Effect of Institutional Investor Ownership on Financial Stability Evidence from the Index Reconstitution
Title: Effect of Institutional Investor Ownership on Financial Stability
On one hand, institutional investors render several external benefits to underlying firms. In particular, institutional investors have been shown to (a) improve monitoring services (Fich, Harford and Tran, 2015; Jun-Koo, Na and Seung, 2018); (b) reduce agency costs (Hartzell and Starks, 2003; Lucian, Cohan and Hirst, 2017); (c) augment public disclosure (Bird, and Karolyi, 2016); (d) enhance firm level governance (Aggarwal, Saffi and Sturgess, 2015; Mccahery, Sautner and Starks, 2016; Borochin, and Yang, 2017); and (e) lower credit risk (Bhojraj, and Sengupta, 2003).
On the other hand, increased institutional ownership can lead to commonality in liquidity effects and elevated systemic risk across banks and hence, higher financial instability (Sensoy, 2017; De George, Reiter, Synnad Williams, 2019). Analogously, a large drop in institutional ownership among banks can lead to significant plummeting of banks’ equity valuations and hence, tier 1 capital losses. If the drop in institutional ownership is pervasive, it can trigger deleveraging and possible fire sales of banks’ loan and asset portfolios, causing surge in funding illiquidity and systemic risks, leading to financial instability.
In this paper, we use S&P 500 index reconstitutions of the financial firms from 2000-16 as quasi-exogenous events triggering institutional passive ownership changes and study their impact on financial stability. Index additions (exclusions) lead to significant increases (decreases) Intel institutional ownership of passive investors. Using a difference-in-difference design with both firm and quarter fixed effects, we find that while index additions have no effects on systemic risks, index exclusions are associated with significant increases in systemic risks for the treated FIs compared to the matched
Further, breaking down the index reconstitution by the ownership type viz., banks, insurance companies and mutual funds, we find that effect of index exclusion effect on capital shortfall and network risks for treated firms is mainly evident where the drop in ownership arises from insurance companies and mutual funds.Interestingly, we find that Conditional Value at risk (CoVar) -measuring the risk contribution from an individual bank to the overall market –goes down following index exclusions by insurance companies and mutual funds. Additionally, we find that the effect of index exclusions on capital shortfall is found for those treated FIs,whose available supply of corporate bonds for lending is in short supply. Finally, the effect of index exclusions on capital shortfall risk is mainly observable for those treated FIs with higher implicit credit (i.e., CDS spreads) and network risks.
Overall, our study contributes to the literature on how endogenous shocks arising from changes in institutional ownership are related to subsequent changes in systematic risks and hence, financial stability.
Bio: MadhuKalimipalli is a full professor in finance at the School of Business and Economics, Wilfrid Laurier University and the Director of PhD and Research-based Master's Programs in Management, where he oversees the graduate research programs. He is also an affiliated member of the Waterloo Research institute in Insurance, Securities and Quantitative finance (WatRISQ), University of Waterloo and of the MS2Discovery Interdisciplinary Research Institute at Laurier. He holds a PhD in Finance from the Bauer College of Business, University of Houston, and MA degrees in Economics from Rutgers University and the Gokhale Institute of Politics and Economics, Pune, India. Prior to joining Laurier in 2000, he was a visiting assistant professor at the Faculty of Management in McGill University.
Evidence from the Index Reconstitution
Speaker: Madhu Kalimipalli, Wilfrid Laurier University
Date: June 16th
Time: 3 pm
Room: LH3058 (Lazaridis Hall, Room 3058)
Abstract: How do changes in institutional ownership in banks and other financial institutions (FIs) affect financial stabilityof the FIs? While the broad benefits of institutional investors are well understood, their role in triggering systemic risks is still unclear.
