Intertemporal diversification in financial intermediation

This paper examines the incentive problem between a bank and depositors (or deposit insurer): limited liability makes risk-shifting lucrative. We show how intertemporal diversification of lending decisions – i.e. bank’s loan portfolio consists of overlapping long-term loans and is thus gradually renewed – may solve the incentive problem of risk-shifting. A new (or expanding) bank sets a high-equity level and acquires depositors’ confidence. Subsequently, it can allow its equity to depreciate to a permanently lower level. Depositors can control the bank by monitoring equity and realized credit losses ex post; they do not have to monitor bank’s lending choices ex ante. Maturity mismatch – illiquidity of long-term loans and liquidity of deposits – is optimal. The analysis can be extended more generally to the borrower–lender relationship.     

A computational approach to pricing a bank credit line

Using trended Brownian motion to characterize borrower cash needs over time, we are able to derive a probability density function for the time to depletion of a bank credit line as well as the likelihoods for the time to exhausting the sources of liquidity that fund the loan. Armed with these analytic results, we solve for the credit line mark-up rate and the configuration of stored liquidity that maximizes the bank’s intertemporal expected profits from the loan. The optimality conditions produce a system of integral differential equations whose solutions we then simulate over a host of scenarios.     

Why do banks choose to finance with equity?

A majority of U.S. banks between 1973 and 2012 held equity capital significantly beyond the required minimum. We study the risk-return tradeoff in connection with a bank’s capital structure, and identify several new significant market factors that drive the level of equity capital in banks. During normal growth periods, bank leverage is negatively related to a level of competition and loan portfolio diversification, while high bank leverage is associated with low past liquidity. During recessions and expansions, the roles of those factors change following distortions in risk-return tradeoff. In distress, when banks approach regulatory capital requirements, market determinants of book leverage lose their significance; however, leverage does not decrease until a bank is within 1% of the minimal capital threshold.     

Implications of bank regulation for loan supply and bank stability: a dynamic perspective

ABSTRACT

We show that internal funds play a particular role in the regulation of bank capital, which has not received much attention, yet. A bank's decision on loan supply and capital structure determines its immediate bankruptcy risk as well as the future availability of internal funds. These internal funds in turn determine a bank's future costs of external finance and its future vulnerability to bankruptcy risks. Using a partial equilibrium model, we study how internal funds affect these intra- and intertemporal links. Moreover, our positive analysis identifies the effects of risk-weighted capital-to-asset ratios, liquidity coverage ratios and regulatory margin calls on the dynamics of internal funds and thus loan supply and bank stability. Only regulatory margin calls or large liquidity coverage ratios achieve bank stability for all risk levels, but for large risks a bank will stop credit intermediation.     

On the determinants of bank interest margins under credit and interest rate risks

This paper explores the determinants of optimal bank interest margins based on a simple firm-theoretical model under multiple sources of uncertainty and risk aversion. The model demonstrates how cost, regulation, credit risk and interest rate risk conditions jointly determine the optimal bank interest margin decision. We find that the bank interest margin is positively related to the bank's market power, to the operating costs, to the degree of credit risk, and to the degree of interest rate risk. An increase in the bank's equity capital has a negative effect on the spread when the bank faces little interest rate risk. The effect of rising interbank market rate on the spread is ambiguous and depends on the net position of the bank in the interbank market. Our findings provide alternative explanations for the empirical evidence concerning bank spread behavior.     

Bank monitoring incentives and optimal ABS

The paper examines a continuous-time delegated monitoring problem between competitive investors and an impatient bank monitoring a pool of long-term loans subject to Markovian “contagion.” Moral hazard induces a foreclosure bias unless the bank is compensated with the right incentive-compatible contract. Fees are paid when the bank’s performance is on target and liquidation arises when the bank’s performance is sufficiently poor. I show that the optimal contract can be implemented with a whole loan sale involving both credit risk retention based on ABS credit default swaps and credit enhancement in the form of a reserve account. The optimal securitization bears out rulemaking recently proposed in the wake of the Dodd-Frank Act on a number of controversial provisions. I argue that further efficiency gains could be reaped by extending the role of the “premium capture” account into a liquidity buffer capturing performance-based compensation as a way of increasing skin in the game over the life of the transaction.     

PARTIAL EXERCISE OF LOAN COMMITMENTS UNDER ADAPTIVE PRICING

The partial takedown phenomenon associated with bank loan commitments is examined in a dynamic context in which banks adjust commitment prices to client takedown behavior. The optimal takedown is an increasing function of client riskiness and a decreasing function of the time the client plans to remain with its present bank and the cost of switching to a new bank. Since the bank's learning is cumulative, the longer a client remains with its bank the smaller is the commitment price adjustment resulting from an aberrant takedown. The enhanced commitment price certainty, obtained with longevity of the client relationship, helps to explain client reluctance to switch banks. Since the optimal takedown is an increasing function of client riskiness under adaptive pricing, such pricing may serve the added purpose of providing information on client risk.     

