Assessing the risk-return trade-off in loan portfolios

This paper proposes a methodology to analyse the risk and return of large loan portfolios in a joint setting. I propose a tractable model to obtain the distribution of loan returns from observed interest rates and default frequencies. I follow a sectoral approach that captures the heterogeneous cyclical features of different kinds of loans and yields moments in closed form. I investigate the validity of mean–variance analysis with a value at risk constraint and study its relationship with utility maximisation. Finally, I study the efficiency of corporate and household loan portfolios in an empirical application to the Spanish banking system.     

Asymmetric effects of the business cycle on bank credit risk

Prior empirical research on the relation between credit risk and the business cycle has failed to properly investigate the presence of asymmetric effects. To fill this gap, we examine this relation both at the aggregate and the bank level exploiting a unique dataset on Italian banks’ borrowers’ default rates. We employ threshold regression models that allow to endogenously establish different regimes identified by the thresholds over/below which credit risk is more/less cyclical. We find that not only are the effects of the business cycle on credit risk more pronounced during downturns but cyclicality is also higher for those banks with riskier portfolios.     

Institutional demand pressure and the cost of corporate loans

Between 2001 and 2007, annual institutional funding in highly leveraged loans went up from $32 billion to $426 billion, accounting for nearly 70% of the jump in total syndicated loan issuance over the same period. Did the inflow of institutional funding in the syndicated loan market lead to mispricing of credit? To understand this relation, we look at the institutional demand pressure defined as the number of days a loan remains in syndication. Using market-level and cross-sectional variation in time-on-the-market, we find that a shorter syndication period is associated with a lower final interest rate. The relation is robust to the use of institutional fund flow as an instrument. Furthermore, we find significant price differences between institutional investors’ tranches and banks’ tranches of the same loans, even though they share the same underlying fundamentals. Increasing demand pressure causes the interest rate on institutional tranches to fall below the interest rate on bank tranches. Overall, a one-standard-deviation reduction in average time-on-the-market decreases the interest rate for institutional loans by over 30 basis points per annum. While this effect is significantly larger for loan tranches bought by collateralized debt obligations (CDOs), it is not fully explained by their role.     

A factor analysis approach to measuring European loan and bond market integration

By using an existing and a new convergence measure, this paper assesses whether bank loan and bond interest rates are converging for the non-financial corporate sector across the euro area. Whilst we find evidence for complete bond market integration, the market for bank loans remains segmented, albeit to various degrees depending on the type and size of the loan. Factor analysis reveals that rates on large loans and small loans with long rate fixation periods have weakly converged in the sense that, up to a fixed effect, their evolution is driven by common factors only. In contrast, the price evolution of small loans with short rate fixation periods is still affected by country-specific dynamic factors. There are few signs that bank loan rates are becoming more uniform with time.     

A statistically robust decomposition of mutual fund performance

Previous decompositions of risk-adjusted mutual fund performance might deliver biased results. In this paper, we provide new reliable insights on the drivers of mutual fund performance by decomposing risk-adjusted performance of U.S. equity mutual funds using the Generalized Calendar Time regression model. According to our results, out of all previously considered fund characteristics, only the negative effect of lagged fund size and the positive effects of lagged performance and lagged family size remain highly significant. Our analysis further suggests that much of the variation in previous empirical results can be attributed to methodological issues.     

A study on long-run inefficiency levels of a panel dynamic cost frontier under the framework of forward-looking rational expectations

This paper aims to provide a theoretical underpinning of the dynamic efficiency model pioneered by [Ahn, S.C., Good, D.H., Sickles, R.C., 2000. Estimation of long-run inefficiency levels: A dynamic frontier approach. Econometric Reviews 19, 461–492]. In the context of a quadratic loss function this paper formulates a multi-period forward-looking rational expectations model on the evolution of the technical inefficiency level, which correctly produces a dynamic panel data model. The model is illustrated using panel data of 112 French banks. Encouraging evidence of superiority in favor of the model is reached. Substantial cost inefficiency prevails in this industry, where the constituent banks are characterized as having volatile adjustment speeds toward their long-run steady states. The sample banks exhibit increasing returns to scale and product-mix economies.     

Macroeconomic effects of corporate default crisis: A long-term perspective

Using an extensive data set on corporate bond defaults in the US from 1866 to 2010, we study the macroeconomic effects of bond market crises and contrast them with those resulting from banking crises. During the past 150 years, the US has experienced many severe corporate default crises in which 20–50% of all corporate bonds defaulted. Although the total par amount of corporate bonds has at times rivaled the amount of bank loans outstanding, we find that corporate default crises have far fewer real effects than do banking crises. These results provide empirical support for current theories that emphasize the unique role that banks and the credit and collateral channels play in amplifying macroeconomic shocks.     

