Lower Default Risk Research Articles

Mortgage Brokers and the Effectiveness of Regulatory Oversights

This paper studies the responses among different types of mortgage brokers to occupational licensing regulations. By explicitly accounting for heterogeneities between sole and corporate brokers, we find evidence that sole brokers respond to financial regulatory oversight by applying a more stringent screening process in conducting brokerage activities, hence achieving better loan performances. Specifically, loans originated through sole brokers exhibit higher quality on an array of credit-relevant characteristics, including those reported and unreported to future investors. By contrast, we find no such regulatory effect on corporate brokers who tend to rely extensively on reported characteristics that are critical to the subsequent loan securitization at the expense of unreported information despite the latter indicating potential risks. Hence, the agency problem among sole brokers can be mitigated by the consolidated financial requirement for occupational licensing. However, such provision is ineffective in governing corporate brokers. Additionally, welfare gains associated with the occupational licensing regulation are achieved at the expense of prospective borrowers paying a higher loan price and having reduced credit access. Stricter licensing regulations may induce welfare loss related to credit rationing as reasonable loan applications are not funded, including those with potentially lower default risk. This paper was accepted by Kay Giesecke, finance.

Strategic co-funding in informal finance market: evidence from China

ABSTRACT Information asymmetry in the anonymous informal finance market drives the lenders to screen the borrowers by disclosed information. Using data from a powerful online peer-to-peer lending platform, we study the effects of formal financing records on successful funding and default outcomes in the informal finance market. We find that lenders are more likely to fund borrowers with formal financing records. Borrowers with formal credit are more likely to repay the loans entirely. Co-funding with the formal financial sector is strategic, corresponding to lower default risk. Moreover, without historical success records or with a low-income level, borrowers can use the formal credit signals to mitigate information asymmetry and improve the funding probability. These results are obtained after controlling for loan-level and borrower-level information, city-by-year-month, and day-of-week fixed effects. Several tests show our findings are unlikely to be an unintentional byproduct of the formal financial signals.

Employee Treatment and Bank Default Risk during the Credit Crisis

We examine whether banks’ interest in the well-being of their workforce, measured by an index of employee relations strengths, explains their default risk during the recent credit crisis. Using a sample of 179 U.S. banks, we find that banks with greater pre-crisis employee relations strengths experience lower default risk and have higher excess returns during the crisis. These banks have lower asset volatility and leverage, suggesting that bank default risk is mitigated through lowering operational and financial risks. Banks’ prudent risk-taking behavior benefits shareholders in times of heightened risk. The results are robust to alternative model specifications and endogeneity issues.

Impact of foreign entry into the banking sector: The case of Thailand in 1999–2014

This paper examines the impact of foreign capital entry on the cost and profit structure of commercial banks in Thailand using bank-level panel data for the period 1999–2014. We distinguish between market-level and individual bank-level impacts. First, we found that market-level foreign capital presence resulted in increases in interest rate spread and non-interest income, and reductions in operating expenses, resulting in higher returns on assets. Second, the increase in bank-level foreign ownership share in domestic banks resulted in a rise in interest rate spread and lower default risk, but at the same time, an increase in operating expenses. Finally, the acquisition of local banks by foreign banks resulted in only a moderate increase in interest income, and the profit structure of these banks remained vulnerable due to their small size. Thus, foreign entry into the Thai banking sector at the beginning of the 21st century has had multi-faceted effects.

The Effects of Political Stability in Local Currency Bond Markets

This study analyzes the effects of political stability, institutional quality, and event shocks on 1-year, 10- year, and 30-year local currency bond yields. The data were collected from Bloomberg, IMF, World Bank, and OECD and cover 15 emerging market countries on a monthly frequency from January 2007 to February 2017. This study found that higher degrees of political stability and quality lead lower yields and lower default risk. Political event shocks such as party-changing elections lead to increased yields and default risk, while politically-motivated acts of violence affected the slope of yield curve.

