Center for Financial Research
CFR Working Paper Series 2007
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.
FDIC Center for Financial Research Working Paper No. 2007- 10
Brent Ambrose, Sumit Agarwal, Souphala Chomsisengphet, Chunlin Liu
Abstract We analyze more than 108,000 home equity loans and lines of credits to study the role of information asymmetry in a credit market where borrowers face a menu of contract options and a lender uses a counteroffer to further mitigate contract frictions. Our results reveal that a less credit-worthy applicant is more likely to select a credit contract that requires less collateral. Further analysis on borrower repayment behavior ex post indicates that the lender may face adverse selection due to private information, controlling for observable risk attributes. We also find that systematic screening ex ante by a lender to mitigate contract frictions can effectively reduce overall credit losses ex post.
JEL Classification: D1; D8; G21
Key Words: Asymmetric Information; Contract Frictions; Screening; Banking; Home Equity Lending
FDIC Center for Financial Research Working Paper No. 2007- 09
Hulya Eraslan, Wenli Li and Pierre-Daniel Sarte
Abstract By compiling a novel data set from bankruptcy court dockets recorded in Delaware be- tween 2001 and 2002, we build and estimate a structural model of Chapter 13 bankruptcy. This allows us to quantify how key debtor characteristics, including whether they are ex- periencing bankruptcy for the .rst time, their past-due secured debt at the time of .ling, and income in excess of that required for basic maintenance, affect the distribution of cred- itor recovery rates. The analysis further reveals that changes in debtors.conditions during bankruptcy play a nontrivial role in governing Chapter 13 outcomes, including their ability to obtain a .nancial fresh start. Our model then predicts that the more stringent provisions of Chapter 13 recently adopted, in particular those that force subsets of debtors to .le for long-term plans, do not materially raise creditor recovery rates but make discharge less likely for that subset of debtors. This .nding also arises in the context of alternative policy exper- iments that require bankruptcy plans to meet stricter standards in order to be con.rmed by the court.
JEL Codes: J22, K35, D14
Keywords: Personal Bankruptcy, Structural Estimation, Recovery Rate
FDIC Center for Financial Research Working Paper No. 2007-08
Charles Cao, Fan Yu, Zhaodong Zhong
Abstract We explore the connection between the market for single-name credit default swaps(CDS)and the market for individual stock options. We find that the contemporaneous link between CDS spreads and option-implied volatilities is stronger among firms with lower credit ratings, higher CDS spread volatilities, and more actively traded options. Among such firms, the changes in both CDS spreads and implied volatilities forecast future stock returns. Although the changes in implied volatility consistently forecast future CDS spread changes, the reverse does not hold. We interpret these findings as broadly consistent with informed traders preferentially using the options market, and to some extent the CDS market, to exploit their information advantage. Although implied volatility dominates historical volatility in forecasting the future realized volatility on individual stocks, the volatility risk premium embedded in option prices also plays a crucial role in explaining CDS spreads. Our results are robust under a pricing analysis using a structural credit risk model. They are also unaffected by historical volatilities estimated at short or long horizons.
JEL Codes: G13, G14
Key words: Credit default swap spread, option-implied volatility, volatility risk premium, informed trading
FDIC Center for Financial Research Working Paper No. 2007- 07
Söhnke M. Bartram, Gregory W. Brown, and Bernadette A. Minton
Theoretical research suggests firms should have significant exchange rate exposure. However, empirical research has not documented such a relation. We extend prior theoretical results to model a global firm's exchange rate exposure. Using this model and a global sample of 1,161 manufacturing firms from 16 countries, we show empirically that firms pass part of currency changes through to customers, utilize operational hedges (e.g., matching foreign sales with foreign production), and employ financial risk management strategies. For a typical firm pass-through and operational hedging each reduce exposure by 10% to 15% and financial hedging reduces exposure by 45% to 50%. The combination of these factors explains the low observed levels of exchange rate exposure.
JEL Codes: G3, F4, F3
Keywords: Competition, hedging, exposure, derivatives, corporate finance, international finance
FDIC Center for Financial Research Working Paper No. 2007- 06
Paul H. Kupiec
The Vasicek single factor model of portfolio credit loss is generalized to include credits with stochastic exposures (EADs) and loss rates (LGDs). The model can accommodate any distribution and correlation assumptions for the LGDs and EADs and will produce a closedform expression for an asymptotic portfolio's conditional loss rate. Revolving exposures draw against committed lines of credit. Dependence among defaults, EADs, and LGDs are modeled using a single common Gaussian factor. A closed-form expression for an asymptotic portfolio's inverse cumulative conditional loss rate is analyzed for alternative EAD and LGD assumptions. Positive correlation in individual credits' EAD and LGD realizations increases portfolio systematic risk, producing wider ranges and increased skewness in portfolio loss distributions.
