Lower Quality Borrowers Research Articles

Moral hazard in online peer-to-peer lending

ABSTRACT Does the shift towards reintermediation in the peer-to-peer (P2P) lending industry increase the market’s vulnerability to moral hazard by the platform? To address this question, we develop a model where the crowdfunding platform screens loan applications and assigns interest rates to listed loans for investors to fund. We find that when the platform’s only source of income is origination fees, the platform has the incentive to relax its screening effort. Relaxing the screening effort allows low-quality borrowers to list their loans on the platform, which is detrimental to lenders and sub-optimal from an aggregate welfare perspective. Our results imply that current regulations governing P2P lending platforms may not be sufficient to protect lenders from this moral hazard risk. We show that the platform’s moral hazard problem can be overcome when it has sufficient skin in the game.

Bank-platform competition in the credit market

We analyze the equilibrium in the credit market when a bank and a lending platform compete to offer credit to borrowers. The platform does not manage deposit accounts, but acts as an intermediary between the borrower and investor, offering a risky contract such that the investor is only reimbursed if the borrower is successful. We show that the platform business model of financial intermediation may generate unexpected effects in the credit market. In particular, investor participation in the platform sometimes decreases when the platform attracts better-quality borrowers. When it competes with the platform, depending on the respective distributions of borrower and investor types, the bank may expand the supply of credit to low-quality borrowers, or restrict it to high-quality borrowers. Bank-platform competition expands the total supply of credit, but has an ambiguous impact on borrower surplus, because some borrowers may have higher repayments.

The Emergence of a Parallel World: The Misperception Problem for Bank Balance Sheet Risk and Lending Behavior

We examine the reason that there have coexisted the two opposing views on distressed banks' lending behavior in Japan's post-bubble period: the one is the stagnant lending in a capital crunch and the other is the forbearance lending to low-quality borrowers. To this end, we address the measurement problem for bank balance sheet risk. We identify the credit supply and allocation effects of bank capital in the bank loan equation specified at loan level, thereby finding that the ``parallel worlds'', or the two opposing views, emerge because the regulatory capital does not reflect the actual condition of increased risk on bank balance sheet, while the market value of capital does. By uncovering banks' engagement in patching-up of the regulatory capital in the Japan's post-bubble period, we show that lowly market capitalized banks that had difficulty in building up adequate equity capital for their risk exposure decreased the overall supply of credits. The parallels world can emerge whenever banks are allowed to overvalue assets with their discretion, as in Japan' post-bubble period.

Social Capital, Trusting, and Trustworthiness: Evidence from Peer-to-Peer Lending

AbstractHow does social capital affect trust? Evidence from a Chinese peer-to-peer lending platform shows that regional social capital affects the trustee’s trustworthiness and the trustor’s trust propensity. Ceteris paribus, borrowers from regions with higher social capital receive larger bids from individual lenders and have higher funding success, larger loan sizes, and lower default rates, especially for low-quality borrowers. Lenders from regions with higher social capital take higher risks and have higher default rates, especially for inexperienced lenders. Cross-regional transactions are most (least) likely to be realized between parties from regions with high (low) social capital.

Does formal financial development crowd in informal financing? Evidence from Chinese private enterprises

The relationship between formal and informal finance is uncertain. They serve as substitute for high-quality borrowers but are complement for low-quality borrowers. As formal financial institutions expand, they may concentrate on high-quality borrowers or diversify among borrowers of different qualities. Using unique survey data from Chinese private firms, we are allowed to investigate the relationship for a group of borrowers who were considered as low-quality. We find that formal financial development imposes a crowd-in effect for private firms’ informal financing, especially in East China. There is heterogeneity between East and West China. We document that the crowd-in effect is greater for private firms with bank access or of large size.

Social Capital, Trusting, and Trustworthiness: Evidence from Peer-to-peer Lending

How does social capital affect trust? Evidence from a Chinese peer-to-peer lending platform shows regional social capital affects the trustee’s trustworthiness and the trustor’s trust propensity. Ceteris paribus, borrowers from higher social capital regions receive larger bid from individual lenders, have higher funding success, larger loan size, and lower default rates, especially for low-quality borrowers. Lenders from higher social capital regions take higher risks and have higher default rates, especially for inexperienced lenders. Cross-regional transactions are most (least) likely to be realized between parties from high (low) social capital regions.

