Lending Contracts Research Articles

A tractable model of limited enforcement and the life-cycle dynamics of firms

We develop a continuous-time model of optimal lending contracts under limited enforcement and provide closed-form solutions. We characterize the dynamics of firms’ growth rate, Tobin’s Q, and capital structure over their life cycles.

Bank Deposits and the Stock Market

I show that households' demand for retail deposits decreases during stock market booms, which induces a contraction in bank lending and a decrease in real activity at bank-dependent firms. I identify this channel using geographic heterogeneity in households' stock market participation. Banks in areas with greater stock ownership see a greater reduction in deposit growth when stock returns are high. This holds even across branches of the same bank, and across zip codes within counties. Counties served by banks financed by more stock-active depositors see a greater decline in bank lending and bank-dependent-firm employment following high stock returns.

An Equilibrium Model of Housing and Mortgage Markets With State-Contingent Lending Contracts

We develop a tractable general equilibrium framework of housing and mortgage markets with aggregate and idiosyncratic risks, costly liquidity and strategic defaults, empirically relevant informational asymmetries, and endogenous mortgage design. We show that adverse selection plays an important role in shaping the form of an equilibrium contract. If borrowers' homeownership values are known, aggregate wages and house prices determine the optimal state-contingent mortgage payments, which efficiently reduces the costs of liquidity default. However, when lenders are uncertain about homeownership values, the equilibrium contract only depends on house prices and takes the form of a home equity insurance mortgage (HEIM) that eliminates the strategic default option and insures the borrower's equity position. Interestingly, we show that widespread adoption of such loans has ambiguous effects on the homeownership rate and household welfare. In economies in which recessions are expected to be severe, the HEIM equilibrium Pareto dominates the equilibrium with fixed-rate mortgages. However, if economic downturns are not severe, HEIMs can lower the homeownership rate and make some marginal home buyers worse-off. We also note that adjustable-rate mortgages (ARMs) may share some benefits with HEIMs, which may help justify a high concentration of ARMs among riskier borrowers. Finally, we find that unrestricted competition between lenders may lead to a non-existence of equilibrium. This suggests that government-sponsored enterprises may stabilize mortgage markets by subsidizing certain mortgage contracts.

Risk, Return and Profit-Loss Shared Lending Under Zero-Interest Financial System

Owing to its unique nature, writing a profit-loss shared lending (PLSL) contract for a Zero-Interest Financial System (ZIFS) bank is a challenge. Like venture capitalists and stock owners, a PLS lender faces some of the same risks as the borrower. However, as a lender and not as an investor (as opposed to the classical definition), it does not share in any increment or loss in the value of equity. While the share of profit going to capital may be constant, the absolute amount going to the lending bank is likely to diminish over a fixed period of time until the loan is paid. In economies where attempts to float a PLSL contract is strong, it is made worse by an abundance of adverse selection (AS) and moral hazard (MH) factors: lack of knowledge and training, errors in planning and projection, tardiness in identifying and reacting to problems, limitations of oversight, nepotism, favoritism, corruption, falsification, legal loopholes, tendency to cut corners, etc. So, despite its obvious benefits PLSL contracts are finding it difficult to take root and become established as a standard financing arrangement. This is vitiated by internal competition posed by mark-up financing. Pivotal to a viable PLSL contract, relevant equations incorporating AS and MH and related explicit and implicit costs are identified. Then risk-adjusted return to ZIFS bank, capital’s share of profit, absolute income accruable to banks and relevant first order conditions are derived.

Transaction costs on the example of credit contract

The article presents the theorem-cal aspects of the transaction-tional costs. Consider HN costs that fuss-cabins before and after the lending contract. Presented methods to reduce costs, to conclude a contract of credit, both for the lender and the borrower.

The spillovers, interactions, and (un)intended consequences of monetary and regulatory policies

Have bank regulatory policies and unconventional monetary policies—and any possible interactions—been a factor behind the recent “deglobalisation” in cross-border bank lending? To test this hypothesis, we use bank-level data from the UK—a country at the heart of the global financial system. Our results suggest that increases in microprudential capital requirements tend to reduce international bank lending and some forms of unconventional monetary policy can amplify this effect. Specifically, the UK׳s Funding for Lending Scheme (FLS) significantly amplified the effects of increased capital requirements on cross-border lending. Quantitative easing did not appear to have a similar effect and countries with stronger prudential capital regulations were partially insulated against the effects of these changes in UK policy. We find that this interaction between microprudential regulations and the FLS can explain roughly 30% of the contraction in aggregate UK cross-border bank lending between mid-2012 and end-2013, corresponding to around 10% of the global contraction in cross-border lending. This suggests that unconventional monetary policy designed to support domestic lending can have the unintended consequence of reducing foreign lending.

