Learning by lending

This paper studies bank learning through repeated interactions with borrowers from a new perspective. To understand learning by lending, we adapt a methodology from labor economics to analyze how loan contract terms evolve as banks acquire new information about borrowers. We construct “proxy” variables for this information using data from borrowers’ out-of-sample, future credit performance. Due to the timing of their construction, banks could not have used these variables directly to price loans. We nonetheless find that these proxies increasingly predict loan prices as relationships progress, even after controlling for possible omitted variable bias. Our methodology provides strong evidence that: (a) bank learning affects loan prices, and (b) relationship benefits are heterogeneous. In particular, higher quality borrowers face differentially lower spreads as their relationship with lenders develop – and banks learn about their quality – while lower quality borrowers see loan prices increase and their loan amounts fall. We further find suggestive evidence that banks incorporate CEO-specific information into loan prices.     

Is the Corporate Loan Market Globally Integrated? A Pricing Puzzle

We offer evidence that interest rate spreads on syndicated loans to corporate borrowers are economically significantly smaller in Europe than in the United States, other things equal. Differences in borrower, loan, and lender characteristics do not appear to explain this phenomenon. Borrowers overwhelmingly issue in their natural home market and bank portfolios display home bias. This may explain why pricing discrepancies are not competed away, though their causes remain a puzzle. Thus, important determinants of loan origination market outcomes remain to be identified, home bias appears to be material for pricing, and corporate financing costs differ across Europe and the United States.     

The rise in student loan defaults

We examine the rise in student loan defaults in the Great Recession by linking administrative student loan data at the individual borrower level to student loan borrowers’ individual tax records. A Blinder-Oaxaca style decomposition shows that shifts in the composition of student loan borrowers and the massive collapse in home prices during the Great Recession can each account for approximately 30% of the rise in student loan defaults. Falling home prices affect student loan defaults by impairing individuals’ labor earnings, especially for low income jobs. By contrast, when comparing the default sensitivities of homeowners and renters, we find no evidence that falling home prices affect student loan defaults through a home equity-based liquidity channel. The Income Based Repayment (IBR) program introduced by the federal government in the wake of the Great Recession reduced both student loan defaults and their sensitivity to home price fluctuations, thus providing student loan borrowers with valuable insurance against negative shocks.     

Liquidity creation and funding ability during the interbank lending crunch

This study examines the portfolio response of US banks to the interbank lending collapse during the global financial crisis. The paper documents that a bank's response to the collapse of interbank markets is related to whether or not the bank was a net borrower or lender of funds. In particular, we find that typical borrowers had lower loan growth than typical lenders, but that the crisis did not differentially affect borrowers and lenders with respect to loan growth. However, borrowing and lending banks were differentially affected by the crisis in terms of their liquid asset growth. The typical borrowers reduced their liquid asset growth relative to lending banks during the crisis. We interpret this finding as saying that borrowing banks had to reduce their risky asset holdings because access to interbank funds had been reduced. The paper presents analogous analyses of the possible differential response of borrowers and lenders to changes in counterparty risk and lending through the Fed's TAF facility.     

The Role of Bank Reputation in “Certifying” Future Performance Implications of Borrowers’ Accounting Numbers

We investigate the role played by the reputation of lead arrangers of syndicated loans in mitigating information asymmetries between borrowers and lenders. We hypothesize that syndications by more reputable arrangers are indicative of higher borrower quality at loan inception and more rigorous monitoring during the term of the loan. We investigate whether borrowers with more reputable lead arrangers realize superior performance subsequent to loan origination relative to borrowers with less reputable arrangers. We further examine whether certification by high‐reputation lead banks extends to the quality of borrowers’ reported accounting numbers. Controlling for endogenous matching of borrowers and lead banks, we find that higher bank reputation is associated with higher profitability and credit quality in the three years subsequent to loan initiation. We also show that bank reputation is associated with long‐run sustainability of earnings via higher earnings persistence, and debt contracting value of accounting via a stronger connection between pre‐loan profitability and future credit quality. We further document that the enhanced earnings sustainability associated with higher reputation lead banks reflects both superior fundamentals and accruals more closely linked with future cash flows.     

Auditor choice and information asymmetry: evidence from international syndicated loans

Analyzing a large sample of non-US public firms from 31 countries that obtain private loans, we find that loan syndicates that lend to borrowers that employ Big N auditors are larger and less concentrated and that the lead arrangers and largest investors of these syndicates are able to hold a lower proportion of the loan after issuance. Further analysis demonstrates that this effect exists only in countries with strong creditor rights and in those countries with high levels of societal trust, suggesting that both sound formal and informal institutional factors are prerequisites for lenders and borrowers to benefit from differential audit quality on loan syndicate structure efficiency. Furthermore, we find that the loan syndicate structure benefits for borrowers that employ Big N auditors are higher for borrowers with greater information asymmetry problems, but we do not find that Big N audits are able to address the information asymmetry and moral hazard issues between the lenders themselves.     

