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Center for Financial Research

CFR Working Paper Series 2008


The CFR sponsors original research on issues associated with deposit insurance, banking performance, risk measurement and management, corporate finance, and financial policy and regulation. The results of CFR-sponsored research, FDIC staff research, and other invited papers on these CFR research lines appear in the CFR Working Paper Series.

Working Paper Series:
Working Paper NumberTitle
2008-12 The Economic Impact of Merger Control Legislation
Elena Carletti, Philipp Hartmann and Steven Ongena
2008-11 Understanding Bank Runs: The Importance of Depositor-Bank Relationships and Networks
Rajkamal Iyer and Manju Puri
2008-10 The Impact of Wealth on Inattention: Evidence from Credit Card Repayments
Barry Scholnick, Nadia Massoud and Anthony Saunders
2008-09 Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930
Paul Kupiec and Carlos Ramirez
2008-08 Credit Contagion from Counterparty Risk
Philippe Jorion and Gaiyan Zhang
2008-07 Deposit Insurance and Bank Risk-Taking: Evidence from Internal Loan Ratings
Vasso P. Ioannidou and MarÝa Fabiana Penas
2008-06 Hedge Fund Activism, Corporate Governance, and Firm Performance
Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas
2008-05 On the Independence of Assets and Liabilities: Evidence from U.S. Commercial Banks, 1990-2005
Robert DeYoung and Chiwon Yom
2008-04 How Do Managers Target Their Credit Ratings? A Study of Credit Ratings and Managerial Discretion
Armen Hovakimian, Ayla Kayhan and Sheridan Titman
2008-03 Time Changed Markov Processes in Unified Credit-Equity Modeling
Peter Carr, Vadim Linetsky, Rafael Mendoza
2008-02 Valuing Convertible Bonds with Stock Price, Volatility, Interest Rate, and Default Risk
Pavlo Kovalov, Vadim Linetsky
2008-01 When Banks are Insiders: Evidence from the Global Syndicated Loan Market
Miguel A. Ferreira, Pedro Matos

The Economic Impact of Merger Control Legislation - PDF 1,206KB (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-12
Elena Carletti, Philipp Hartmann and Steven Ongena
December 2008

Abstract
Based on a unique dataset of legislative changes in industrial countries, we identify events that strengthen the competition control of mergers and acquisitions, analyze their impact on banks and non-financial firms and explain the different reactions observed with specific regulatory characteristics of the banking sector. Covering nineteen countries for the period 1987 to 2004, we find that more competition-oriented merger control increases the stock prices of banks and decreases the stock prices of non-financial firms. Bank targets become more profitable and larger, while those of non-financial firms remain mostly unaffected. A major determinant of the positive bank returns is the degree of opaqueness that characterizes the institutional setup for supervisory bank merger reviews. The legal design of the supervisory control of bank mergers may therefore have important implications for real activity.

Keywords: mergers and acquisitions, competition policy, legal institutions, financial regulation.

JEL Codes: G21, G28, D4.

Understanding Bank Runs: The Importance of Depositor-Bank Relationships and Networks - PDF 1,323k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-11
Rajkamal Iyer and Manju Puri
August 2008

Abstract
We use a unique, new, database to examine micro depositor level data for a bank that faced a run. We use minute-by-minute depositor withdrawal data to understand the effectiveness of deposit insurance, the role of social networks, and the importance of bank-depositor relationships in influencing depositor propensity to run. We employ methods from the epidemiology literature which examine how diseases spread to estimate transmission probabilities of depositors running, and the significant underlying factors. We find that deposit insurance is only partially effective in preventing bank runs. Further, our results suggest that social network effects are important but are mitigated by other factors, in particular the length and depth of the bank-depositor relationship. Depositors with longer relationships and those who have availed of loans from a bank are less likely to run during a crisis, suggesting that cross-selling acts not just as a revenue generator but also as a complementary insurance mechanism for the bank. Finally, we find there are long term effects of a solvent bank run in that depositors who run do not return back to the bank. Our results help understand the underlying dynamics of bank runs and hold important policy implications.