Patent Activity of Start-Ups and the Structuring of Venture Lending Contracts

Patent Activity of Start-Ups and the Structuring of Venture Lending Contracts

Patent Activity of Start-Ups and the Structuring of Venture Lending Contracts

Patent Activity of Start-Ups and the Structuring of Venture Lending Contracts

Shielding of assets and lending contracts

The primary means of enforcement of legal liabilities is through the seizure of debtors’ assets. However, debtors can shield their assets in various ways and thereby reduce the power of enforcement. This paper studies the circumstances under which a debtor would choose to shield assets and the value of assets that would be shielded.A key idea is that borrower’s wealth mutes shielding incentives. Intuitively, avoiding debts through shielding requires that enough assets will be shielded, for else the debts can be collected from exposed assets. A wealthier debtor would thus need to shield more assets, and at a greater cost, than a debtor with limited wealth. Using this basic understanding, I develop a theory of asset shielding and explore its implications for incomplete lending contracts, explaining the role of equity agreements, equity cushions and collateral, and debt forgiveness, and explore the some of the policy implications.

Estimating defaults in organized security lending markets

Purpose This paper aims to analyze the dynamics of the security lending process and lending markets to identify the market-wide variables reflecting the characteristics of the stock borrowed and to measure the credit risk arising from lending contracts. Design/methodology/approach Using the data provided by Istanbul Settlement and Custody Bank on the equity lending contracts of Securities Lending and Borrowing Market between 2010 and 2012 and the data provided by Borsa Istanbul on Equity Market transactions for the same timeframe, this paper analyzes whether stock price volatility, stock returns, return per unit amount of risk and relative liquidity of lending market and equity market affect the defaults of lending contracts by using both linear regression and ordinary least squares regression for robustness and proxying the concepts of relative liquidity, volatility and return constructs by more than variable to correlate findings. Findings The results illustrate a statistically significant relationship between volatility and the default state of the lending contracts but fail to establish a connection between default states and stock returns or relative liquidity of markets. Research limitations/implications With the increasing pressure for clearing security lending contracts in central counterparties, it is imperative for both central counterparties and regulators to be able to precisely measure the risk exposure due to security lending transactions. The results gained from a limited set of lending transactions merit further studies to identify non-borrower and non-systemic credit risk determinants. Originality/value This is the first study to analyze the non-borrower and non-systemic credit risk determinants in security lending markets.

Banks as Tax Planning Intermediaries

We provide the first large-sample evidence of banks playing an important role in facilitating tax planning by client firms. Banks could be associated with client tax avoidance through two separate mechanisms. First, banks may act as tax planning intermediaries by developing and implementing tax strategies for corporate clients or by spreading tax strategies across clients. Second, banks may select borrowers in part based on their tax avoidance. Capturing bank-client relationships using lending contracts, we find that a borrower’s own tax avoidance is strongly associated with the average tax avoidance of its bank’s other borrowers. Further tests are consistent with this result being driven in part by banks acting as tax planning intermediaries. Finally, we find that borrowers experience meaningful increases in tax avoidance when they begin a new relationship with a bank whose existing borrowers are substantial tax avoiders. Overall, our results suggest that banks, in addition to being financial intermediaries, also act as tax planning intermediaries in facilitating corporate tax planning.

The Spillovers, Interactions, and (Un)Intended Consequences of Monetary and Regulatory Policies

Have bank regulatory policies and unconventional monetary policies — and any possible interactions — been a factor behind the recent “deglobalisation” in cross-border bank lending? To test this hypothesis, we use bank-level data from the UK — a country at the heart of the global financial system. Our results suggest that increases in microprudential capital requirements tend to reduce international bank lending and some forms of unconventional monetary policy can amplify this effect. Specifically, the UK’s Funding for Lending Scheme (FLS) significantly amplified the effects of increased capital requirements on external lending. QE may also have had an amplification effect, but these estimates are usually insignificant and smaller in magnitude. We find that this interaction between microprudential regulations and the FLS can explain roughly 30% of the contraction in aggregate UK cross-border bank lending between mid-2012 and end-2013, corresponding to around 10% of the contraction globally. This suggests that unconventional monetary policy designed to support domestic lending can have the unintended consequence of reducing foreign lending.

Optimal lending contracts

This paper deals with financial contracting between a lender and a borrower with a project to finance. The borrower is protected by limited liability. We consider that the revenue from the project is observable and verifiable but its distribution is influenced by both the borrower’s choice of action and the project’s quality, which are private information. We find that debt contracts are endogenously optimal, as under moral hazard alone. Moreover, while moral hazard leads to credit rationing for the lowest-quality projects only, adding adverse selection creates a bang-bang result: either all projects or none are credit rationed.