Microfinance board and default risk in sub-Saharan Africa

PurposeThis paper examines whether board structure affects microfinance institutions' (MFIs) default risk in sub-Saharan Africa (SSA).Design/methodology/approachThe paper uses a pooled OLS and system generalized method of moments (GMM) model on unbalanced panel data from 214 MFIs in 26 SSA countries over 2005–2016 period. Default risk is measured using non-performing loans (loans overdue 30 and 90 days) and loans written-off ratios. Board size, proportion of independent and female directors are used as proxies for board structure.FindingsThe empirical results indicate that unregulated MFIs with larger and more independent boards tend to have a lower default risk. In addition, unregulated MFIs with a female director tend to lower default risk.Research limitations/implicationsThis research mainly focusses on SSA. Future research may consider a broader geographical area.Practical implicationsPoor loan portfolio quality is one of the major problems of MFIs operating in SSA. The findings of this study will contribute in emphasizing the role of an effective board structure in lowering MFI default risk.Originality/valueThis study is unique in terms of investigating whether board structure impacts default risk based on MFI regulation.

Female leadership and bank risk-taking: Evidence from the effects of real estate shocks on bank lending performance and default risk

This paper examines whether banks with female Chief Executive Officers (CEOs) and chairpersons of the board are associated with better lending performance and lower default risk when faced with severe real estate price shocks. Using a large panel of U.S. commercial banks, we document that female-led banks with high real estate exposure are associated with lower loan charge-offs and lower non-accrual loans relative to similar male-led banks. Furthermore, our empirical findings indicate that female-led banks with high real estate exposure have lower default risk and are less likely to fail in the aftermath of real estate price shocks. However, we find no evidence of superior lending performance or reduced default risk for female-led banks which are not exposed to severe real estate price shocks through high levels of real estate lending.

Optimal branching strategy, local financial development, and SMEs’ performance

This paper examines whether and to what extent development of the local-level financial sector improves SMEs’ performances. While only a handful of studies examines the relationship between local financial development and firm growth, no theoretical basis has been provided in those studies to understand transmission channels and instruments through which local financial development works in favor of firm growth. This paper attempts to fill that gap. In a theoretical framework, this paper shows that an optimal number of bank branches in an area works as an instrument of the transmission channel from financial development to growth, which helps reduce excess liquidity and increase SMEs’ access to bank credit by creating links between the demand and supply of liquidity. Banks default credit risk and cost of branch expansion determine the optimal number of branches in an area: a higher number of branches will reduce asymmetry of information about borrowers and monitoring costs, leading to lower default risks. Using new firm-level survey data of 1084 SME manufacturing firms from Bangladesh, our empirical analysis suggests that there is a threshold level of bank branches that can improve SME performance at the sub-district level. Our findings highlight the importance of potential returns to an optimal branching strategy of banks at the sub-national level that will lead to inclusive finance and growth within a country.

Mortgage Brokers and the Effectiveness of Regulatory Oversights

This paper studies the responses among different types of mortgage brokers to occupational licensing regulations. By explicitly accounting for heterogeneities between sole and corporate brokers, we find evidence that sole brokers respond to financial regulatory oversight by applying a more stringent screening process in conducting brokerage activities, hence achieving better loan performances. Specifically, loans originated through sole brokers exhibit higher quality on an array of credit-relevant characteristics, including those reported and unreported to future investors. By contrast, we find no such regulatory effect on corporate brokers who tend to rely extensively on reported characteristics that are critical to the subsequent loan securitization at the expense of unreported information despite the latter indicating potential risks. Hence, the agency problem among sole brokers can be mitigated by the consolidated financial requirement for occupational licensing. However, such provision is ineffective in governing corporate brokers. Additionally, welfare gains associated with the occupational licensing regulation are achieved at the expense of prospective borrowers paying a higher loan price and having reduced credit access. Stricter licensing regulations may induce welfare loss related to credit rationing as reasonable loan applications are not funded, including those with potentially lower default risk.

An analysis of credit risk of middle and small-sized enterprises in the inclusive financial system: an example from China

Inclusive finance is a development direction of current finance reform for the nations of the world. Based on the theory of inclusive finance, this paper analyses the credit risk of middle and small-sized enterprises in China through KMV model. In empirical analysis, we choose the sample data coming from ST company, *ST company and non-ST company in the growth enterprise market of China. After calculating the default risk and the default probability of enterprises, the results show that, in general, the enterprises in unnormal operation have higher default risks relative to the enterprise in normal operation. According to sample data, individual enterprises in unnormal operation also have lower default risks. In the inclusive financial system, governments should pay more attentions to the development of middle and small-sized enterprises, and establish some proper measures to provide financial services for middle and small-sized enterprises, especially for enterprises in unnormal operation.

