meet them, demonstrating potential welfare gains from incorporating more and less informationally sensitive securities into the design of capital regulations. Finally, the analysis generates insights into the joint design of equity capital requirements and additional tier 1 capital securities..

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A good sketch is better than a long speech: evaluate delinquency risk through real-time video analysis

Authors: Xiangyu Chang, Lili Dai, Lingbing Feng, Jianlei Han, Jing Shi, Bohui Zhang

This article proposes an innovative method to assess borrowers’ creditworthiness in consumer credit markets by conducting machine-learning-based analyses on real-time video information that records borrowers’ behavior during the loan application process. We find that the extent of borrowers’ micro-facial expressions of happiness is negatively associated with loan delinquency likelihood, while the degree of fear expressions is positively associated with delinquency risk. These results are consistent with two economic channels relating to the adequacy and uncertainty of borrowers’ future income, drawn from the extant psychology and economics literature. Our study provides important practical implications for fintech lenders and policymakers.

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Saving externality: when depositing too much breaks the bank

Authors: Agnese Leonello, Caterina Mendicino, Ettore Panetti, Davide Porcellacchia

In recent years, banks have experienced unprecedented growth in deposits, particularly during the COVID-19 pandemic. In the U.S., total bank deposits as a percentage of GDP surged by around 15 percentage points in the first quarter of 2020, while the Euro Area saw an increase of approximately 20 percentage points. While this inflow provided short-term bank liquidity, it possibly contributed to build up conditions that triggered recent failures, like that of Silicon Valley Bank in 2023. This paper investigates the implications of rising deposit levels on bank stability and economic efficiency, offering insights into how these dynamics contribute to financial fragility.

The paper extends the classic bank-run framework (e.g., Goldstein and Pauzner, 2005) by introducing a consumption-saving decision. Investors allocate their initial endowment between immediate consumption and deposits in a bank. Banks invest deposits in a long-term project but face the risk of early withdrawals due to coordination failures among depositors. The model features three main ingredients: (i) risk-averse investors with idiosyncratic liquidity needs, (ii) imperfect information about economic fundamentals and (iii) strategic complementarities in withdrawal decisions: depositors, fearing others will withdraw, may preemptively withdraw their own funds, thereby making the bank go bankrupt.

Our findings highlight a positive relation between the level of deposits and the probability of bank runs, in that a higher level of deposits increase depositors’ incentives to run. Individual depositors fail to consider this effect in their saving decisions, in contrast to what a social planner would do. Consequently, the decentralized equilibrium is inefficient. This “saving externality” leads to over-saving as well as exceedingly large banks, excessive financial fragility, and an inefficient provision of bank liquidity.

The inefficiency caused by the saving externality suggests a role for public intervention. Fiscal policies, in particular a proportional tax on deposits, could resolve the inefficiency by aligning individual saving decisions with the socially optimal level. The deposit tax is proportional to the marginal effect of deposits on the run probability and the utility loss from runs, and has the effect of discouraging overly large banks, reducing financial fragility, and restoring constrained efficiency.

This study contributes to the literature on bank fragility, financial intermediation, and policy design by highlighting a previously overlooked externality in saving decisions. From a policy perspective, it also underscores the importance of integrating prudential and fiscal policies to address financial fragility in a comprehensive manner.

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How do corporate tax hikes affect investment allocation within multinationals?

Authors: Antonio De Vito, Martin Jacob, Dirk Schindler, Guosong Xu

This paper studies how corporate tax hikes transmit across countries through multinationals’ internal networks of subsidiaries. Prior theoretical models of tax competition suggest that the investment of a multinational in one country should increase if the business unit is exposed to a foreign corporate tax hike. The rationale is that following the tax hike, the parent firm will shift resources from the foreign jurisdiction with higher taxation to the other subsidiary with relatively lower taxation. However, we argue that focusing on tax competition is incomplete because it does not capture the complete picture of multinationals’ networks, which feature significant intra-firm production linkages.

As a novel contribution of this paper, we first develop a model that incorporates (i) tax competition between jurisdictions and (ii) production linkages between subsidiaries within a multinational firm. We show that production linkages can generate negative spillover effects. The intuition is that a tax hike in an upstream subsidiary makes the intermediate good more costly, which reduces the marginal after-tax profitability in a downstream subsidiary and, hence, its investment. Likewise, when a tax hike happens in the downstream subsidiary, the after-tax profitability in the downstream subsidiary falls. This makes investment in the intermediate input by the upstream subsidiary less attractive. Hence, investments decline following a foreign tax hike.

We empirically show that local business units cut investment by approximately 0.5% for a 1% increase in foreign corporate tax, consistent with the negative spillover effect of foreign tax hikes. Our empirical exercise is based on a large sample of subsidiary-level data of multinational companies from 20 European countries during 2004–2017. Using exogenous tax hikes and a stacked difference-in-differences design, we confirm our theoretical prediction that when within-firm supply chain connections are material, the negative spillover dominates the positive spillover effect suggested by the conventional wisdom of tax competition.

Our results are important for policymakers given the increasing budget deficits around the world and the call for raising (corporate) taxes. For example, our results suggest that there may be an unintended negative effect on corporate investment in high-tax countries when the Global Minimum Tax (OECD Pillar 2) is implemented in lower-tax countries with substantial productive (upstream) subsidiaries, such as Hungary.