Bank Forward Lending in Alternative Funding Environments

This paper examines the effects of loan commitments on bank lending behavior in both deposit-funding and liability management environments. Assuming that the bank lends exclusively under commitments and that the number of commitments exercised is uncertain, the bank must choose its supply of commitments. Given this choice, the bank becomes a passive lender to commitment holders. Our focus on forward credit markets sheds new light on the private bankers' assertion that they do not directly determine their level of lending, but merely “accommodate” the credit needs of their customers. Similarly, the central banker's claimed inability to control monetary aggregates in the short-run becomes understandable in a new context. It is shown that the advent of liability management will reduce the volume of loan commitments and the expected size of the bank and of the banking system. It is also shown that increased uncertainty regarding borrower takedown behavior diminishes the volume of commitments, expected bank and banking system size.     

Liquidity risk management and credit supply in the financial crisis

Liquidity dried up during the financial crisis of 2007-2009. Banks that relied more heavily on core deposit and equity capital financing, which are stable sources of financing, continued to lend relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased takedown demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.     

货币政策对流动性风险的影响——基于银行信贷行为视角

本文基于我国现实背景和《巴塞尔协议Ⅲ》,利用2008年至2017年间194家商业银行的相关数据,对我国银行净稳定资金率进行了度量,并在此基础上,检验了货币政策对我国商业银行流动性风险的影响,探究了其影响机理和传导渠道。研究表明:扩张型货币政策会提高商业银行的流动性风险;不同经济环境下,货币政策对流动性风险的影响存在差异但不具备异质性;不同类型的商业银行中,货币政策对流动性风险的影响不具有异质性;在货币政策对流动性风险的影响中,银行信贷行为是重要的传导渠道。因此,央行可基于货币政策对流动性风险的影响差异进行相机抉择;商业银行则要加强信贷规模和质量的管理,优化资产结构,通过弱化信贷渠道作用来降低货币政策对银行流动性风险的不良影响。     

结售汇如何影响银行风险承担水平?——基于银行资产负债表的视角

本文构建了一个基于银行资产负债表的理论模型,研究了结售汇对银行风险承担水平的影响机制,并采用结售汇报表数据进行实证检验。结果表明,为实现利润最大化,银行会将外汇流入创造的流动性用于投放较高风险的贷款,导致净结汇对银行风险承担水平有正向影响,异质性分析结果显示大型银行受影响程度高于中小银行。本文结论意味着,当考虑结售汇波动可能进一步加剧时,有必要出台更多结构性政策,补足外汇流入减少带来的货币缺口,优化存款市场结构,稳定金融机构流动性预期,以缓冲外需冲击可能带来的影响,并激励银行服务重心进一步下沉,为小微企业提供更多信贷支持,完成好金融服务实体经济的重要使命。     

Capital Market Regimes and Bank Structure in Europe

We hypothesize that fundamental features that distinguish European capital markets have predictably influenced emerging national differences in bank capitalization and loan growth. Using bank‐level data from 13 European countries, 1998 to 2004, we find evidence of positive effects of “equity‐friendly” market features on bank capitalization and positive effects of both “equity‐friendly” and “credit‐friendly” market features on loan growth. The findings are strongest in small banks and in banks with cooperative charters. Our results suggest that ongoing and prospective integration of European banking markets is mitigated by relatively static features of the equity and credit markets on which banks rely.     

The integration of bank syndicated loan and junk bond markets

This paper hypothesizes that the special role of banks as corporate quasi-insiders has been changing due to developments in informational, legal and institutional infrastructures of syndicated loan markets. We investigate the integration of intermediated and disintermediated financial markets through highly leveraged transaction (HLT) syndicated loans during the 1990s. We demonstrate that, with the emergence of traded HLT syndicated loans as an alternative high-yield asset to high-yield bonds, market integration has dramatically increased. Taking the late 1980s and 1990s together, different factors explain the movement of credit spreads of the two markets. HLT loan market’s spreads are strongly affected by bank liquidity. Bank liquidity’s effect on HLT loan spreads disappears after 1993. From 1994–1999, junk bond market liquidity factors affect bank loan pricing. We interpret these changes as evidence of the erosion of bank specialness.     

Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa

The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999. In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels. We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.     

