skip to content

Cambridge Endowment for Research in Finance (CERF)


Institutional Investor Monitoring and Earnings Management: A Network Approach

Wolfgang Drobetz (University of Hamburg)

Sadok El Ghoul (University of Alberta)

Omrane Guedhami (University of South Carolina)

Marwin Mönkemeyer (University of Hamburg, CERF Visiting Associate)

Henning Schröder (University of Hamburg)

June 2022

Ever since Berle and Means’ (1932) seminal work on the separation of ownership and control in modern firms, scholars have debated about the potential conflict of interests between managers and shareholders. According to the agency theory, this separation incentivizes managers to select and apply accounting estimates and techniques that increase their own managerial wealth. But because such opportunistic earnings management occurs to the detriment of the firms’ other stakeholders, auditors, regulators, and investors have their own motivation to detect and mitigate these self-serving managerial practices.

It is a common notion in the field of corporate governance that institutional investors can reduce the agency problem between managers and shareholders by monitoring managers’ actions (Jensen and Meckling (1976); Shleifer and Vishny (1986); Hartzell and Starks (2003)). Studies have put forward two main arguments supporting institutional investors’ comparative advantage in monitoring over individual (retail) investors. First, sophisticated institutions have professional research, traders, and portfolio managers that guide their decisions, allowing them to detect earnings management already in the first place. Second, because they are powerful and equipped with the right incentives to engage in monitoring, they can utilize their privileged access to information and effectively constrain opportunistic managerial behavior (Balsam et al. (2002); Ayers et al. (2011); Kang et al. (2018)).

Acknowledging institutional investors’ superior monitoring abilities, studies typically use the level of institutional ownership or the heterogeneity among different types of institutional investors to explain the quality of financial reporting (Bushee (1998); Tsang et al. (2019); Ramalingegowda et al. (2021)). Despite a growing body of research, the literature so far has neglected the role of the network created by institutional investors holding stakes in the same firms. However, the structure of such network is likely to affect the dynamics of information dissemination between institutions as well as an investor’s influence and power in interacting with firm management. As a result, networks increase monitoring effectiveness. Central as compared to peripheral institutions are likely to obtain more timely and superior information necessary to constrain opportunistic managerial behavior. Moreover, due to their higher number of connections in the network, central institutions can effectively discipline managers by pursuing other investors to vote into the same direction (Bajo et al. (2020))

Given the above arguments, we propose shareholder centrality as a major determinant with an explanatory power that is incremental to traditional proxies for institutional monitoring. To provide empirical evidence on the relation between institutional investor centrality and earnings management, we use a comprehensive sample of 6,870 U.S. firms over the 1990–2019 period.

Our analyses reveal four key findings:

First, we find that the presence of central institutional shareholders is associated with lower levels of earnings management. This evidence is robust to the use of alternative earnings management proxies and network centrality measures. This effect is also economically relevant. Recognizing the potentially endogenous nature of the relation, we implement two identification strategies, which seem to suggest a causal relationship.

Second, turning to firms that have particular incentives to manipulate earnings (so-called suspect firms), we find that shareholder centrality plays an even more important role in limiting earnings management in such firms.

Third, we substantiate that information advantages obtained through institutional investor networks effectively drive reductions in earnings management. To this aim, we rerun our main analysis using measures of centrality among heterogeneous investor types. In line with an information-based explanation, we observe stronger reductions in earnings management in the presence of “monitoring institutions”, i.e., institutions that are most likely to use information to monitor management such as independent or long-term investors.

Finally, we examine the effect of network centrality on shareholder proposal outcomes to shed light on the role of power and reputation through which institutional investor networks affect earnings management. We find that shareholder proposals filed by central institutions are less likely to be omitted from proxy statements and more likely to be withdrawn or put to a vote. The results indicate that central institutions use their negotiation power to engage in governance via voice.

Overall, our results emphasize the role of the institutional shareholdings network as a corporate governance mechanism that influences accounting quality and shed light on how investors obtain valuable information for monitoring. The findings have implications for academics and practitioners alike. For academics, our results reveal how institutions obtain information through network centrality. Future studies on reporting quality should thus incorporate network-based proxies to avoid model misspecification. For practitioners, our work highlights a novel determinant of institutional investor monitoring and, more specifically, the quality of financial reporting.




Ayers, B., S. Ramalingegowda, and P. Yeung, 2011, Hometown advantage: The effects of monitoring institution location on financial reporting discretion, Journal of Accounting and Economics 52, 41–61.

Bajo, E., E. Croci, and N. Marinelli, 2020, Institutional investor networks and firm value, Journal of Business Research 112, 65–80.

Balsam, S., E. Bartov, and C. Marquardt, 2002, Accruals management, investor sophistication, and equity valuation: Evidence from 10–Q filings, Journal of Accounting Research 40, 987–1012.

