The American Finance Association has awarded its 2015 Fischer Black Prize to Yuliy Sannikov, of the Princeton University Benheim Center for Finance.
Fischer Black, of course, was one of the founders of modern finance theory, and a namesake of the Black-Scholes Theorem. The AFA says that their Black Prize is for work in Black’s spirit, that is, original research relevant to finance practitioners, from an individual under 40.
So … what has Sannikov done? Among much else, he has studied the macroeconomic significance of financial frictions, that is, of the fact that funds aren’t always liquid, and don’t always flow where they “should” according to classical economic theory. Differences in patience, risk aversion, and optimism affect fund flows from one contracting party to another, although in abstract theoretical terms what matters would be “the most profitable project or … the person who values the funds most.”
I can hear you yawning already, in the third row there. Yes, the presence of friction in real-world economic situations is very old news, even in academia. But Sannikov’s contention has been that the significance of this friction remains poorly understood, largely because of the way the study of economics itself is Balkanized. Macroeconomics is one subject, finance is another, and general equilibrium theory is a third. What frictionology [excuse the coinage] requires is cross-fertilization thereof, and Sannikov has worked to that end.
Consider the word “liquidity.” It is so common a word in economics, and especially in the study of finance, that one can infer too easily that it has a single understood meaning. But Sannikov has helped clarify this, distinguishing among three meanings: technological, market, and funding liquidity. Technological liquidity means an investment is reversible. Market liquidity means that capital may be sold with only limited price impact. Funding liquidity involves the maturity structure of debt and – closely tied to that – the sensitivity of margins/haircuts.
In a survey article on friction-related literature, Sannikov and his two co-authors explained the unity of sensitivity and maturity structure with this example: if the margin “can move from 10% to 50% overnight, then 40% of the loan is essentially a maturity of one day.” With these distinctions made, the authors of this article, “Macroeconomics with Financial Frictions” proceeded to identify the precise sort of liquidity mismatch that creates friction at the macro level, a mismatch between “technological and market liquidity on the asset side of the balance sheet and the funding liquidity on the liability side.”
Alpha Seekers and Equity Investors
For alpha seekers, the significance of such research may lie in the ability to predict and to get ahead of changes in the demand for liquid assets. As the survey article, published in March 2012, indicated, as volatility rises “individuals become more likely to hit their borrowing constraints and hence they demand moire liquid assets for precautionary reasons.”
More recently, (April 2014) Sannikov has written a fascinating working paper, “Moral Hazards and Long-Run Incentives.” The title is very general, but Sannikov’s specific focus is on contracts in which reward is tied to performance, yet the real value (or disvalue) of the performance involved isn’t clear when the pay-out have to be made, that is, clawback situations. In true academic style, Sannikov wants to “design a formal tractable framework to analyze these issues.”
The model he ends up with suggests that “some of a CEO’s compensation should be deferred after termination, a feature observed rarely in practice.” More generally, his optimal model has a “consumption smoothing” feature, so that a new contracting party’s exposure to firm risk will be low, and will be adjusted toward a target over time, with rewards for good performance “banked in” to offset potential future losses.” This work may contribute to discussion of best practices for governance. If other students of the matter agree that Sannikov has identified an optimal contract from the point of view of incentives and performance, then their investments may well be influenced by the degree to which a specific issuer’s governance polices match that model.
In all, it is an impressive body of work from a scholar who has many more (and, I hope, productive) years of research ahead of him. My congratulations to him on the prize.