Loan Market Competition and Bank Risk-Taking

Recent literature (Boyd and De Nicoló, J Finance 60:1329–1343, 2005) has argued that competition in the loan market lowers bank risk by reducing the risk-taking incentives of borrowers. Using a model where competition arises from falling switching costs for entrepreneurs, we show that the impact of loan market competition on banks is reversed if banks can adjust their loan portfolios. The reason is that when borrowers become safer, banks want to offset the effect on their balance sheet and switch to higher-risk lending. They even overcompensate the effect of safer borrowers because loan market competition erodes their franchise values and thus increases their risk-taking incentives.     

Banking deregulation and credit risk: Evidence from the EU

This paper studies the effect of banking deregulation on credit risk. Its theoretical model shows that a bank is willing to invest more resources in screening borrowers when there is an entry threat, even though loan rates are driven lower. Thus, deregulation may result in improved loan quality and lower credit risk. This result is tested using bank-level balance sheet data and macroeconomic data for the European Union. The data reveal that competition intensified after the completion of the Second Banking Directive, while loan quality improved in most markets. Evidence is found that the loan quality improvement is associated with lower interest margin.     

What does peer-to-peer lending evidence say about the Risk-Taking Channel of monetary policy?

This paper uses loan application-level data from a peer-to-peer lending platform to study the risk-taking channel of monetary policy. By employing a direct ex-ante measure of risk-taking and estimating the simultaneous equations of loan approval and loan amount, we provide evidence of monetary policy's impact on a nonbank financial institution's risk-taking. We find that the search-for-yield is the main driving force of the risk-taking effect, while we do not observe consistent findings of risk-shifting from the liquidity change. Monetary policy easing is associated with a higher probability of granting loans to risky borrowers and greater riskiness of credit allocation. However, these changes do not necessarily relate to a larger loan amount on average.     

Sovereign stress and SMEs’ access to finance: Evidence from the ECB's SAFE survey

We study the effect of sovereign stress on SMEs’ capital structure using restricted-access data from the European Central Bank. We find that during the sovereign debt crisis, and controlling for borrowers’ quality, firms in stressed countries became more likely to be denied credit, to be credit rationed, and to face higher loan rates. Less creditworthy firms were not more likely to become credit constrained, suggesting no flight to quality in lending. We also find that in order to make up for the decline in bank credit firms in stressed countries began relying considerably more on retained earnings and government subsidies.     

Differences in the Cost of Mortgage Credit Implications for Discrimination

This paper estimates the mortgage interest rate differences paid by Asian, Hispanic, and African–American borrowers to a national home mortgage lender in the years 1988–1989. Controlling for differences in market rates, rate lock protection, and borrower risk factors, conventional loan interest rates are almost perfectly race-neutral. The single deviation from race-neutrality is that when interest rates fall during the borrower's rate-lock period, only African–American borrowers are unable to capture a share of this decline. Government (FHA and VA) credit models show small premia paid by African–American borrowers of about $1.80 per month on average. In government lending, Hispanic borrowers alone are unable to capture rate declines occurring during the borrower's rate-lock period.     

Bank reputation in the private debt market

We examine the impact of lead arrangers' reputation on the design of loan contracts such as spread and fees charged. Controlling for the non-randomness of the lender–borrower match (self-selection bias), we find that the reputation of top tier arrangers leads to higher spreads, and that top tier arrangers retain larger fractions of their loans in their syndicates. These larger spreads are especially pronounced for borrowers without credit rating that have the most to gain from the certification assumed by virtue of a loan contract with a top tier arranger. This certification channel differs from the one found in public markets, where certification leads to a reduced spread offered to the best clients. These differences between public and private markets can be explained by differences in the way they operate and are structured. Interestingly, the effect is strongest for transactions done after the changes in the banking regulations (including the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994) that led to significant consolidations in the banking industry, including among the largest commercial banks.     

Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants

Covenants in corporate bonds and loan agreements mitigate agency conflicts between borrowers and lenders and may provide a signal of borrower quality to help resolve information asymmetry. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads based on borrowers’ subsequent performance. Our covenant signaling framework views interest‐decreasing performance pricing as a tight covenant associated with borrowers’ private information on improved future performance accompanied by reduced credit risk. This positive signal is associated with larger positive loan announcement returns and greater improvements in future borrower performance. Further, in addition to signaling value, we find that the spread impact of this class of covenant also depends on its option value and reduction in transaction costs.     