Berle, A., and G. Means, 1932, The Modern Corporation and Private Property (Mac-Millan, New York, New York).

Bushee, B., 1998, The influence of institutional investors on myopic R&D investment behavior, The Accounting Review 73, 305–333.

Hartzell, J., and L. Starks, 2003, Institutional investors and executive compensation, Journal of Finance 58, 2351–2374.

Jensen, M., and W. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, 305–360.

Kang, J., J. Luo, and H. Na, 2018, Are institutional investors with multiple blockholdings effective monitors? Journal of Financial Economics 128, 576–602.

Ramalingegowda, S., S. Utke, and Y. Yu, 2021, Common institutional ownership and earnings management, Contemporary Accounting Research 38, 208–241.

Shleifer, A., and R. Vishny, 1986, Large shareholders and corporate control, Journal of Political Economy 94, 461–488.

Tsang, A., F. Xie, and X. Xin, 2019, Foreign institutional investors and corporate voluntary disclosure around the world, The Accounting Review 94, 319–348.



Voting for Socially Responsible Corporate Policies

Adam Meirowitz, David Eccles School of Business, University of Utah

Shaoting Pi, CERF Research Associate, Cambridge Judge Business School, University of Cambridge

Matthew C. Ringgenberg. David Eccles School of Business, University of Utah


Voting plays an important role in corporate governance. Shareholders vote to elect members of the board of directors and they vote on proposals that may directly affect the actions of the firm. Similarly, members of the board of directors vote to appoint the chief executive officer and vote on a variety of firm policies. Traditionally, these stakeholders broadly agreed on the objective of the firm – maximize firm value – and this one-dimensional objective simplified voting.[1]  Yet more recently, a number of academics, practitioners, and regulators have argued that firms ought to care about more than just value. While concern over ESG is exploding, there has been little conceptual work evaluating whether this shift in the scope of what matters to shareholders and board members impacts the performance of firm governance.[2]


How does one conceive of firm governance in the presence of ESG concerns? One defensible position is that now board members and shareholders have a multi-dimensional objective function; they must make tradeoffs between value creation and socially responsible behavior. (e.g., B´enabou and Tirole (2010), Hart and Zingales (2017)). This departure itself can be consequential. With agreement on just maximizing firm value, we might have thought of governance challenges as emerging from just differences of opinion about the best way to enhance firm value. Now shareholders or board members may genuinely disagree about how much value they are willing to give up in order to advance a social objective (and they may disagree about the best way to achieve any particular balancing of these goals). But, on further consideration, we find that this perspective itself is insufficiently nuanced. As the name, Environment, Social, and Governance, suggests, ESG may be multidimensional. In other words, we may think of board members facing disagreements over both the margin between value creation and socially responsible behavior as well as a potentially large number of margins between different aspects of socially responsible behavior. This is the perspective that we take. In this paper, we build a theory of corporate voting over policies that impact value as well as ESG dimensions. Our analysis fleshes out how the movement from concern over value to concern over value plus ESG impacts. In particular, we find that a narrow or focused notion of ESG can result in minimal challenges, while a broader or multi-dimensional notion may degrade governance in important ways.


Building on the literature on social choice theory, we theoretically examine voting for corporate policies when voters face a trade-off between maximizing firm value and one or more social policies (for example, reducing pollution and increasing employee satisfaction). Arrow (1951) famously shows that no method of aggregating preferences will satisfy a small set of naturally satisfying axioms. However, subsequent literature shows that stable choices can emerge under various restrictions on voter preferences. A well-studied restriction is the case of single-peaked preferences which is satisfied if the feasible policies can be arranged in a single dimension and on this dimension, all agents’ preferences are quasi-concave (informally, monotone or tent-shaped). When this restriction is satisfied, it is possible to identify choices that seem to reflect the will of a majority or aggregate preferences. We show that a number of challenges arise when the firm objective function is expanded to incorporate social policies. Interestingly, we show that adding just one social dimension does not lead to additional problems. After accounting for a feasibility constraint, preferences over firm value and one social dimension still satisfy an order restriction, and social choice is well-behaved. However, when more than one social dimension is present, challenges emerge – we show that the resulting choices are likely to be sensitive to institutional features that may vary or be difficult for investors to understand and track. In other words, our findings show that decision-makers may be able to add one social dimension to a firm’s objective function; however, the quality of the firm’s governance will decline if decision-makers care about too many objectives.