Keywords: Bank Runs, Relationships, Loan Linkages

JEL Classification: G21, E58

The Impact of Wealth on Inattention: Evidence from Credit Card Repayments - PDF 800k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-10
Barry Scholnick, Nadia Massoud and Anthony Saunders
May 9, 2008

Abstract
Inattentive decision makers do not make full use of information available to them. Existing, psychologically based, explanations for inattention include the impact of competing stimuli and the salience of the decision. These existing explanations, however, do not predict whether richer or poorer individuals are more likely to be inattentive, since either can face competing demands on their limited supplies of attention. We examine this issue using a confidential credit card database of more than one million data points. We document that a proportion of individuals who are delinquent have sufficient surplus funds on deposit, implying that these individuals could have avoided the costs of delinquency if they had been more attentive to their credit card repayments. Using various measures of income and wealth, we provide strong evidence that these inattentive individuals are more likely to be poorer.

Keywords: deposit insurance, risk-taking, internal credit ratings.

JEL Classification: G21, G28

Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930 - PDF 2,017k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-09
Paul Kupiec and Carlos Ramirez
July 2008

Abstract
This paper investigates the effect of bank failures on economic growth using data from 1900 to 1930, a period that predates active government stabilization policies and includes periods of banking system distress that are not coincident with recessions. Using both VAR and a difference-in-difference methodology that exploits the reactions of the New York and Connecticut economies to the Panic of 1907, we estimate the impact of bank failures on economic activity. The results indicate that bank failures reduce subsequent economic growth. Over this period, a 0.12 percent (1 standard deviation) increase in the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real GNP growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as a measure of the costs of systemic risk in the banking sector.

Keywords: bank failures; systemic risk; vector autoregressions; Panic of 1907; commercial failures.

JEL Codes: N11, N21, E44, E32

Credit Contagion from Counterparty Risk - PDF 1,051k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-08
Philippe Jorion and Gaiyan Zhang
July 2008

Abstract
Standard credit risk models cannot explain the observed clustering of default, sometimes described as "credit contagion." This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We examine the wealth effects of bankruptcy announcements on creditors using a unique database. On average, creditors experience severe negative abnormal equity returns and increases in CDS spreads. In addition, creditors are more likely to suffer from financial distress later. These effects are stronger for industrial creditors than financials. Simulations calibrated to these results indicate that counterparty risk can potentially explain the observed excess clustering of defaults. This suggests that counterparty risk is an important additional channel of credit contagion and that current portfolio credit risk models understate the likelihood of large losses.

Keywords: credit contagion, counterparty risk, portfolio credit risk models, default correlation, trade credit.

JEL Codes: G14, G12, G33

Deposit Insurance and Bank Risk-Taking: Evidence from Internal Loan Ratings - PDF 1,102k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-07
Vasso P. Ioannidou and MarÝa Fabiana Penas
May 2008

Abstract
This paper analyzes the effect of deposit insurance on banks' risk-taking in the context of a natural experiment using detailed credit registry data. We study the case of an emerging economy, Bolivia, that introduced a deposit insurance system during the sample period, and we compare banks' risk-taking before and after the introduction of this system. We find that after the introduction of deposit insurance, banks are more likely to initiate riskier loans (i.e., loans with worse ratings at origination). These loans carry higher interest rates and are associated with worse ex-post performance. We also find that collateral requirements and loan maturities are not adjusted to compensate for the extra risk. Additional results suggest that the increase in risk-taking is due to a decrease in market discipline from large depositors. Our findings also suggest that differences in risk-taking between large (too-big-to-fail) and small banks diminished after deposit insurance.

Keywords: deposit insurance, risk-taking, too-big-to-fail, internal credit ratings

JEL Codes: G21, G28

Hedge Fund Activism, Corporate Governance, and Firm Performance 835k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008-06
Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas
May 2008

Abstract
Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two thirds of the cases. Hedge funds seldom seek control and in most cases are nonconfrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.

Keywords: Hedge Fund, Activism, Corporate Governance.

JEL Codes: G14, G23, G3

On the Independence of Assets and Liabilities: Evidence from U.S. Commercial Banks, 1990-2005 1.1M (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008- 05
Robert DeYoung and Chiwon Yom
March 2008

Abstract
Traditional asset-liability management techniques limit banks' abilities to structure their balance sheets-but more recently, financial innovations have allowed banks the chance to manage interest rate risk without constraining their asset-liability choices. Using canonical correlation analysis, we examine how the relationships between asset and liability accounts at U.S. commercial banks changed between 1990 and 2005. Importantly, we show that asset-liability linkages are weaker for banks that are intensive users of risk-mitigation strategies such as interest rate swaps and adjustable loans. Perhaps surprisingly, we find that asset-liability linkages are stronger at large banks than at small banks, although these size-based differences have diminished over time, both because of increased asset-liability linkages at small banks and decreased linkages at large banks.