Getting the Right Mix of Capital and Cash Requirements in Prudential Bank Regulation*

Cash reserve requirements are useful as a broadly conceived prudential tool, not just as a narrowly focused means of limiting the risks associated with illiquidity. Indeed, illiquidity risk is neither a necessary nor a sufficient condition for establishing bank liquidity requirements. The primary means of mitigating the systemic costs of bank illiquidity risk is the creation of an effective lender of last resort (LOLR). But instead of focusing narrowly on bank funding risks when designing liquidity requirements, regulators should consider tradeoffs among capital requirements, liquidity requirements, and LOLR policies for achieving the broader prudential goal of limiting bank default risk. When considering the optimal tradeoff between capital ratios and cash ratios as prudential requirements, five “frictions” are identified that favor the use of one or the other: (1) the adverse‐selection costs of raising equity (which favors the use of cash); (2) the opportunity cost of forgone abnormal profits (or “quasi rents”) from lending (which favors the use of capital); (3) the limited verifiability of loan outcomes (which favors the use of cash); (4) the moral hazard that results from costly or postponed loss recognition, given the incentive for risk shifting in bad states (which favors the use of cash); and (5) the prospect of changes in the risk environment (which favors cash since it creates greater option value for maintaining targeted default risk with lower adjustment costs in the face of changing loan risk or illiquidity risk). When viewed from the perspective of achieving the main prudential goal of controlling default risk at a minimum social cost, capital requirements have some limitations that favor liquidity requirements, and vice versa. And thus the optimal regulatory policy will combine liquidity and capital requirements.     

The impact of joint participation on liquidity in equity and syndicated bank loan markets

Market liquidity is impacted by the presence of financial intermediaries that are informed and active participants in both the equity and the syndicated bank loan markets, specifically informationally advantaged lead arrangers of syndicated bank loans that simultaneously act as equity market makers (dual market makers). Employing a two-stage procedure with instrumental variables, we identify the simultaneous equations model of liquidity and dual market maker decisions. We find that the presence of dual market makers improves the liquidity of the more competitive and transparent equity markets, but widens the spread in the less competitive over-the-counter loan market, particularly for small, informationally opaque firms.     

How investor demands for safety influence bank capital and liquidity trade-offs

We construct a model of a bank’s optimal funding choice, where the bank negotiates with both safety-driven short-term bondholders and (mostly) risk-taking long-term bondholders. We establish that investor demands for safety create a negative relationship between the bank’s capital choices and short-term funding, as well as negative relationships between capital and common measures of bank liquidity. Short-term investors’ demands for safety force the bank to hold more collateral, which diminishes the demands by long-term bondholders for higher holdings of bank capital. Consistent with our model, our bank-level empirical analysis of these capital–liquidity trade-offs shows that bank liquidity measures have a strong and negative relationship to the capital ratio. Furthermore, we show that this trade-off does not appear to be regulation related and has diminished in size over time.     

AGENT BANK BEHAVIOR IN BANK LOAN SYNDICATIONS

Using Shared National Credit (SNC) Program data from 1995 to 2000, we extend previous empirical work on bank loan syndications. First, we examine recent trends in the volume and examiner‐based credit quality of loans syndicated through the banking system. Second, we estimate a panel regression model to explain changes in an agent bank's retained share of a syndicated loan in terms of information asymmetries, loan credit quality, capital constraints, and loan age and maturity. We find that these variables are significant determinants of the proportion of a SNC loan retained by an agent bank for its portfolio over time.     

Laying off credit risk: Loan sales versus credit default swaps

How do markets for debt cash flow rights, with and without accompanying control rights, affect the efficiency of lending? A bank makes a loan, learns if it needs monitoring, and then decides whether to lay off credit risk. The bank can transfer credit risk by either selling the loan or buying a credit default swap (CDS). With a CDS, the originating bank retains the loan's control rights; with loan sales, control rights pass to the loan buyer. Credit risk transfer leads to excessive monitoring of riskier credits and insufficient monitoring of safer credits. Increases in banks' cost of equity capital exacerbate these effects. For riskier credits, loan sales typically dominate CDS but not for safer credits. Once repeated lending and consequent reputation concerns are modeled, although CDSs remain dominated by loan sales for riskier credits, for safer credits they can dominate loan sales, supporting better monitoring (albeit to a limited extent) while allowing efficient risk sharing. Restrictions on the bank's ability to sell the loan expand the range in which CDSs are used and monitoring is too low.     

The determinants of private capital flow volatility in Sub-Saharan African countries

The study investigates the underlying factors of patterns of volatility for FDI, portfolio equity and cross-border bank lending inflows for sub-Saharan African countries using a panel framework with data from 1990 to 2011. No other study has focussed exclusively on sub-Saharan Africa when investigating the determinants of private capital flow volatility. This study is further unique in that it employs clearly-delineated cross-border bank lending data from the Bank of International Settlements’ (BIS) Locational Banking Statistics that has not been used by similar prior studies. The findings of the study are as follows: (1) global liquidity lowers FDI volatility while private sector credit increases volatility; (2) global liquidity increases portfolio equity volatility with growth and the quality of macroeconomic policies found to be important pull factors in lowering volatility; and (3) the quality of macroeconomic policies and trade openness are important pull factors in lowering cross-border bank lending volatility while financial openness increases volatility.