A simple example helps to illustrate our key findings. Imagine a firm with three possible policy choices. The firm can implement a policy, P, that maximizes firm value or a policy G that is less profitable but environmentally sustainable or a policy E that is less profitable still but mandates ethical treatment of workers. Consider three investors (or three board members) who are charged with making the policy choice, denoted as investors 1, 2, and 3. Suppose that investor 1 cares only about firm value and thus orders the alternatives by expected firm value: P, G, then E. Suppose that investor 2 most prefers to protect the environment, but would still rather support the ethical treatment of workers over just maximizing firm value and so ranks the alternatives, G, E, then P. Finally, suppose investor 3 cares about the ethical treatment of workers but is not willing to sacrifice returns for environmental policies and thus ranks the alternatives E, P, and then G. If any two of these policies are offered, a stable choice will emerge. In particular: given a choice between E and P, E wins. Given a choice between P and G, P wins. And given a choice between G and E, E wins.  However, if all three policies are offered, none of the alternatives beats the other two alternatives. While E beats P, G beats E, yet P beats G. As a result, when the three policies are offered, none of them is naturally preferred or stable under majority rule. The ultimate policy choice may thus depend on additional and less obvious features of the institution. This creates additional challenges for an investor who might face serious uncertainty about the firm’s likely policy choice.


What are the implications of this finding? If the firm faces more than two dimensions in its objective function, there is generally no natural policy choice. As a consequence, the choices that emerge will depend on the process by which policies are proposed, and the volatility of firm choices will tend to increase. This simple example illustrates a deep and practical concern about preference aggregation. Although majority rule (and other stronger super-majority rules) is not immune from Arrow’s impossibility theorem, there are still compelling reasons to use them. In particular, when preferences are single-peaked (or more general satisfy order restriction), the majority rule is known to be well-behaved; many systems that involve fairly decentralized proposal rights and majority voting will tend to select policies that are quite responsive to the preferences of the so-called median voter. But when preferences do not satisfy these types of restrictions, the outcomes can depend heavily on seemingly subtle institutional features. Whether a policy-making domain exhibits enough preference diversity for this problem to become important is an applied question, that to date, has not been extensively studied in finance contexts (such as choosing socially responsible corporate policies). Our paper fills this void. We show that when a group of voters have monotone preferences over at most two dimensions (firm value and one social dimension) and face a natural feasibility constraint, then we may think of the preference aggregation problem as nice or well-behaved. But this no longer holds with three or more dimensions.



Admati, A. R., Pfleiderer, P., & Zechner, J. (1994). Large shareholder activism, risk sharing, and financial market equilibrium. Journal of Political Economy, 102(6), 1097–1130.

Arrow, K. (1951). A difficulty in the concept of social welfare. Journal of Political Economy, 58, 328–346.

B´enabou, R., & Tirole, J. (2010). Individual and corporate social responsibility. Economica, 77, 1—19.

Berle, A. A., & Means, G. C. (1932). The Modern Corporation and Private Property. New York: Macmillan Publishing Co.

Burkart, M., Gromb, D., & Panunzi, F. (1997). Large shareholders, monitoring, and the value of the firm. The Quarterly Journal of Economics, 112(3), 693–728.

DeMarzo, P. M. (1993). Majority voting and corporate control: The rule of the dominant shareholder. Review of Economic Studies, 60(3), 713–734.

Demsetz, H. (1983). The structure of ownership and the theory of the firm. The Journal of

Law and Economics, 26(2), 375–390.

Hart, O., & Zingales, L. (2017). Companies should maximize shareholder welfare not market value. Journal of Law, Finance, and Accounting, 2, 247–274.

Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.

Maug, E. (1998). Large shareholders as monitors: is there a trade-off between liquidity and control? Journal of Finance, 53(1), 65–98.

Meirowitz, Adam and Pi, Shaoting and Ringgenberg, Matthew C., Voting for Socially Responsible Corporate Policies (March 14, 2022). Available at SSRN: or


[1] DeMarzo (1993) shows an exception: if markets are incomplete, then investors may also disagree on how to maximize firm value, which complicates the public choice problem.

[2] A large literature examines the challenges of corporate governance when the goal is to maximize firm value. For example there is extensive work on the agency conflict that arises between investors and managers when ownership and management are separate. See, for example, Berle and Means (1932); Jensen and Meckling (1976); Demsetz (1983); Admati, Pfleiderer, and Zechner (1994); Burkart, Gromb, and Panunzi (1997); Maug (1998).




Cross-Country Stock Market Comovement: a Macro Perspective

Elisa FaragliaCERF Fellow

April 2022

In the post WW2 period, the cross-country correlations between the stock markets in developed economies were fairly low, implying significant potential benefits from diversification. Beginning in the mid 1990s, stock market correlations started increasing and continued to do so up until the aftermath of the Great Recession. These increases have been quantitatively large; for example the correlation of US equity returns with the equity returns in an aggregate index of other developed economies has risen from below 0.4 in the 1980s to above 0.8 in the 2010s and a similar pattern emerges when looking at bilateral developed country pairs. The increase in stock market correlations has coincided with a concurrent strengthening in foreign direct investment (FDI) linkages between the largest economies with developed equity markets. The aim of the project is to explore the relationship between these two phenomena.