Borrower Selection into Credit Markets: Evidence from Peer-to-Peer Lending

We exploit a quasi-natural experiment in the peer-to-peer lending market to show that the mechanism determining interest rates, irrespective of their levels, influences households' decisions to participate in credit markets. A large online platform unexpectedly switched from auction pricing of loans to centralized price assignment by credit grade. After the change all borrowers in a given credit grade were assigned the same interest rate, potentially exacerbating asymmetric information between borrowers and lenders. Surprisingly, we find that the creditworthiness of borrowers listing on the platform improves. This effect is mainly driven by lower quality borrowers leaving the platform, and is most pronounced for households looking to consolidate existing debt. As a result, less credit is allocated to lower credit quality borrowers. Our findings suggest that the manner in which interest rates are set is an important determinant of households' financing decisions and of selection into credit markets.

Information contents of collateral under heterogeneous borrower qualities on the bank loans market in China

We analyze the risk of default and provision of collateral for bank loans made to firms of varied credit qualities using a unique dataset obtained from a major state-owned commercial bank in China. Both high and low quality borrowers provide collateral more often than medium quality debtors do. Using models that explicitly incorporate heterogeneous borrower qualities, we find a positive relation between collateralization and risk of default for loans issued to debtors with low credit ratings. In contrast, collateral provided by debtors with high credit ratings is negatively associated with the risk of default. These results suggest that low quality borrowers may be required to provide collateral at the bank's request to mitigate moral hazard problem. On the other hand, high quality borrowers may provide collateral willingly to signal quality in order to mitigate adverse selection problem when competing for getting access to bank loans. Our findings shed new lights on different information contents of collateral on the bank loans market of China, and have important implications for banks in screening, contracting and monitoring the risk of commercial loans for clients with diverse credit qualities.

Why Do Financial Firms Borrow Short-Term? Debt Maturity and Information Production

The maturity of a firm's liabilities affects the information financiers produce about the firm’s assets. In my model, long-term financing creates an excessive tendency for financiers to acquire information and screen out lower quality borrowers. In contrast, short-term financing deters information production at origination but induces it when firms are forced to liquidate, depressing the market value of assets due to adverse selection. Through the feedback effect between firms' maturity structures and asset prices, increases in uncertainty can impair the aggregate volume of short-term financing and investment. The analysis can jointly rationalize i) the widespread use of short-term debt by financial firms, ii) periodic disruptions in short-term funding markets and iii) regulations that curb short-term funding markets in normal times and support them in periods of market stress.

The Emergence of a Parallel World: The Misperception Problem for Bank Balance Sheet Risk and Lending Behavior

We examine the reason why two opposing views on distressed banks' lending behavior in Japan's postbubble period have coexisted: one is stagnant lending in a capital crunch and the other is forbearance lending to low-quality borrowers. To this end, we address the measurement problem for bank balance sheet risk. We identify the credit supply and allocation effects of bank capital in the bank loan equation specified at the loan level, thereby finding that the parallel worlds, or the two opposing views, emerge because the regulatory capital does not reflect the actual condition of increased risk on bank balance sheets, while the market value of capital does. By uncovering banks' efforts to increase regulatory capital in Japan's postbubble period, we show that banks with low market capitalization, and which had difficulty in building up adequate equity capital for their risk exposure, decreased the overall supply of credit. Parallel worlds can emerge whenever banks are allowed to overvalue assets at their discretion, as in Japan' postbubble period.

Fintech Isn’t So Different From Traditional Banking: Trading Off Aggregation of Soft Information for Transaction Processing Efficiency

We examine trade-offs that Prosper, a large online peer-to-peer lending platform, has made over time in its lending processes. Since its 2006 inception, Prosper has (1) changed the way it sets the interest rates on loans from auctions among peer lenders to pre-set pricing based on a proprietary credit-rating model in December 2010; (2) enabled institutional investors to fund whole rather than just fractional loans in April 2013; and (3) reduced the extent of soft information available to peer lenders in September 2013. In each of these changes, Prosper has traded off the aggregation of soft information by peer lenders for transaction processing efficiency, a trade-off similar to that made by large traditional banks. We provide the following evidence regarding the costs and benefits of this trade-off. On the cost side, after the December 2010 change the distribution of loan interest rates shrinks and the ability of interest rates to predict loan default deteriorates, particularly for loans to low credit quality borrowers for whom soft information is more important for credit screening. After the April 2013 change interest rates for low credit quality loans in the fractional loan market are more predictive of default than are interest rates in the whole loan market. On the benefit side, loan volume and funding speed rise sharply after each of these changes. Moreover, the costs appear manageable, as peer lenders’ ability to diversify increases and the weighted-average interest rate of a modest-size portfolio of Prosper loans remain just as predictive of default. Placebo and difference-in-differences tests using a peer-to-peer lender that did not change its lending processes during our sample period (Lending Club) indicates that these effects are attributable to the changes in Prosper’s processes.

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.