The Democratization of Credit and the Rise in Consumer Bankruptcies

Financial innovations are a common explanation for the rise in credit card debt and bankruptcies. To evaluate this story, we develop a simple model that incorporates two key frictions: asymmetric information about borrowers’ risk of default and a fixed cost of developing each contract lenders offer. Innovations that ameliorate asymmetric information or reduce this fixed cost have large extensive margin effects via the entry of new lending contracts targeted at riskier borrowers. This results in more defaults and borrowing, and increased dispersion of interest rates. Using the Survey of Consumer Finances and Federal Reserve Board interest rate data, we find evidence supporting these predictions. Specifically, the dispersion of credit card interest rates nearly tripled while the “new” cardholders of the late 1980s and 1990s had riskier observable characteristics than existing cardholders. Our calculation suggest these new cardholders accounted for over 25% of the rise in bank credit card debt and delinquencies between 1989 and 1998.

When good investments go bad: The contraction in community bank lending after the 2008 GSE takeover

Abstract In September 2008, the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, were placed into conservatorship. The GSEs' equity prices dropped considerably in response, and, as a result, many banks that held sizable amounts of the preferred stock of the two GSEs recognized substantial losses. Fifteen failures and two mergers resulted. We treat these losses as plausibly exogenous, unanticipated, supply-side shocks to bank lending, as they are likely unrelated to demand-side factors that could affect lending, and because GSE investments were considered to be safe by banks, regulators, and rating agencies. As a result, this event allows us to examine the relationship between community bank condition and lending during the global financial crisis. We find that, following the shock, loan growth at exposed banks was about 2 percentage points lower than other banks.

Debt-overhang banking crises: Detecting and preventing systemic risk

This paper shows how the debt-overhang distortion on bank lending can generate a self-fulfilling-expectations banking crisis accompanied by a plunge in the value of banks’ assets and a contraction of bank lending and economic activity. Moral hazard in banking adds an additional channel that can generate multiple equilibria, worsen the debt-overhang distortion, and deepen the crisis. Some signals of systemic risk include: high volatility and the presence of two modes in the probability distribution functions of the returns on bank-issued bonds and on portfolios of bank-issued bonds and equities; and high correlation between the returns on bank-issued bonds. Macroprudential regulation should discourage the exposure of banks to the economic and financial cycle by raising the capital requirements for banks with more cyclical assets.

Bank loan terms and conditions: Is there a macro effect?

We examine whether macroeconomic factors contain significant information for bank loan contracting terms and conditions (T&Cs), over and above that of standard firm-specific or country-level institutional factors. Our estimation is based on a seemingly unrelated mixed-processes methodology that accommodates two salient data properties: (i) the fact that loan contract terms are determined jointly as a single lending contract, and (ii) the fact that the elements of loan T&Cs are generated by different distributional formats. Our findings indicate that cross-country variation accounts for a significant portion of observed variation in loan T&Cs. In addition, macroeconomic fundamentals significantly explain the “package” of loan T&Cs offered to corporate borrowers, with this effect being distinct from any influence that T&Cs receive from firm-specific factors, and also from country-specific institutional factors.

Venture Capitalist Reputation And The Effect On Venture Lending Contracts

This study is based on a proprietary dataset entailing 119 venture lending contracts issued by a European venture lending fund between 2002 and 2009 in Europe, United States and Israel. We conduct ...

The Financial Accelerator and the Optimal Lending Contract

In the financial accelerator literature pioneered by Bernanke, Gertler and Gilchrist (1999) entrepreneurs are myopic and loans have a fixed rate of return by assumption. We relax both of these assumptions and derive the optimal lending contract for forward looking entrepreneurs who can choose a state-contingent lending rate. We show that under the optimal lending contract, when entrepreneurs care about the future and are given the option of a state-contingent borrowing rate to insure against aggregate risk, financial frictions do not amplify business cycle fluctuations.

The 2012 Eurozone Crisis and the ECB's OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation

This paper develops a model to interpret the 2012 eurozone crisis and the ECB’s policy response. In the model, bank lending is distorted by debt overhang, banks hold sovereign bonds, and the government guarantees the bailout of bank creditors. A self-fulfilling pessimistic view of the economy can trigger a banking and sovereign crisis: with pessimistic economic expectations, the value of sovereign bonds declines, the bank risk of default rises, and the debt overhang distortion worsens; this leads to a contraction in bank lending and to a decline in economic activity, which confirms the initial pessimistic expectations. A commitment by the central bank to purchase the sovereign bonds at pre-crisis market spreads manages to eliminate the crisis equilibrium.