We propose an intuitive mechanism through which increases in bilateral FDI positions can lead to higher stock market correlations between two countries. Because multinational corporations engage in FDI abroad, they become exposed to country specific TFP shocks in the foreign country. In an environment with increased FDI, firms generate a larger fraction of their earnings abroad. This implies stronger incentives to increase investment in response to shocks in the foreign country. In the presence of intangible technology capital, increased investment abroad can also spill over to investment at home, due to the complementarity between tangible and intangible capital. Investment and capital are therefore more synchronized across multinationals and this implies their equity values are also more correlated. We first establish an empirical link between the comovement of stock returns with international stock markets and FDI. We provide evidence that the returns of multinational firms comove with foreign stock markets more than the returns of non-multinational firms; this is more so when multi-national firms have more intangible assets, or have high R&D expenditure, which is consistent with our theoretical mechanism. Additionally, using a panel of 21 developed economies, we also find that increases in FDI of the order of magnitude observed across these countries, are associated with in-creases in their bilateral stock market comovement that are sizeable, positive, and highly significant, even when controlling for trade.

With this empirical evidence in place, we propose a production-based asset pricing model (see Jermann, 1998) extended to two countries and, crucially, incorporating multinational firms investing in technology capital as in McGrattan and Prescott (2010). To quantify the importance of the mechanism, we add country-specific shocks, introduce incomplete international asset markets and calibrate the model to two regions, the US, and the rest of the world. We find that the observed increase in FDI positions leads to a rise in stock market correlation from 0.380 to 0.520, accounting for one third of the overall observed increase.

When markets are incomplete, a firm’s FDI operations provide access to foreign markets and, at the same time, offer diversification benefits for its shareholders. The model assigns FDI an important role in explaining stock market comovements, even when abstracting from the diversification channel.

To show this, we recompute our experiments assuming a complete set of contingent claims available to shareholders. In that case, firms’ investment decisions are decoupled from portfolio diversification considerations. We find that the level of stock market correlation increases as markets become more complete, as expected. However, the increase in stock market correlation when FDI linkages are strengthened is present for all asset market structures, including the two extremes of complete markets

and financial autarky. This is even though the correlation of dividends can be quite different across market structures and can go up or down in response to the FDI increase, depending on the degree of market incompleteness. Thus, the divergence between the comovement of dividends and the comovement of equity prices, highlighted in Jordà, Schularick, Taylor and Ward (2019), can be rationalized in our model by incomplete markets. The key insight from the production asset pricing model is that equity price comovements must reflect comovement in investment and capital across multinationals, but can be entirely independent of dividend comovements.

Concurrently with the increase in FDI, the US experienced moderate increases in cross-border equity holdings, as well as in goods trade with other developed economies. Our work also sheds light on the contribution of those two changes to the stock market comovement. Consider first cross-border equity holdings. In contrast to standard models of diversification as in Heathcote and Perri (2004, 2013) where FDI and portfolio diversification are treated as interchangeable, our model allows for a distinction and thus a non-trivial interaction between the two. When we introduce cross-border equity holdings to the model, and allow them to rise exogenously at the same time as FDI and in line with the data, this does not generate additional increases in the stock market correlation. We also extend our model to allow for trade as in McGrattan and Waddle (2020). In our setup, trade and FDI are substitutes reflecting the focus of the model on horizontal FDI between developed economies. As a result, an increase in trade tends to decrease FDI and hence stock market correlation. Thus, in our experiments, increased trade does not contribute to stock market comovement either.

The mechanism we propose highlights a key role for FDI in explaining stock market correlation over and above any indirect effects it might have through inducing GDP synchronization. Our calibration exercise suggests that increased GDP synchronization could have also played a role.

Link to the paper:


Heathcote, J. and F. Perri, 2004. “Financial Globalization and Real Regionalization”, Journal of

Economic Theory, 119(1): 207-243.

Heathcote, J. and F. Perri, 2013. “The International Diversification Puzzle is Not as Bad as you

Think”, Journal of Political Economy, 121(6): 1108-1159.

Jermann, U., 1998. “Asset Pricing in Production Economies”, Journal of Monetary Economics,

41(2): 257-275.

Jordà, O., M. Schularick, A. M. Taylor and F. Ward, 2019. “Global Financial Cycles and Risk

Premiums”, IMF Economic Review, 67(1): 109-150.

McGrattan, E.R. and E. C. Prescott, E.C., 2010. “Technology Capital and the US Current Ac-

Count”, American Economic Review, 100 (4): 1493-1522.

McGrattan, E.R. and A. Waddle, 2020. “The Impact of Brexit on Foreign Direct Investment and

Production”, American Economic Journal: Macroeconomics, 12 (1): 76-103.



How do climate risks affect trading behaviour?