Keywords: asset-liability management, canonical correlation, commercial banks, deregulation, technological change.

JEL Codes: G21, G32

How Do Managers Target Their Credit Ratings? A Study of Credit Ratings and Managerial Discretion 2.1M (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008- 04
Armen Hovakimian, Ayla Kayhan and Sheridan Titman
February 2008

Abstract
Managers choose credit rating targets by trading off the benefits associated with a high rating against the higher cost of capital associated with the additional equity required to maintain the high rating. We find that small and risky firms tend to target lower ratings, whereas firms with high growth opportunities tend to target higher ratings. In addition, firms with small boards and large blockholders tend to target lower ratings. We also find that deviations from rating targets influence subsequent capital structure choices. When observed ratings are below (above) the target, managers tend to make security issuance and repurchase decisions that reduce (increase) leverage. In addition, firms are more likely to increase dividend payouts when they have above target ratings and are less likely to make acquisitions when they have below target ratings.

Keywords: credit rating, capital structure, target capital structure, tradeoff theory, managerial discretion, governance

JEL Codes: G32, G34

Time Changed Markov Processes in Unified Credit-Equity Modeling 1.15M (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008- 03
Peter Carr, Vadim Linetsky, Rafael Mendoza
December 2007

Abstract
This paper develops a novel class of hybrid credit-equity models with state-dependent jumps, local-stochastic volatility and default intensity based on time changes of Markov processes with killing. We model the defaultable stock price process as a time changed Markov diffusion process with state-dependent local volatility and killing rate (default intensity). When the time change is a LÚvy subordinator, the stock price process exhibits jumps with state-dependent LÚvy measure. When the time change is a time integral of an activity rate process, the stock price process has local-stochastic volatility and default intensity. When the time change process is a LÚvy subordinator in turn time changed with a time integral of an activity rate process, the stock price process has state-dependent jumps, local-stochastic volatility and default intensity. We develop two analytical approaches to the pricing of credit and equity derivatives in this class of models. The two approaches are based on the Laplace transform inversion and the spectral expansion approach, respectively. If the resolvent (the Laplace transform of the transition semigroup) of the Markov process and the Laplace transform of the time change are both available in closed form, the expectation operator of the time changed process is expressed in closed form as a single integral in the complex plane. If the payoff is square-integrable, the complex integral is further reduced to a spectral expansion. To illustrate our general framework, we time change the jump-to-default extended CEV model (JDCEV) of Carr and Linetsky (2006) and obtain a rich class of analytically tractable models with jumps, local-stochastic volatility and default intensity. These models can be used to jointly price and hedge equity and credit derivatives.

Keywords:

JEL Codes: G12, G13

Valuing Convertible Bonds with Stock Price, Volatility, Interest Rate, and Default Risk - PDF 1.32M (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008- 02
Pavlo Kovalov, Vadim Linetsky
January 2008

Abstract
This paper develops a computational framework to value convertible bonds in general multi-factor Markovian models with credit risk. We show that the convertible bond value function satisfies a variational inequality formulation of the stochastic game between the bondholder and the issuer. We approximate the variational inequality by a penalized nonlinear partial differential equation (PDE). We solve the penalized PDE formulation numerically by applying a finite element spatial discretization and an adaptive time integrator. To provide specific examples, we value and study convertible bonds in affine, as well as nonaffine, models with four risk factors, including stochastic interest rate, stock price, volatility, and default intensity.

Keywords: Convertible bonds, credit risk, volatility skew, credit spreads, stochastic games, variational inequalities, penalty approximation, finite element method-of-lines

JEL Codes: G12, G13

When Banks are Insiders: Evidence from the Global Syndicated Loan Market - PDF 961k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2008- 01
Miguel A. Ferreira, Pedro Matos
December 2007

Abstract
This paper studies the impact of connections between banks and firms on the lead arranger bank choice and loan pricing in the global syndicated loan market. We examine cases where the bank is an insider on the borrower firm by representation on the board of directors or by holding equity stakes directly and indirectly (through affiliated institutional money managers). These connections have a positive and significant effect on a firm's lead arranger bank choice. Additionally, we find that banks charge higher interest rate spreads and face less credit risk after origination when lending to firms where the bank is an insider. Our findings suggest that the influence of banks over firms seems to accrue mostly to the banks' benefit, and therefore conclude for the existence of a conflict of interest between the role of lender and that of insider in the firm.

Keywords: Bank loans, Corporate Boards, Ownership, Lending relationships

JEL classification: G21, G32