Will CEOs with banking experience lower default risks? Evidence from P2P lending platforms in China

Using a novel dataset of 121 Chinese P2P lending platforms, we investigate the impact of CEOs’ banking experience on default risk. The empirical results indicate that CEOs with prior banking experience manage default risk better. Moreover, CEOs’ banking experience has a stronger influence on small platforms and in situations where the platforms’ depository banks are city commercial banks. Our results indicate that although fintech provides technology to reduce risks, we cannot ignore the constructive role of professional experience in risk management. Thus, investors and regulators in emerging markets should pay attention to managers’ financial qualifications, and especially to CEOs’ banking experience.

Determinants of Market Power in the Peruvian Regulated Microfinance Sector

The objective of this study is to analyze the evolution and determinants of market power in Peru’s regulated microfinance sector during the period of January 2003 to June 2016. We estimate both a conventional Lerner index (LICON) and an efficiency-adjusted Lerner index (LIADJ) using information from a wide panel of microfinance institutions (MFIs), thus finding that the LIADJ is significantly greater than the LICON. This result confirms that not considering MFIs’ inefficiency leads to an underestimation of their market power. Both indices decreased until 2014, which indicates that regulated MFIs’ market power decreased significantly for more than a decade. Beginning in 2015, market power significantly grew; the largest entities as well as those with the highest efficiency have greater market power. This last result evidences the fulfillment of the efficient structure (ES) hypothesis. In addition, a less elastic demand for microcredit, a lower default risk, as well as the processes of mergers, takeovers, and changes in the business structure of some MFIs, increase market power. Finally, the MFIs that operate in localized areas exhibit greater market power.

Bond Liquidity Premiums: Evidence from Catastrophe Bonds with Exogenous Default Risk

Based on a TRACE dataset of 9393 cat bond trades on the secondary OTC market from 2015 to 2019, we analyze trading patterns, liquidity determinants, and the liquidity premium of catastrophe bonds. We find that cat bonds are mostly traded without inventory involvement of dealers, and they are less frequently traded during the hurricane season. Based on 3341 dealer-buy and dealer-sell trade pairs from 229 cat bonds with exogenous default risk, we find that liquidity is high for bonds with low default risk, bonds close to maturity, and in periods of high trading activity in the overall market. Using bid-ask spreads as a liquidity measure, we find that 21% of the observable yield spread on the cat bond market is attributable to the liquidity premium, with an average liquidity premium of 98 bps, which even increases to 141 bps for high-risk bonds

Can Auditors Become Over-Conservative? Evidence From the Investors’ Perception of Auditor Changes

This paper investigates whether investors perceive high levels of auditor conservatism as excessive. Auditors can reduce their litigation risk by issuing going concern opinions to firms with relatively low default risk. However, this strategy is costly for investors. Investors cannot observe the estimated probability of default but can only estimate the average threshold at which the audit office started to issue going concern opinions in the past. If they perceive the office’s threshold as too low, they should discount the firm’s market value because going concern opinions negatively affect the future cash flows. As the valuation should rebound if a firm replaces such an over-conservative auditor, I investigate the market reaction to auditor changes. I introduce a novel measure of auditor conservatism that is closely related to the audit offices’ going concern thresholds. Using a sample of 1,687 auditor changes from 2004 to 2014, I document a positive abnormal return if firms replace the most conservative auditors. However, additional analyses reveal that investors only perceive the most conservative non-Big 4 audit offices in the period after the financial crisis as over-conservative. That is, in the post-crisis period the non-Big 4 auditors increased their level of conservatism to levels that investors perceive as excessive.

Financial Heterogeneity and the Investment Channel of Monetary Policy

We study the role of financial frictions and firm heterogeneity in determining the investment channel of monetary policy. Empirically, we find that firms with low default risk—those with low debt burdens and high “distance to default”— are the most responsive to monetary shocks. We interpret these findings using a heterogeneous firm New Keynesian model with default risk. In our model, low‐risk firms are more responsive to monetary shocks because they face a flatter marginal cost curve for financing investment. The aggregate effect of monetary policy may therefore depend on the distribution of default risk, which varies over time.