Andreas Charisiadis, CERF Research Assistant

March 2022

Mitigating climate change has become one of the defining challenges of our time. Indeed, there is global concern about the potentially disastrous long-term consequences of unmitigated climate change. The risks arising from climate change have far-reaching implications for the real economy and financial markets in particular. Two types of climate risk are particularly prevalent: direct environmental risk and policy (or regulatory) risk. The former relates to the occurrence of extreme climatic events, such as storms, floods, droughts, or wildfires, whereas the latter refers to the uncertain impact and timing of regulations aimed at mitigating climate change, such as the introduction of carbon taxes or emission caps. Several recent contributions explore how such risks impact capital markets, and specifically how these risks – and the way they are perceived by investors – can affect trading behaviour.

Climate risks and investor behaviour

Alok et al. (2020) explore whether professional money managers misestimate the risk of climatic disasters. The authors hypothesize that misestimation of such risks may be driven by salience bias, i.e. the behavioural tendency to overweight more readily available information. Tversky and Kahneman (1973) document that this type of bias can induce individuals to overestimate the risk of salient events depending on the ease with which instances thereof can be recalled. On that basis, Alok et al. (2020) hypothesize that fund managers may overestimate the risk of extreme climatic events if they have experienced such events in the (recent) past themselves and may therefore substantially reduce their holdings of assets exposed to such risks. The distance of funds from climatic disaster zones – defined as areas directly hit by an extreme weather event – serves as an exogenous source of variation in the salience of climatic disasters for money managers. While all funds tend to reduce their exposure to equities of firms located in a disaster area, this decrease in portfolio weights is significantly more pronounced for funds located closer to the affected area. Alok et al. (2020) attribute this asymmetric portfolio reallocation to overestimation of the disaster risk by fund managers located in the vicinity of the disaster zone. The trading behaviour ensuing from such salience bias can be shown to hurt financial returns: a zero-cost portfolio consisting of long positions in disaster zone stocks which closely located fund managers underweighted the most, and short positions in stocks which were underweighted the least, yields significant risk-adjusted excess returns for a holding period of two years following the disaster.

Choi et al. (2018) study how investors update their beliefs about climate risk. They find that investors revise their expectations about climate change when experiencing an episode of unusually high temperatures. During abnormally warm months there is a significant increase in attention to climate change as measured by the volume of Google searches for ‘global warming’. On that basis, Choi et al. (2018) explore whether and how the ensuing updated investor beliefs about climate risk affect prices and trading behaviour in financial markets. They document that retail investors exhibit a tendency to divest from carbon-intensive equities when experiencing abnormally warm episodes, resulting in a relative underperformance of such stocks vis-à-vis their low-carbon counterparts. The authors also find that institutional investors appear less prone to be swayed by such transitory weather events and therefore – in contrast to retail investors – do not systematically react to abnormal temperatures.

Hedging climate risks

An important strand of the literature explores the methods which investors can use to insure themselves against climate risks. For instance, Engle et al. (2020) study a dynamic approach for forming portfolios of publicly traded assets in order to hedge climatic risks. This method allows investors to (partially) insulate themselves from risks which would otherwise be difficult to insure, as the inherently long-run and systemic nature of climate risk impedes the implementation of standard insurance contracts. Rather than relying on securities which generate positive returns in the event that climate risks materialize, Engle et al. (2020) construct portfolios whose short-term returns hedge innovations in news about climate change. Using textual analysis of newspapers, the authors extract climate change related news, which carry information about the perceived and actual level of climate risk. This allows constructing a climate news index which tracks the intensity of climate change reporting over time. On that basis, equity portfolios which hedge innovations in the time series of climate news can be constructed. These portfolios overweight stocks which rise in value upon the arrival of (negative) climate change news, and contain short positions in stocks whose prices decline during such events. The resulting hedge portfolios require continuous rebalancing based on the latest information about the relationship between equity returns and climate news, similar to the dynamic hedging approach of Black and Scholes (1973) and Merton (1973). Continued updating will eventually yield a portfolio which provides compensation for losses incurred as a result of the materialization of climate risks over the long run. Interestingly, the resulting hedge portfolios do not necessarily align with the common prior that optimally hedging climate risks primarily relies on placing industry bets, i.e. holding long positions in ‘clean’ industries, such as renewable energy, and short positions in ‘dirty’ industries, such as fossil fuels. In a series of out-of-sample performance tests, Engle et al. (2020) document that their methodology yields hedge portfolios which outperform alternative methods of constructing climate risk hedges (for instance, using industry tilts via positions in energy ETFs).

