High-quality Borrowers Research Articles

Ignorance Is Bliss? Anonymous Lending with Roll over Risk

Market design matters when heterogeneous borrowers roll over loans, facing funding shocks. Borrower anonymity is a key feature of various financial markets, such as short term, interbank lending markets. We show that anonymous markets experience systemic runs for large shocks, but provide insurance against rollover risk for moderate shocks. Insurance operates via loan contracts, pooling high and low quality borrowers, and is welfare enhancing when early liquidation of the project is costlier than continuation. Non anonymous markets allocate more funding to high quality borrowers, but moderate shocks trigger runs on low quality borrowers. When funding shocks have large variance, non anonymous markets generate larger welfare than anonymous markets. We study other market features, such as contract novation, default fund and collateral. In anonymous markets, novation and default fund reduce the risk of systemic runs. Collateral aligns private incentives with the socially optimal strategy, inducing the liquidation of inefficient projects.

Short-Termism Spillovers from the Financial Industry

To meet short-term benchmarks, lenders may alter their monitoring behavior, providing a channel for short-termism incentives to spillover into the corporate sector. We find that lenders with short-termism incentives enforce material covenant violations at abnormally high rates. Further, they are more likely to target high-quality borrowers with which they have a prior relationship and that are less financially constrained. Affected borrowers are more likely to switch lenders, receive worse loan terms on future loans, and reduce investment. Market reactions to technical default announcements when lenders have short-term incentives are 0.63% lower, suggesting that short-termism spillovers are value-decreasing.

Competition in Lending and Credit Ratings

This article relates corporate credit rating quality to competition in lending between the public bond market and banks. In the model, the monopolistic rating agency's choice of price and quality leads to an endogenous threshold separating low-quality bank-dependent issuers from higher-quality issuers with access to public debt. In a baseline equilibrium with expensive bank lending, this separation across debt market segments provides information, but equilibrium ratings are uninformative. A positive shock to private (bank) relative to public lending supply allows banks to compete with public lenders for high-quality issuers, which threatens rating agency profits, and informative ratings result to prevent defection of high-quality borrowers to banks. This prediction is tested by analyzing two events that increased the relative supply of private vs. public lending sharply: legislation in 1994 that reduced barriers to interstate bank lending and the temporary shutdown of the high-yield bond market in 1989. After each event, the quality of ratings (based on their impact on bond yield spreads) increased for affected issuers. The analysis suggests that strategic behavior by the rating agency in an issuer-pays setting dampens the influence of macroeconomic shocks, and explains the use of informative unsolicited credit ratings to prevent unrated bond issues, particularly during good times. Additionally, the controversial issuer-pays model of ratings leads to more efficient outcomes than investor-pays alternatives.

A New Look at Second Liens

We use data from credit reports and deed records to better understand the extent to which second liens contributed to the housing crisis by allowing buyers to purchase homes with small down-payments. At the top of the housing market, second liens were quite prevalent: As many as 45 percent of home purchases in coastal markets and bubble locations involved a piggyback second lien. Owner-occupants were more likely to use piggyback second liens than were investors. Second liens in the form of home equity lines of credit (HELOCs) were originated to relatively high-quality borrowers, and originations were declining near the peak of the housing boom. By contrast, characteristics of closed-end second liens (CES) were worse on all these dimensions. Default rates of second liens are generally similar to that of the first lien on the same home, although HELOCs perform better than CES. About 20 to 30 percent of borrowers will continue to pay their second lien for more than a year while remaining seriously delinquent on their first mortgage. By comparison, about 40 percent of credit card borrowers and 70 percent of auto loan borrowers will continue making payments a year after defaulting on their first mortgage. Finally, we show that delinquency rates on second liens, especially HELOCs, have not declined as quickly as those on most other types of credit, raising a potential concern for lenders with large portfolios of second liens on their balance sheets.

The impact of corporate social responsibility on the cost of bank loans

This study examines the link between corporate social responsibility (CSR) and bank debt. Our focus on banks exploits their specialized role as delegated monitors of the firm. Using a sample of 3996 loans to US firms, we find that firms with social responsibility concerns pay between 7 and 18 basis points more than firms that are more responsible. Lenders are more sensitive to CSR concerns in the absence of security. We document a mixed reaction to discretionary CSR investments. Low-quality borrowers that engage in discretionary CSR spending face higher loan spreads and shorter maturities, but lenders are indifferent to CSR investments by high-quality borrowers.