Seeing is important: the usefulness of video information in P2P

P2P lending is an important research subject of rising internet finance research. This paper uses unique data from Renrendai, a leading platform in China, to test the influence of video information on P2P lending behavior. Results suggest that, first, the lower the borrower's credit rating is, the more likely they are to provide video information. Second, compared to the video‐information‐absent borrowers, the otherwise borrowers can get easier access to a loan and offer a lower interest rate. These results indicate that compared to text messages, video information can increase the borrower's creditworthiness and reduce the transaction risk. Thereupon seeing is important in online P2P lending. Third, when the borrower's credit rating is lower, the video effect is significant. The study makes sense in terms of the enrichment of P2P lending literature and the enlightenment on decision‐making of both lenders and borrowers.     

The Effect of Down Payment Assistance on Mortgage Choice

Lack of wealth for a down payment is one of the most recognized barriers to home ownership. In response to this barrier, state and federal government have implemented many programs that provide down payment assistance to potential home buyers. Numerous studies have shown that this assistance can increase homeownership rates, but few have measured how receiving assistance may alter borrowing behavior. Using data from a down payment assistance grant in the Midwest, this study compares the loan type and size of grant recipients to other borrowers that report similar income and buy homes in the same census tract. Results indicate grant recipients are more likely to use conventional loans, which are less expensive than other loan types that require a smaller down payment. Estimates also suggest that the grant may reduce loan size for borrowers who are on the margin of using a conventional loan.     

Do Banks Value Innovation? Evidence from US Firms

This study evaluates how innovation within companies alleviates the information asymmetry problems in relationship lending. We hypothesize that patenting activities could reveal favorable private information and, hence, reduce the information asymmetry between innovative borrowers and banks. Using a sample of US patenting firms from 1987 to 2004, we show that borrowers with higher innovation capability (revealed by having more patent applications, higher research & development (R&D) productivity, or higher‐quality patents) enjoy lower bank‐loan spreads and better nonprice‐related loan terms. Our evidence further suggests that the information benefits of patenting activities on loan spreads is more pronounced for small or less R&D‐intensive firms.     

The Home Bias and the Credit Crunch: A Regional Perspective

Using detailed data on loan applications and decisions for a large sample of manufacturing firms in Italy during the recent financial crisis, we find that the credit crunch has been harsher in provinces with a large share of branches owned by distantly managed banks. Inconsistent with a flight to quality we do not find evidence that economically weaker firms suffered more during the crisis. In contrast, we find that financially healthier firms were affected more in functionally distant credit markets than in markets populated by less distant banks, consistent with a home bias on the part of nationwide banks.     

Cost stickiness and bank loan contracting

This study examines whether and, if so, how borrowers' asymmetric cost behavior (i.e., cost stickiness) is factored into the price and non-price terms of bank loan contracts. We provide strong and reliable evidence that ex-ante, the loan spread increases with cost stickiness after controlling for other known determinants of loan contract terms. Moreover, we find that the effect is more pronounced for borrowers with higher default risk and higher information risk. This is consistent with borrowers' asymmetric cost behavior increasing lenders' uncertainty about the liquidation value of assets, and hence, lenders need to be compensated ex-ante. Additionally, we conjecture that higher cost stickiness may increase the need for ex-post monitoring. Consistent with this conjecture, we find some evidence that lenders impose tighter non-price terms on firms with stickier costs. This study integrates cost stickiness research with the banking literature by showing that banks incorporate borrowers' asymmetric cost behavior into loan contracting terms.     

Bank lending opportunities and credit standards

This article empirically tests the hypothesis that credit-screening standards can be first increasing and then decreasing in the quality of the bank's pool of potential borrowers, which in turn may vary through the business cycle or across different segments of the lending markets. A key implication is that banks with lending opportunities toward the middle of the quality spectrum can have loan portfolios that perform better than do the portfolios of banks with loan-origination opportunities that are either too weak or too strong. Using banks’ volume of secondary-market loan sales as a proxy for the richness of lending opportunities, I find an inverse U-shaped relation between the performance of banks’ loan portfolios and their activity in the loan sales market. The pattern deserves scrutiny for its policy implications, as many regulators hold the view that countercyclical variation in credit standards may have a destabilizing effect on business cycles.     

FHA vs. Subprime Mortgage Originations: Is FHA the Answer to Subprime Lending?

We analyze originations of mortgages guaranteed by the Federal Housing Administration (FHA) and of subprime mortgages—loans that dominate the non-prime mortgage market for riskier borrowers. Using home purchase and refinance loans data for 2005, we estimate that a sizeable number of borrowers who got subprime loans would have qualified for FHA loans, implying a potential net flow of borrowers from subprime to FHA, especially for refinance loans at a rate of about 30%. Also, consistent with the FHA’s modernization proposal to increase its loan limits, we find that increasing the limits on FHA loans could help to attract borrowers, mostly of home purchase loans, who are likely to be constrained by the lower-priced house limits. Our findings are generally in line with the recent increased flow of mortgages to FHA, and suggest that FHA loans could be the answer to the current subprime lending crisis.