Andersson et al. (2016) present a dynamic investment strategy with which long-term passive investors can hedge climate policy risks while avoiding substantial sacrifices in returns. They describe a procedure for ‘decarbonizing’ standard equity indices in order to construct a hedge against the risk of the introduction (or the tightening) of carbon reduction policies. The formation of their ‘green’ index follows a two-step procedure: First, the k most carbon-intensive stocks are excluded from the chosen benchmark (say, the S&P 500). These firms are the ones most vulnerable to climate change mitigation policies. The remaining stocks in the index are then optimally re-weighted in order to minimize the tracking error with respect to the benchmark. As a result, the only significant difference in aggregate risk exposure between the benchmark and the decarbonized index is with respect to carbon risk. The authors show that their approach allows the tracking error to be almost eliminated, while simultaneously achieving a substantial reduction in the exposure to carbon risk. In fact, as long as carbon reduction policies are pending, the decarbonized index achieves returns comparable to the reference index. However, once regulatory risks materialize (i.e., more stringent carbon reduction policies are introduced, or are expected to be introduced) the ‘green’ index is bound to outperform its benchmark.



Alok, S., Kumar, N., and Wermers, R. (2020) “Do fund managers misestimate climatic disaster risk?” Review of Financial Studies, 33(3): 1146-1183.

Andersson, M., Bolton, P., and Samama, F. (2016) “Hedging climate risk.” Financial Analysts Journal, 72(3): 13-32.

Black, F. and Scholes, M. (1973) “The pricing of options and corporate liabilities.” Journal of Political Economy, 81: 637-654.

Choi, D., Gao, Z., and Jiang, W. (2020) “Attention to global warming.” Review of Financial Studies, 33(3): 1112-1145.

Engle, R.F., Giglio, S., Kelly, B., Lee, H., and Stroebel, J. (2020) “Hedging climate change news.” Review of Financial Studies, 33(3): 1184-1216.

Merton, R.C. (1973) “Theory of rational option pricing.” Bell Journal of Economics and Management Science, 4: 141-183.

Tversky, A. and Kahneman, D. (1973) “Availability: A heuristic for judging frequency and probability.” Cognitive Psychology, 5(2): 207-232.



Dynamic Group Decision Making of Private Firms

Shiqi Chen, CERF Research Associate

February 2022


Unlike what is often assumed in the standard corporate finance literature that firms are often governed by a single representative agent on behalf of the principal, in reality, many corporate decisions are indeed determined by a group of agents or investors, who are heterogeneous in many dimensions (e.g. beliefs, risk preferences, investment horizons, capital contributions, etc). Group decision making is very prevalent in finance, for example, board meetings, partnerships, team-managed mutual funds, or general management teams within firms. All these mean that ignoring such heterogeneity and interactions within the decision coalition will miss out on an essential ingredient of the corporate decision-making process and lead to inconclusive results.

Existing experimental studies have shown that group behaviour is very different from individual behaviour. The literature offers two competing hypotheses for group decisions. The group shift hypothesis (e.g. Moscovici and Zavalloni (1969); Kerr (1992)) suggests that group decisions often shift toward one of the dominant individuals in a team, and this person usually has a prevalence preference. As a result, the team eventually gravitates toward extremes and makes more polarized decisions than its members. The diversification hypothesis (e.g. Sah and Stiglitz (1986, 1988)) suggests that the extreme preferences or opinions are averaged out, and teams make less extreme decisions than individual members. Although so far, the diversification hypothesis receives more empirical support (Bär, Kempf and Ruenzi (2011)), it struggles to explain the puzzling observation that the average group is more (less) risk-averse than the average individual in high (low) risk situations (Shupp and Williams (2008)). The working paper by Chen and Lambrecht (2021) reconciles the two hypotheses by examining a private firm's financial decision from the lenses of group decision making.

Compared to public firms, there are two distinct characteristics of private firms that are currently underexplored. First, the stakes are not traded on a public market, meaning that shares in private firms are highly illiquid, and investors cannot withdraw from the firm easily. Second, unlike public firms that are often run by management and owned by dispersed investors, private firms are often owned and run by a small group of investors, all of which are actively involved in the day-to-day running of the business. Taking into account these two properties, this paper studies a private firm founded and run by a group of investors with heterogeneous capital contributions and risk preferences, who cannot trade their claims on the firm. They group together because one of the investors (the entrepreneur) has a superior investment opportunity but not enough capital, while other co-investors have the required capital but no access to the investment opportunity, which incentivizes all the investors to join the firm. However, they have to jointly agree on the firm's investment, financing and payout decisions, as well as the internal governance structure.

Ideally, each investor prefers policies that maximize their own lifetime utility. Nevertheless, such policies cannot sustain because of the heterogeneity in preferences. This paper shows that the firm's optimal investment and financing policies are not merely a weighted of the investors' optimal policies. Interesting, these weights are time-varying, with more weight shifting toward the less (more) risk-averse investors in good (bad) times. This means that the firm will act more aggressively (conservatively) in good (bad) times by taking on more (less) debt and investing more (less) in the risky project. The resultant leverage is procyclical as the firm dynamically rebalances its assets and liabilities in response to income shocks. Even though all investors have constant levels of risk aversion and their compositions within the firm are fixed, the implied coefficient of relative risk aversion for the group is time-varying and spikes (declines) in bad (good) times.