Management Earnings Forecasts and the Cost of Debt

Prior studies have indicated that earnings are useful for bond market investors and that beating earnings benchmarks is related to a firm’s lower cost of debt. This study examines whether management earnings forecasts are related to a firm’s cost of debt. Our results indicate that (a) positive forecast innovations (i.e., forecasted increases in earnings) are related to a firm’s lower bond yield spread after controlling for the effect of other earnings benchmarks and (b) the negative association between positive forecast innovations and bond yield spread is weaker for firms with high default risk than for those with low default risk. The results suggest that management earnings forecasts are useful for investors in the Japanese bond market and are consistent with the findings in the equity market. However, the usefulness of management earnings forecasts in the bond market depends on a firm’s level of default risk. Our results suggest that bond investors discount the management earnings forecasts of firms with high default risk because such forecasts are more likely to have an optimistic bias.

When Saving Is Not Enough – The Wealth Decumulation Decision in Retirement

In this study, we investigate the wealth decumulation decision from the perspective of a retiree who is averse to the prospect of fully annuitizing her accumulated savings. We field a large online survey of hypothetical product choices for phased drawdown offerings and annuities. While the demand for annuities remains low in our sample, we find significant demand for phased withdrawal products with equity-based asset allocations and flexible payout structures. Consistent with the product choice, the most important self-reported considerations for the wealth decumulation decision are low default risk in the products they purchase, the size of the withdrawal rates, and flexibility in the timing of their withdrawal. As determinants of the decision of how much wealth individuals are willing to draw down, we identify consumers’ attitudes towards future economic conditions, the extent to which they are protected against longevity risk, and their desire to leave bequests. Policy implications are discussed.

Contingent Convertible bond literature review: making everything and nothing possible?

Contingent Convertible (CoCo) bonds are subject to a considerable theoretical and practical debate. This article presents a systematic literature survey from five databases between 2002 and June 30, 2018, based on a content analysis approach. I do so by analyzing the multidisciplinary linking points of 244 CoCo-related publications from 27 countries. This literature review considers—in addition to peer-reviewed journal articles—first-tier gray literature in order to receive the most comprehensive picture possible. Although CoCos that qualify for Basel III have various advantages such as less social costs due to optimal capital regulation and equilibrium leverage, lower default risk, cheaper financing and enhanced returns for issuers, they cause at least as many undesirable effects in the field of moral hazard such as the preference for higher risk-taking of management and equity holders or the acceptance of elevated asset volatility as a result of the high wealth transfer risk for CoCo holders. The explanations for the established CoCo design are multifaceted and vary greatly. In academia, caution needs to be exercised on the tendency to over-engineer the possible future design of CoCos and the myriad of outcomes.

Sustainability and bank risk

Banks play a key role in society and are crucial for economic development. The existing literature finds a positive association between bank performance and sustainability, but tends to neglect the risk dimension. As human-driven processes interact with global social-ecological connectivity and exhibit cross-scale relationships, we investigate whether sustainability affects banks’ individual default risk and their systemic risk, that is, their contribution to the risk of the financial system. As banks are financial intermediaries and there is no direct measure of their sustainability, we proxy for sustainability with banks’ performance on environmental, social, and governance attributes, especially their policies and performance. We control for relevant bank, market and country characteristics. It shows that higher sustainability scores of banks significantly associate with lower default risk. We also establish that outperformance on sustainability reduces banks’ contribution to systemic risk. Thus, it appears that banks’ sustainability performance can spill over to the financial system. This implies sustainability is material for banks and their supervisors. Accounting for sustainability can augment bank risk management and prudential policy decision making, and provide guidance as to how to finance a transition towards an economic system that effectively internalizes externalities.

Identifying the Risk Culture of Banks Using Machine Learning

Although risk culture is a key element in the risk management process, identifying the risk culture of a firm can be challenging due to the abstract concept of culture. We introduce text mining and unsupervised machine learning algorithms to define the risk culture for U.S. bank holding companies and examine the relation between risk culture and performance. Applying principal component analysis on textually extracted features from 10-K filings identifies uncertainty, litigious and constraining sentiments among risk culture features to be significant in defining risk culture of banks. Cluster analysis of these features proposes three distinct risk culture clusters which we label as good, fair and poor. Consistent with regulatory expectations, sound risk culture in banks is characterized by high profitability ratios, bank stability, lower default risk and good governance.