Information Sharing and Rating Manipulation

We show that banks manipulate borrowers’ credit ratings before sharing them with competing banks. Using a unique feature on the timing of information disclosure of a public credit registry, we disentangle the effect of manipulation from learning of credit ratings. We show that banks downgrade high-quality borrowers for which they have positive private information to protect their informational rents. Banks also upgrade low-quality borrowers with multiple lenders to avoid creditor runs. Our results suggest that credit ratings manipulation limits the positive effects of credit registries’ information disclosure on credit allocation.Received April 18, 2016; editorial decision April 1, 2017 by Editor Philip Strahan.

The effect of lender and loan type on a borrowing firm’s equity return

ABSTRACTPast empirical studies appear to support the idea that banks and finance companies do not differ in their ability to resolve adverse selection problems associated with issuing new debt. In this article, we find there is a difference. More specifically, using an event study we find larger abnormal returns for secured loan disclosures to lower quality borrowers when the lender is a finance company versus a bank. This suggests the market views finance companies as more effective than banks in evaluating/monitoring lower quality borrowers obtaining secured loans. We posit this is due to finance companies’ greater expertise in this type of lending, resulting from specialization. Our findings extend the literature on how lender identity can influence signals about firm value from loan disclosures. Our results also support recent findings that positive abnormal returns to borrowing firms may not be a general feature across the loan population, but may be restricted to smaller, lower quality borrowers. Finally, we are the first to provide evidence that the market takes loan type into account, not just lender and borrower type, when considering the information embedded in loan disclosures.

Information Sharing and Rating Manipulation

We show that banks manipulate the credit ratings of their borrowers before being compelled to share them with competing banks. Using a unique feature on the timing of information disclosure of the Argentinean public credit registry, we disentangle the effect of manipulation from learning of credit ratings. We show that banks downgrade high quality borrowers on which they have positive private information to protect their informational rents. Banks also upgrade low quality borrowers to avoid creditor runs. Our results can explain the limited effectiveness of public credit registries and cast doubt on the use of credit ratings in reducing information asymmetry.

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.

Bad Management, Skimping, or Both? The Relationship between Cost Efficiency and Loan Quality in Russian Banks

This paper investigates the relationship between operating cost efficiency and the loan quality of Russian banks. It tries to answer the question whether it is always beneficial for banks to be highly cost efficient (the “bad management” hypothesis) or whether this higher cost efficiency could mean inadequate spending on borrower screening, which could subject banks to higher credit risk exposures in the future (the “skimping” hypothesis)? Our main result implies that, while the “bad management” hypothesis holds on average for the banking sector as a whole, the “skimping” hypothesis could be the case for those Russian banks that are not just highly cost efficient, as predicted by Berger and DeYoung (1997) for US banks, but that at the same time pursue aggressive strategies in the market for loans to households and non-financial firms, especially during the pre-crisis periods when banks are too optimistic to pay increased attention to the quality of borrowers in order to extract higher profits in the short run. Interestingly, we show that the “skimping” strategy is not the case for those Russian banks that demonstrate a lower equity-to-assets ratio and that are highly cost efficient at the same time because, as we believe, higher financial leverage forces these banks to filter out low quality borrowers to be able to repay borrowed funds. From perspective of regulatory policy, these conclusions provide clear arguments in favor of differential prudential regulation in Russia, which could, if being implemented, positively affect the loan quality of both banks that are skimpers (through restricting loans growth by higher capital adequacy requirements and/or increased payments to the Russian Deposit Insurance Agency) and banks that are not (through eliminating incentives to grow too fast), thus improving the stability of the banking sector as a whole.

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 economic function of credit rating agencies – What does the watchlist tell us?

Credit rating agencies do not only disclose simple ratings but announce watchlists (rating reviews) and outlooks as well. This paper analyzes the economic function underlying the review procedure. Using Moody’s rating data between 1982 and 2004, we find that for borrowers of high creditworthiness, rating agencies employ watchlists primarily in order to improve the delivery of information. For low-quality borrowers, in contrast, the review procedure seems to have developed into an implicit contract á la Boot et al. (2006), inducing the companies “on watch” to abstain from risk-augmenting actions. The agencies’ economic role hence appears to have been enhanced from a pure information certification towards an active monitoring function.

Securitization and distressed loan renegotiation: Evidence from the subprime mortgage crisis

We examine whether securitization impacts renegotiation decisions of loan servicers, focusing on their decision to foreclose a delinquent loan. Conditional on a loan becoming seriously delinquent, we find a significantly lower foreclosure rate associated with bank-held loans when compared to similar securitized loans: across various specifications and origination vintages, the foreclosure rate of delinquent bank-held loans is 3% to 7% lower in absolute terms (13% to 32% in relative terms). There is a substantial heterogeneity in these effects with large effects among borrowers with better credit quality and small effects among lower quality borrowers. A quasi-experiment that exploits a plausibly exogenous variation in securitization status of a delinquent loan confirms these results.