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Do salient climatic risks affect shareholder voting?

Authors: Eliezer M Fich and Guosong Xu

This paper studies whether exposure to salient climatic disasters affects institutional investors’ assessment of the environmental risks threatening their portfolio firms and, in turn, their support for environmental proposals. To inform this research question, we empirically examine voting on environmental proposals by mutual funds recently exposed to major hurricanes that hit their headquarter location.

We examine a sample of 357,649 votes by institutional shareholders on environmental proposals from 2006 to 2020 in the U.S. We find that mutual funds in areas affected by a hurricane are significantly more likely to endorse an environmental proposal in a non-affected firm immediately after the strike. We show that two economic channels account for our results:

• First, fund managers start caring more about the externalities of firms’ environmental policies after personally experiencing a hurricane. Consistent with this possibility, we find that Democratic managers are significantly more likely to support an E-proposal after a hurricane than their Republican counterparts. Moreover, we observe that managers who experienced a stock price drop when a previous E-proposal was ratified continue to vote for new environmental proposals following a hurricane.

• Second, managers, concerned about their careers and their fund’s performance, become worried about post-hurricane fund outflows related to their fund investors’ changed environmental preferences. As a result, fund managers cater to their fund investors’ preferences by increasing support for firms’ environmental policies. Consistent with this explanation, we find that after a hurricane strike, local and high-brown-stock-holding funds are more likely to boost their support for environmental proposals. We also find that managerial tenure, a common proxy for lessened career concerns, attenuates the overreaction towards E-proposals.

Moreover, we find that after hurricane exposure, funds reallocate their investment towards firms that faced a close-vote for an E-proposal that did not pass in the previous year. According to our results, after enduring a hurricane hit, funds are 2% more likely to buy shares of these marginal E-firms where their votes are likely very consequential.

Because of increased institutional investor support, E-proposals are more likely to pass after more institutional investors are exposed to hurricane strikes, and this impact is particularly strong for proposals that face close votes within a narrow passage/fail margin. However, we find that the passage of environmental proposals, particularly those endorsed by more hurricane-stricken funds, is met with lower stock market reactions. These findings suggest that salience-induced shareholder activism represents an overreaction and is not value-creating.

These findings should be of interest to regulators, academics, investors, and other groups debating the role of corporations in environmental protection. While our tests indicate that salience-induced climate activism harms shareholder wealth, we do not assess the impact of these engagements on the welfare of society at large. We hope that our work motivates other researchers to explore this important piece of the puzzle.

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Blockbuster or bust? Silver screen effect and stock returns

Authors: Sanghyun Hong and Xiaopeng Wei

Individuals in an enhanced mood tend to assess future prospects more optimistically, which subsequently fosters greater optimism in their investment decisions and drives stock market returns higher. In the behavioral finance literature, mood measures are typically classified into two broad categories. The first category consists of endogenous indicators, where the underlying cause of mood shifts is difficult to discern. For instance, it is not completely clear whether individuals listen to happy music because they are already in a positive mood or if the music itself induces happiness. The second category includes exogenous but unpredictable indicators, such as the outcomes of sporting events, where the winner is unknown in advance, and the resulting market reaction is therefore uncertain. In this study, we introduce a novel mood metric — blockbuster movie release—that is exogenous and demonstrates a strong capacity to predict mood changes.

The psychological literature suggests, as a dominant form of media entertainment, movies generally enhance mood by providing enjoyment and escapism. With their release schedules and cinema screenings determined well in advance, often months or even years before their debut, blockbuster movie releases are not affected by mood-congruent behavior or equity market sentiment during the release week, allowing their effects to be clearly identified.

Employing U.S. movie data from Box Office Mojo in 21st century before the outbreak of COVID19, we find that the release of blockbuster movies presents a strong predictive effect on the market return in subsequent week, while it shows no significant correlation with contemporaneous market returns. The changes in weekly box office revenue and increased Internet searches for movie-related terms, such as popular theater chains, further affirm this relationship. Moreover, releases of blockbuster movies predict lower expected market volatility and risk aversion. The positive predictive effect on market returns is also evident in international markets with well-established movie industries.

Our study contributes to the literature the on how investor mood influences stock market dynamics. We introduce a novel approach by demonstrating that mood shifts can be predicted ahead of time based on exogenously determined blockbuster movie release schedules. These release dates are known in advance, making the mood effects foreseeable, with economically significant magnitudes. While traditional market efficiency theories assert that predictable effects should be fully arbitraged away, our findings suggest that this is not entirely the case, and we provide a psychological rationale to support our findings. Particularly, our paper challenges the misconception that mood variables are insignificant drivers of returns, unpredictable or unhelpful for investments, or incapable of distinguishing cause from effect.

Our study also contributes to psychology research that investigates the effects of movies on mood, many of which are based on laboratory experiments and other settings with relatively small numbers of participants who are shown movies without their own active selection. We test the implication of these psychological studies in in real-life settings where viewers actively choose when and which movies to watch in cinemas within the context of a very high-stakes field: the equity market. Our results suggest that blockbuster movies enhance mood.

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