Marking-to-model credit and operational risks of loan commitments: A Basel-2 advanced internal ratings-based approach

Within a marking-to-model framework, this research computes the bank's capital charge for credit and operational risks of loan commitments at Basel-2 fixed audit date. This is done in three steps. The first one prices commitment credit risk as a Gram-Charlier put value and determines the commitment forward-funding proportion. In the second one, put value and funding proportion are combined to compute Basel-2 ‘fair’ capital charge for credit and operational risks. By producing a moderate total capital charge, marking-to-model offers substantial capital relief with respect to the corresponding charge computed with Basel-2 simplified approach. Both charges are however larger than the corresponding nil charge arrived at in Basel-1. In the third step, marking-to-model reveals its flexibility by showing how banks can determine the cost of their exposure to borrowers' credit-rating downgrades and how they can also hedge any exposure to commitment default risk.     

Nonlinear dynamics in discretionary accruals: An analysis of bank loan-loss provisions

Several studies have analyzed discretionary accruals to address earnings-smoothing behaviors in the banking industry. We argue that the characteristic link between accruals and earnings may be nonlinear, since both the incentives to manipulate income and the practical way to do so depend partially on the relative size of earnings. Given a sample of 15,268 US banks over the period 1996–2011, the main results in this paper suggest that, depending on the size of earnings, bank managers tend to engage in earnings-decreasing strategies when earnings are negative (“big-bath”), use earnings-increasing strategies when earnings are positive, and use provisions as a smoothing device when earnings are positive and substantial (“cookie-jar” accounting). This evidence, which cannot be explained by the earnings-smoothing hypothesis, is consistent with the compensation theory. Neglecting nonlinear patterns in the econometric modeling of these accruals may lead to misleading conclusions regarding the characteristic strategies used in earnings management.     

Reject inference in consumer credit scoring with nonignorable missing data

We generalize an empirical likelihood approach to deal with missing data to a model of consumer credit scoring. An application to recent consumer credit data shows that our procedure yields parameter estimates which are significantly different (both statistically and economically) from the case where customers who were refused credit are ignored. This has obvious implications for commercial banks as it shows that refused customers should not be ignored when developing scorecards for the retail business. We also show that forecasts of defaults derived from the method proposed in this paper improve upon the standard ones when refused customers do not enter the estimation data set.     

House prices,bank instability,and economic growth: Evidence from the threshold model

This paper examines the effects of house prices on bank instability when gauged at various levels of income growth. Bank stability may respond differently to house price changes or deviations from fundamental values in an economic boom environment than in a bust circumstance. A threshold estimation technique developed by Hansen (1999) is applied to a panel of 286 U.S. Metropolitan Statistical Areas (MSAs) over the period 1990Q1–2010Q4. We consider two house price indicators: the house price changes and the house price deviations from long-run equilibrium. The results suggest the existence of income growth threshold effects in the relationship between house prices and bank instability. Specifically, there are two income growth thresholds when using the house price changes and one income growth threshold when the house price deviations are applied. Robustness results using the non-MSAs sample from 1995Q1 to 2010Q4 provide further evidence of income growth threshold effects.     

The influence of loan officers on loan contract design and performance

We investigate the extent to which loan officers generate independent, individual effects on the design and performance of syndicated loans. We construct a large database containing the identities of loan officers involved in structuring syndicated loan deals, allowing us to systematically disentangle borrower, bank, and loan officer fixed effects. We find that loan officers have significant influence on interest spreads, loan covenant design, and loan performance. Inclusion of borrower fixed effects increases our power to rule out the alternative that loan officer fixed effects reflect the matching of officerds to borrowers based on time-invariant borrower characteristics. We document heterogeneity in loan officers’ influence across loan contract terms, with loan officers exerting stronger influence over covenant package design than over interest spreads, but marginal influence on loan maturity. Lead officers have greater influence than participant officers over covenant package design and loan performance, but less robust differential influence on interest spreads.     

Impact of idiosyncratic volatility on stock returns: A cross-sectional study

This paper proposes a new approach to estimate the idiosyncratic volatility premium. In contrast to the popular two-pass regression method, this approach relies on a novel GMM-type estimation procedure that uses only a single cross-section of return observations to obtain consistent estimates. Also, it enables a comparison of idiosyncratic volatility premia estimated using stock returns with different holding periods. The approach is empirically illustrated by applying it to daily, weekly, monthly, quarterly, and annual US stock return data over the course of 2000–2011. The results suggest that the idiosyncratic volatility premium tends to be positive on daily return data, but negative on monthly, quarterly, and annual data. They also indicate the presence of a January effect.     

