Lower Quality Borrowers Research Articles

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 a 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 bankheld 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.

Relationship Banking, Monetary Policy, and Consumer Credit Reform

The increasing dependence of American households on debt financing and the rising rates of personal bankruptcy raise several welfare considerations that we analyze in this paper. We pose a theoretical model of relationship banking to first evaluate how strategic actions between banks and borrowers yield interest rates for various credit types and drive credit rationing in the market. Based on these results, we evaluate several policies that the government may implement to influence lending policies in consumer credit markets. We derive conditions under which the government optimally wishes to induce credit rationing and show that under some conditions, it is welfare enhancing to encourage banks to have a liberal lending policy, even if it means that interest rates are exceedingly high for low credit quality borrowers. Finally, we analyze the effects that a credit rating agency has on the dynamics of this market. Our theoretical analysis is consistent with empirical observations from these markets, and has significant importance especially given the recent subprime mortgage financial crisis.

The Joint Size and Ownership Specialization in Banks' Lending

In this paper we study the specialization of Spanish banks along two intertwined dimensions: size and ownership form. We find some interesting results at odds with the existing empirical literature. As commercial banks increase their size, they lend more to large borrowers but that is not the case for the largest banks. For savings banks, the larger the size the more likely is the lending to small borrowers. Moreover, we find evidence that larger commercial banks are more willing to lend to low credit quality borrowers than medium size banks, while the opposite is true among savings banks. Banks' specialization in lending to business firms seems to go across the reputation considerations, risk shifting behavior and lending technologies most often considered in the literature.

Loan Collateral Decisions and Corporate Borrowing Costs

We examine the relation between borrowing costs and the presence of loan collateral. We find the presence of collateral increases with default risk, consistent with low quality borrowers reducing their risks and borrowing costs through the use of collateral. By explicitly controlling for the interdependence between the decision to pledge collateral and borrowing costs, we find that secured loans have predicted spreads substantially lower than if they had been made on an unsecured basis. Alternatively, loans made on an unsecured basis have spreads not substantially different from if they had been secured. The evidence suggests that collateral pledging decisions are generally consistent with borrowing cost minimization.

Heterogeneous borrowers, liquidity, and the search for credit

We develop a general equilibrium model of credit formation where borrowers and lenders must search for matches and where the composition of borrowers adjusts to satisfy equilibrium entry conditions. When market liquidity dries up as a result of fundamental shocks to the system, fewer borrowers will participate in the credit market with low-quality borrowers suffering disproportionately because of a flight to quality. However, less liquid credit markets need not be associated with lower social output, because the effect of higher average quality may outweigh that of reduced market participation, depending crucially on the source of the liquidity shock.

Bank Seniority and Corporate Debt Restructuring

This paper analyzes the role of priority on lenders' behavior during the process of financial distress. A bank with a senior claim at the onset of financial distress benefits from a strong bargaining power in subsequent debt restructurings and can exploit this enhanced power to hold up other claimants (the firm and junior lenders). The senior bank's opportunistic behavior has various consequences. First, it allows the senior bank with an initial impaired claim to rule out repayment risk. The concentration of liquidation rights in the hands of the bank also leads to more favorable debt restructurings for low-quality borrowers. The impact of seniority on the bank's incentive to monitor is more ambiguous. If senior banks have incentives to monitor at an interim date in order to hasten liquidation, we show that nonsenior banks may have incentives to monitor in order to outstrip other lenders with equal standing. On the contrary, the ex post strong bargaining power of a senior bank might lower its incentives to monitor at the early stages of financial distress. More generally, the results of our model are consistent with Franks and Sussman (2003) who show the opportunistic behavior of banks towards distressed firms in a pro-creditor environment.

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.

Competition, Adverse Selection, and Information Dispersion in the Banking Industry: Table 1

Proprietary information generated through the process of lending can impact the structure of the banking industry. With more competing banks, borrower-specific information becomes more disperse, as each bank becomes informed about a smaller pool of borrowers. This reduces banks' screening ability, creating an inefficiency as more low-quality borrowers obtain financing. Incumbent banks' information advantage may also create difficulties for potential entrants, so that entry should be easier in markets with high borrower turnover or where entrants have specific expertise in evaluating credit risks. We draw implications for whether financial deregulation is likely to increase borrowers' surplus, and what patterns of entry might be observed. Copyright 2002, Oxford University Press.

Competition, Adverse Selection, and Information Dispersion in the Banking Industry

Proprietary information generated through the process of lending can impact the structure of the banking industry. With more competing banks, borrower-specific information becomes more disperse, as each bank becomes informed about a smaller pool of borrowers. This reduces banks' screening ability, creating an inefficiency as more low quality borrowers obtain financing. Incumbents banks' information advantage may also create difficulties for potential entrants, so that entry should be easier in markets with high borrower turnover or where entrants have specific expertise in evaluating credit risks. We draw implications for whether financial deregulation is likely to increase borrowers' surplus, and what patterns of entry might be observed.

Financial Matchmakers in Credit Markets with Heterogeneous Borrowers

What happens when liquidity increases in credit markets and more funds are channeled from borrowers to lenders? We examine this question in a general equilibrium model where financial matchmakers help borrowers (firms) and lenders (households) search out and negotiate profitable matches and where the composition of heterogeneous borrowers adjusts to satisfy equilibrium entry conditions. We find that enhanced liquidity causes entry by all borrowers and tends to benefit low-quality borrowers disproportionately. However, liquid credit markets may or may not be associated with higher output and welfare. The result is determined by whether the effect of higher market participation outweighs that of lower average quality. The net effect depends crucially on the source of the liquidity shock (financial matching efficacy, productivity, or entry barriers).