The Stabilizing Effects of Risk-Sensitive Bank Capital

The aim of the present paper is to assess the pro-cyclical impact of risk-sensitive bank capital. We develop a theoretical model where banks may apply two capital management rules: (i) either keep a constant, time-invariant, capital to loan ratio for all loans (flat capital ratio), (ii) or hold distinct, time-variant, capital to loan ratios depending on the measured riskiness of the loans (risk-based capital ratio). Despite its inherent cyclicality we show that the risk-sensitive capital rule may work to stabilize banks’ supply of credit over the business cycle when the credit market is characterised by over-investment, i.e. credit standards are loose and resources are inefficiently allocated to risky projects. In this case the decrease in the capital-to-high-quality-loan ratio in good times provides banks with more leeway to lend to high quality borrowers, limits the search for higher but riskier yields, reduces over-investment, and ultimately smoothes the credit cycle. We test the relevance of this stabilizing effect using quarterly balance sheet data from a panel of US banks over the period 2003-2007. This period, characterized by easy access to credit and —presumably— over-investment, is particularly well suited for our test. We start by partitioning our sample of banks into two groups: banks whose capital to asset ratio has been observationally counter-cyclical, and banks whose capital has been either flat or pro-cyclical over our sample. We then compare the elasticities of credit to GDP across the two groups. Although such partitioning works to biase our statistical test against finding stabilizing effects, we find that banks with counter-cyclical, risk-sensitive, capital ratios have been the least sensitive to the business cycle. This paper thus provides both theoretical support for and empirical evidence of the stabilizing effects of risk-sensitive bank capital management.

Signaling Credit Risk in Agriculture: Implications for Capital Structure Analysis

Signaling is an important element in the lender-borrower relationship that influences the cost and availability of debt capital to agricultural borrowers. This paper analyzes the effects of signaling on farm capital structure in conjunction with the pecking order and trade-off theories. The aggregate estimation indicates that signaling does affect agricultural credit relationships through measures of past cash flow and profitability. High-quality borrowers achieve greater credit capacity by providing lenders with valid signals of their financial status, while adjusting toward target debt levels over time and following the pecking order relationship in the short run.

The concentration of creditors: evidence from small businesses

This article examines the determinants of concentration of creditors. The empirical evidence drawn from this article supports the proposition of Bolton and Scharfstein (1996) that for negotiation reasons, high-quality borrowers tend to borrow from multiple sources and is contrary to the theoretical prediction of Bris and Welch (2005). This finding implies the existence of hold-up problems in financing small businesses where information conveyance is difficult between lenders. It is further supported by the evidence that dispersed bank relationships are associated with relationships of a longer history and a closer physical distance to lenders.

Common Liquidity Risk and Market Collapse: Lessons from the Market for Perps

We show how a high degree of commonality in investor liquidity shocks can diminish incentives for intermediaries to keep markets open and lead to market collapse, even without information asymmetry or news affecting fundamentals. We motivate our model using the perpetual floating rate note market where two years of explosive growth - in which issues by high quality borrowers were placed with institutional investors and traded in a liquid secondary market - were followed by a precipitous collapse when market intermediaries withdrew due to large order imbalances. We shed new light on the trade-off between ownership concentration and market liquidity.

Common liquidity shocks and market collapse: Lessons from the market for perps

We show how a high degree of commonality in investor liquidity shocks can diminish incentives for intermediaries to keep markets open and lead to market collapse, even without information asymmetry or news affecting fundamentals. We motivate our model using the perpetual floating-rate note market where two years of explosive growth – in which issues by high quality borrowers were placed with institutional investors and traded in a liquid secondary market – were followed by a precipitous collapse when market intermediaries withdrew due to large order imbalances. We shed new light on the trade-off between ownership concentration and market liquidity.

Does a Large Loss of Bank Capital Cause Ever-greening or Flight to Quality?: Evidence from Japan

Constructing a strong and unique instrument for bank capital from the empirical observation of Japanese banks’ past behavioral changes, we identify the impact of capital adequacy on the allocation of bank lending supply across low quality and high quality borrowers. We find that, in FY 1997, a large loss of capital resulting from the regulator’s tougher stance against banks induced banks to rebalance their lending portfolio toward low quality borrowers. Our findings also suggest that the public recapitalization of banks in FY 1998 effectively helped banks abandon the assistance of such zombies.

Collateral and Competitive Equilibria with Moral Hazard and Private Information

The authors examine equilibrium credit contracts and allocations under different competitivity specifications and explain the economic roles of collateral under these specifications. Both moral hazard and adverse selection are considered. The principal message is that how a competitive equilibrium is conceptualized significantly affects the characterization of equilibrium credit contracts. Specifically, some well-known results in the rationing literature are shown to rest delicately on the adopted equilibrium concept. Two somewhat surprising results emerge. First, high-quality borrowers with unlimited collateral may be priced out of the market despite the bank having idle deposits. Second, high-quality borrowers may put up more collateral.