Heterogenous preferences also give rise to a capital structure that consists of safe debt, equity and preferred equities. The claim for the least risk-averse investor is convex in the firm's total net worth, similar to an equity contract. The claims for the most risk-averse investor is concave, while for investors with intermediate levels of risk aversion, the claims are S-shaped, resembling preferred equities with different levels of seniority and payout caps. Such a finding helps explain the mixture of contracts adopted in private firms such as venture capitals.

The paper further reveals that the internal governance structure depends not only on the initial capital contribution but also on the heterogeneity in risk preferences and the investors' outside options. The internal governance weights (which resemble ownership shares) are fixed at the startup. In the equilibrium, a co-investor's weight shrinks toward zero as her capital contribution vanishes. In contrast, the entrepreneur retains a positive weight even without any capital contribution, reflecting the synergies she generates from her human capital! Meanwhile, the entrepreneurs' net worth stake in the firm is greater than the capital she contributes. This means the entrepreneur is buying her share at a discount, and the co-investors are paying a premium to access a better investment opportunity.

The paper demonstrates that the dynamics in the firm's financial policies and the diversity in equity claims resolve the divergence in preferences and compensate for the inability to trade. The paper also highlights the importance to take into account such 'group' elements in the analysis of corporate financial behaviour. Indeed, dynamic models of group decision making in corporate finance are very rare (see Garlappi, Giammarino and Lazrak (2017, 2021)). Nevertheless, we hope that the work we are currently working on can provide some insights into how firms make their decisions and serve as the first step for many more to come.



Bär, M., A. Kempf, and S. Ruenzi (2011): “Is a team different from the sum of its parts? Evidence from mutual fund managers,” Review of Finance, 15(2), 359–396.

Chen, S., and B. Lambrecht (2021): “The Dynamics of Financial Policies and Group Decisions in Private Firms,” Available at SSRN: or

Garlappi, L., R. Giammarino, and A. Lazrak (2017): “Ambiguity and the corporation: Group disagreement and underinvestment,” Journal of Financial Economics, 125(3), 417– 433.

Garlappi, L., R. Giammarino, and A. Lazrak  (2021): “Group-managed real options,” Review of Financial Studies, forthcoming, hhab100.

Kerr, N. L. (1992): “Group decision making at a multialternative task: Extremity, interfaction distance, pluralities, and issue importance,” Organizational Behavior and Human Decision Processes, 52(1), 64–95.

Moscovici, S., and M. Zavalloni (1969): “The group as a polarizer of attitudes,” Journal of Personality and Social Psychology, 12(2), 125–135.

Sah, R. K., and J. E. Stiglitz (1986): “The architecture of economic systems: Hierarchies and polyarchies,” The American Economic Review, 76(4), 716–727.

Sah, R. K., and J. E. Stiglitz (1988): “Committees, hierarchies and polyarchies,” The Economic Journal, 98(391), 451–470.

Shupp, R. S., and A. W. Williams (2008): “Risk preference differentials of small groups and individuals,” The Economic Journal, 118(525), 258–283.



The Gender Gap in Household Bargaining Power: A Portfolio-Choice Approach

Ran Gu (University of Essex) and Cameron Peng (London School of Economics and Political Science) and Weilong Zhang, CERF Fellow (University of Cambridge)

January 2022


When studying the allocation of household assets, virtually all existing papers start with the household as the primitive unit of analysis (Gomes et al. 2020). In most models, a household is an imagined individual solving the optimal portfolio problem with a well-defined set of goals and constraints. In empirical analysis, it is common to treat a household as an average of all its members or to use the head of the household to represent the entire household, without further considering how each household member may play a different role or have a different say. These treatments, by simplifying the portfolio-choice problem, allow researchers to focus on other important aspects of household finance. However, they embed a fundamental disconnect between individuals and households: household members may have different characteristics and need to resolve their differences to make financial decisions for the household.

Risk preference, for example, is a key determinant of portfolio choice under standard portfolio theory, and it has been observed that members of the same household often report different attitudes towards risk. When such internal disagreement occurs, household members will inevitably need to bargain with each other in order to make decisions for the entire household. What characteristics determine an individual's bargaining power when making financial decisions? Which characteristics are quantitatively more important? Between men and women, is there a gender gap in bargaining power? If so, what drives it?