Speaker: Madhu Kalimipalli, Wilfrid Laurier University
Date: June 16th
Time: 3 pm
Room: LH3058 (Lazaridis Hall, Room 3058)
Abstract: How do changes in institutional ownership in banks and other financial institutions (FIs) affect financial stabilityof the FIs? While the broad benefits of institutional investors are well understood, their role in triggering systemic risks is still unclear.
On one hand, institutional investors render several external benefits to underlying firms. In particular, institutional investors have been shown to (a) improve monitoring services (Fich, Harford and Tran, 2015; Jun-Koo, Na and Seung, 2018); (b) reduce agency costs (Hartzell and Starks, 2003; Lucian, Cohan and Hirst, 2017); (c) augment public disclosure (Bird, and Karolyi, 2016); (d) enhance firm level governance (Aggarwal, Saffi and Sturgess, 2015; Mccahery, Sautner and Starks, 2016; Borochin, and Yang, 2017); and (e) lower credit risk (Bhojraj, and Sengupta, 2003).
On the other hand, increased institutional ownership can lead to commonality in liquidity effects and elevated systemic risk across banks and hence, higher financial instability (Sensoy, 2017; De George, Reiter, Synnad Williams, 2019). Analogously, a large drop in institutional ownership among banks can lead to significant plummeting of banks’ equity valuations and hence, tier 1 capital losses. If the drop in institutional ownership is pervasive, it can trigger deleveraging and possible fire sales of banks’ loan and asset portfolios, causing surge in funding illiquidity and systemic risks, leading to financial instability.
In this paper, we use S&P 500 index reconstitutions of the financial firms from 2000-16 as quasi-exogenous events triggering institutional passive ownership changes and study their impact on financial stability. Index additions (exclusions) lead to significant increases (decreases) Intel institutional ownership of passive investors. Using a difference-in-difference design with both firm and quarter fixed effects, we find that while index additions have no effects on systemic risks, index exclusions are associated with significant increases in systemic risks for the treated FIs compared to the matched
financial firms that were not in the index.The results are robust to alternative percentile tail risks measured using normalized expected shortfall (NSRISK), as well as network risk measures (Das, 2016; Das, Kalimipalli and Nayak, 2022; Kalimipalli, Morohunfolu, Marisetty and Shankar, 2023. Addressing potential endogeneity using Propensity Scored Matching (PSM) approach for identifying control firms, we find that the index exclusions lead to systemic risk spikes mainly through increases in capital shortfall.
Further, breaking down the index reconstitution by the ownership type viz., banks, insurance companies and mutual funds, we find that effect of index exclusion effect on capital shortfall and network risks for treated firms is mainly evident where the drop in ownership arises from insurance companies and mutual funds.Interestingly, we find that Conditional Value at risk (CoVar) -measuring the risk contribution from an individual bank to the overall market –goes down following index exclusions by insurance companies and mutual funds. Additionally, we find that the effect of index exclusions on capital shortfall is found for those treated FIs,whose available supply of corporate bonds for lending is in short supply. Finally, the effect of index exclusions on capital shortfall risk is mainly observable for those treated FIs with higher implicit credit (i.e., CDS spreads) and network risks.
Overall, our study contributes to the literature on how endogenous shocks arising from changes in institutional ownership are related to subsequent changes in systematic risks and hence, financial stability.
Bio: MadhuKalimipalli is a full professor in finance at the School of Business and Economics, Wilfrid Laurier University and the Director of PhD and Research-based Master's Programs in Management, where he oversees the graduate research programs. He is also an affiliated member of the Waterloo Research institute in Insurance, Securities and Quantitative finance (WatRISQ), University of Waterloo and of the MS2Discovery Interdisciplinary Research Institute at Laurier. He holds a PhD in Finance from the Bauer College of Business, University of Houston, and MA degrees in Economics from Rutgers University and the Gokhale Institute of Politics and Economics, Pune, India. Prior to joining Laurier in 2000, he was a visiting assistant professor at the Faculty of Management in McGill University.