Risk sharing,finance, and institutions in international portfolios

We develop a standard model to show how transaction costs in international investment affect conventional tests of consumption risk sharing, both in a multilateral and a bilateral setting. We implement the tests in a novel international data set on bilateral holdings of equity, bonds, foreign direct investment (FDI) and bank loans. In our data, high foreign capital holdings are associated with international consumption risk sharing as implied by our theory. This is especially true of investment in equity or bonds, but not of foreign direct investment or bank loans. In our model, the implication is that transaction costs are higher for FDI and international loans. The discrepancy could reflect technological differences, but also the prospect of expropriation, perhaps most stringent for FDI or loans. We argue that expropriation risk is endogenous to both the borrower's institutions and its openness to international markets. The detrimental impact of poor institutions is muted in open economies, where the possibility of subsequent exclusion from world markets deters expropriation of foreign capital. We show the implied effects of institutions prevail in both the cross-section of consumption risk sharing and in observed international investment patterns.     

Practical methods for measuring and managing operational risk in the financial sector: A clinical study

This paper analyzes the implications of the advanced measurement approach (AMA) for the assessment of operational risk. Through a clinical case study on a matrix of two selected business lines and two event types of a large financial institution, we develop a procedure that addresses the major issues faced by banks in the implementation of the AMA. For each cell, we calibrate two truncated distributions functions, one for “normal” losses and the other for the “extreme” losses. In addition, we propose a method to include external data in the framework. We then estimate the impact of operational risk management on bank profitability, through an adapted measure of RAROC. The results suggest that substantial savings can be achieved through active management techniques.     

Information asymmetry and self-selection bias in bank loan announcement studies

Event-study driven research has produced a consensus that loans are unique relative to other financial contracts. But these studies assume that small samples of loan announcements adequately represent the loan population. We find that loan announcements are rare and driven by factors such as information asymmetry and perceived materiality. We show that the sample used by Billett, Flannery, and Garfinkel (1995) fails to represent the loan universe and that significant abnormal announcement returns are confined to their smallest firms. Our sample, which better represents the loan population, produces an abnormal return insignificantly different from zero. The findings suggest that self-selection bias affects extant loan announcement research and do not support the views that loans are a special form of finance or that private and public debt differ in significant ways. Were all loans to be announced, the average abnormal return would likely be insignificant.     

Incorporating risk input into the analysis of bank productivity: Application to the Taiwanese banking industry

This study reappraises banks’ productivity by using 42 Taiwanese banks during 1999–2007 as observations. It introduces an input-oriented generalized metafrontier Malmquist productivity index (I-gMMPI), while considering the latent effect of risk-taking behavior in the analytic framework. We learn that public and private banks should face separate short-term technological frontiers, while the econometric model considering risk input can portray banks’ operating frontiers better. Moreover, neglecting the influence of risk input would bring about distortions of efficiency, technology and TFP dynamic estimations for banks; meanwhile, the degree of scale economies would also be overestimated. The paper concludes that neglecting the risk-taking essence in bank performance evaluation is equal to allowing banks to barter risk-bearing as the term for further output growth. Consequently, the potential cost is that banks may excessively aggrandize their scales of business, implying the possibility of another financial crisis.     

Corporate tax,capital structure,and the accessibility of bank loans: Evidence from China

In this paper, we investigate whether listed firms in China adjust their capital structure in response to an increase in the corporate tax rate. Although theories of capital structure suggest that corporate tax is an important determinant of capital structure, how exogenous changes of the tax rate affect firms’ leverage decisions has not been fully explored. We examine a unique circumstance in which the Chinese government increased the corporate tax rate of firms that had previously received local government tax rebates. The evidence indicates that these firms increased their leverage when the corporate tax rate increased. Further investigation suggests that the adjustment of leverage was mostly driven by firms with a high level of access to bank loans.     

Investment,internal funds and public banking in Germany

Previous studies supposed that low investment-cash flow sensitivities of German firms may be caused by a dominance of public banking. The paper addresses this assumption and applies a unique accounting dataset of German firms. Results from a dynamic version of the sales accelerator model show that the dependence of investment spending on internal funds does not significantly differ among firms attached to savings banks, cooperative banks or commercial banks. Thus, the importance of the public banking sector in Germany may not explain the rather low dependence of German firms on internal funds, and public ownership of banks does not seem to be important for reducing financing constraints.     

Shadow Banks and Macroeconomic Instability

We develop a macroeconomic model in which commercial banks can offload risky loans to a “shadow” banking sector, and financial intermediaries trade in securitized assets. The model can account both for the business cycle comovement between output, traditional bank, and shadow bank credit, and for the behavior of macroeconomic variables in a liquidity crisis centered on shadow banks. We find that following a liquidity shock, stabilization policy aimed solely at the market in securitized assets is relatively ineffective.