Existing approaches

A budding literature begins to tackle these questions with two main approaches. The first approach links the variation in individual-level characteristics to household-level outcomes (e.g., Addoum 2017; Olafsson and Thornqvist 2018; Ke 2020). This approach can establish the relevance of a plausible factor, but is restricted by the availability of plausible instruments. Therefore, it usually does not allow for a quantitative comparison among multiple factors. A second approach finds an empirical proxy for bargaining power and studies its properties and determinants (e.g., Friedberg and Webb 2006; Yilmazer and Lich 2015; Zaccaria and Guiso 2020). A popular proxy is constructed based on so-called “final say” question, whereby each household is asked to report who has ultimate responsibility for making a decision in financial matters and acts as the “financial head” of the household. However, when separately surveyed, different household members often give different answers to the same question, suggesting nontrivial noise and disagreement. Furthermore, a common concern about survey responses directly used in this survey-based approach still lingers: is what people say consistent with what they do?


Our approach

We propose a novel approach that directly estimates bargaining power by combining individual risk preference with household portfolio choice. The basic intuition is that household members with more bargaining power are more able to incorporate their own risk preferences into the household's overall portfolio decision. This departs from the survey-based approach by examining what people actually do rather than what they say. By explicitly modeling the portfolio-decision process and the determinants of bargaining power, we also depart from earlier approaches by studying multiple channels—such as income, employment status, education, and personality traits—at the same time and quantifying each channel's relative importance.


With this idea in mind, we build a tractable model of intrahousehold financial decisions and structurally estimate it using detailed longitudinal data. In our model, spouses differ in their risk preferences and other individual characteristics, and they make portfolio decisions for the entire household portfolio in two steps. In the first step, they cooperatively decide on a household risk preference, which is the weighted average of their respective risk preferences. The weight represents each individual's bargaining power and is determined by spousal differences in individual characteristics and a gender effect. In the second step, the household makes portfolio decisions based on this household-level risk aversion as if it were a single individual, with additional considerations, such as wealth, participation cost, family size, literacy, and education, as suggested in the literature. The household then decides whether to participate in the stock market (the extensive margin) and by how much (the intensive margin), in the spirit of the Merton model. We estimate the model using panel datasets from three countries: Australia, Germany and US. We adopt maximum likelihood method in the estimation, with stock market participation and risky asset holdings as the two outcome variables.


Results 1: Men have more bargaining power in financial decisions

We estimate our model using panel samples from three different countries: Australia, Germany and US. Our estimation result shows a significant gender gap in the bargaining power: in the average Australia household, the weight placed on husband's risk preference is about 0.59, while the weight placed on the wife's is 0.41; in the average Germany household, the weight placed on husband's risk preference is about 0.68; and in the average US household, the weight placed on husband's risk preference is about 0.61. Consistent with a greater gender gap among the German population, German households show a much more traditional attitude towards gender roles according to the World Values Survey (Ke 2018).

Result 2: The gender gap in bargaining power can be traced back to observed characteristics as well as a gender effect

Our subsequent analysis tries to understand the sources of this gender gaps in bargaining power. While the gap is partially explained by gender differences in individual characteristics such as income and employment, it is also due to gender effects. Overall, income, employment, and age tilt bargaining power toward the husband, as men on average earn more, are more likely to be employed, and are older. However, all observable characteristics combined can only account for above half of the gap, leaving the other half unexplained. This suggests a gender effect that contributes to husbands' disproportionally high bargaining power.


Result 3: The gender effect is associated with gender norms

We link the gender effect to direct measures of gender norms. The Australian Survey includes three specific questions about gender norms, and husbands and wives need to answer these questions separately. The questions elicit attitudes toward traditional gender roles and how housework and childcare studies should be shared. We find that households with progressive attitudes toward gender norms are more likely to elect the wife as the head of the household, thereby empowering women with more say in financial decisions. In particular, we find that subjective perceptions of both the husband and the wife matter.




Addoum, J. M. (2017). Household portfolio choice and retirement. Review of Economics and Statistics, 99(5):870–883.


Friedberg, L. and Webb, A. (2006). Determinants and consequences of bargaining power in households. Technical report, National Bureau of Economic Research.


Gomes, F., Haliassos, M., and Ramadorai, T. (2020). Household finance. Journal of Economic

Literature, forthcoming.


Ke, D. (2018). Cross-country differences in household stock market participation: The role of

gender norms. In AEA Papers and Proceedings, volume 108, pages 159–62.


Ke, D. (2020). Who wears the pants? gender identity norms and intra-household financial decision making. Forthcoming at Journal of Finance.


Olafsson, A. and Thornqvist, T. (2018). Bargaining over risk: The impact of decision power on

household portfolios.


Yilmazer, T. and Lich, S. (2015). Portfolio choice and risk attitudes: a household bargaining

approach. Review of Economics of the Household, 13(2):219–241.


Zaccaria, L. and Guiso, L. (2020). From patriarchy to partnership: Gender equality and household finance. Available at SSRN 3652376.