The ripple effects of financial misconduct

Shi, Rui and Banerjee, Shantanu (2021) The ripple effects of financial misconduct. PhD thesis, Lancaster University.

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Abstract

This thesis consists of three studies related to the wider effects of financial misconduct. In the first study, I show that information complementarities play an important role in the spillover of transparency shocks. I exploit staggered revelation of financial misconduct by S&P500 firms and find that the implied cost of capital increases for “close” industry peers relative to “distant” peers. Disclosure also increases. The effects are particularly strong when the close peers share common analysts and institutional ownership with the fraudulent firm. While disclosure remains high for the next four years, with sustained disclosure, the cost of equity starts to decrease. Firms’ financing patterns tilt more towards debt financing initially at the expense of equity, but eventually revert. In the second study, I investigate how suppliers adjust their innovation when financial fraud by a major customer is revealed. Consistent with the importance of “trust” when contracts are incomplete, suppliers reduce R&D, generate fewer patents, engage in more explorative innovation, and innovate in areas different from those of the fraudulent customer. Surprisingly, while the survival likelihood of the affected suppliers decreases in the next three years, over a ten-year period, survival likelihood is higher, and they attract more principal customers, than control firms. The results suggest that customer pressure and myopic incentives of supplier managers cause suppliers to pursue suboptimally diversified innovation strategies. In the third study, I examine the strategic response of product market competitors when financial fraud by an industry leader is publicly revealed. I document evidence of predatory advertising and pricing. Close competitors of the leader step up advertisement spending relative to control firms. Although I do not directly observe product prices, I find that even though advertisement increases, competitors’ profit margins drop, consistent with predatory pricing. Evidence of predation is stronger when rival firms have larger market share, the fraud firm has higher leverage, and when the average leverage of rival firms is lower. The effects appear mainly in industries that produce customized products and consumer switching costs are high. Increasing advertising expenditure appears to be a more potent predatory strategy in industries that experience new customer growth, whereas cutting prices appears more potent in industries with stagnant customer base. I present a switching cost model similar to Klemperer (1995) that generates implications broadly consistent with these observations.