JEL Codes: C40, G11, G21, G28
Keywords: Credit risk measurement, portfolio credit risk, portfolio loss distribution
FDIC Center for Financial Research Working Paper No. 2007- 05
Manju Puri and Jorg Rocholl
While the importance of bank-firm relationships is well documented in the banking literature, there is relatively little research on the importance of retail banking relationships. In this paper we collect proprietary data from multiple sources to analyze the importance of retail banking relationships in an experimental setting where commercial banks have depositors and also underwrite securities. We are able to distinguish between the lead bank's own retail clientele vis-a-vis other retail clientele to ask if lead banks take advantage of their retail investors to dump "lemons" or whether their retail investors benefit from getting higher allocation of underpriced issues. We provide evidence that lead underwriters' retail customers demand more of the highly underpriced issues and end up with a higher allocation of underpriced issues. We use grey market prices to show that it is actual underpricing over and beyond that predicted by the grey market that drives the differential demand from the lead bank retail clientele. This is consistent with the bank passing on information about underpriced IPOs to their retail clientele and encouraging them to demand more of such issues. We next analyze the underlying incentives of the bank to treat their retail clientele well by examining cross-selling potential from other services of the bank by accessing data from the Central Bank. In particular, we document increases in both new brokerage accounts and retail consumer loans which are related to increased IPO underwriting, especially underwriting of underpriced IPOs by the commercial bank. We document brokerage accounts are sticky, they go up when IPO activity is high but are not shut down when IPO activity tapers off, and quantify that the economic benefits from the increase in brokerage accounts alone to the bank are substantial. We additionally provide evidence that increased IPO activity also goes hand in hand with additional cross selling through an increase in retail consumer loans. Interestingly, we do not see similar increases in corporate loans over the same time interval. Our results are robust to controls for competitive deposit and lending rates and to the use of instruments. Our evidence suggests retail banking relationships are important and provides a rationale for why this is the case.
JEL Codes: G3.
Keywords: Banking, retail, relationships, cross-selling, underwriting.
Center for Financial Research Working Paper No. 2007- 04
Steven Drucker and Manju Puri
This paper examines the secondary market for loan sales, focusing on whether loan contract design can reduce agency problems in loan sales and the benefits and costs to corporate borrowers. We argue that covenants aid loan sales by protecting the loan buyer from potential losses caused by informationally-advantaged borrowers and loan sellers. Using loan-level data, we find that sold loans contain more restrictive covenant packages, particularly when agency problems are more severe. Why do borrowers agree to incur the additional costs associated with loan sales? We show that borrowers whose loans are sold have high leverage ratios, and loan sales increase their access to loans. Also, contrary to concerns that loan sales weaken lending relationships, we find more durable lending relationships when loans are sold.
JEL Codes: G21, G32
Keywords: Loan Sales, Covenants, Financial Contracting, Lending Relationships
Center for Financial Research Working Paper No. 2007- 03
Timothy J. Curry, Gary S. Fissel, Gerald A. Hanweck
January 2007, Revised August 2007
Outside monitors provide important information that can help stockholders, creditors, regulators and other stakeholders apply market discipline. In the banking industry, government examiners are an additional outside monitor but with one important difference: bank examination ratings are not public information, and are known only to top bank managers. Still, exam ratings directly influence bank operations and performance because they are used to determine banks' required capital and banks' deposit insurance premiums and, in extreme cases, can constrain banks' investment decisions. Because of banks' special role in the economy, changes in exam ratings can have implications for credit availability and economic growth. Unlike corporate bond ratings-- which by design attempt to measure steady state credit worthiness across the business cycle-- bank exam ratings are designed to reflect bank safety and soundness at a given point-in-time. Indeed, we find that exam ratings for U.S. banking companies exhibit a much greater volatility, although they are correlated with, bond ratings for U.S. banks. Much of this volatility coincides with the contemporaneous phase of the business cycle. However, in a model that controls for bank characteristics, financial market conditions, past supervisory information, and aggregate macroeconomic factors, we find that bank exam ratings exhibit inter-temporal characteristics. First, exam ratings exhibit some examiner bias--- which we define as a significant and persistent deviation of our forecasted changes in upgrades, downgrades and no changes from those actually assigned-- for most periods analyzed. When the business cycle turns, examiners often depart from standards that they set during the previous phases of the business cycle. However, this bias is not widespread or systematic. Second, exam ratings exhibit some stickiness. In marginal cases, our results suggest that examiners rate on the side of not changing (rather than upgrading or downgrading) an institution's exam rating. Third, we find strong and robust evidence of a secular trend towards more stringent examination ratings standards over time.
JEL Codes: G21
Key words: Bank Holding Company Risk Ratings, Cyclical and Secular Trends in Bank Risk Ratings
Center for Financial Research Working Paper No. 2007- 02
Robert A Jarrow, Dilip B. Madan and Haluk Unal
This paper proposes an aggregate deposit insurance premium design that is risk-based in the sense that the premium structure ensures the deposit insurance system has a target of survival over the longer term. Such a premium system naturally exceeds the actuarily fair value and leads to a growth in the insurance fund over time. The proposed system builds in a swap in premia that reduces premia when fund size exceeds a threshold. In addition, we build in a swap contract that trades premia in good times for relief in bad times.
JEL Codes: G28, G22, G21
Key words: Deposit insurance, Procyclicality, Default probabilty, Loss distributions
Center for Financial Research Working Paper No. 2007- 01
Greg Nini, David C. Smith and Amir Sufi
We provide novel empirical evidence of a direct contracting channel through which firm financial policy affects firm investment policy. We examine a large sample of private credit agreements between banks and publicly traded U.S. corporations and find that 32% of the agreements contain an explicit restriction on the firm’s capital expenditures. Creditors are more likely to impose a restriction following negative borrower performance, and the effect of negative performance on the likelihood of facing a capital expenditure restriction is larger than the effect of negative performance on other loan terms such as the interest spread or pledging of collateral. We also demonstrate that the restrictions affect firm investment policy. For example, we show that most of the actual capital expenditures of borrowers with restrictions cluster just below their restricted amount, while in the year prior to the contract, the same borrowers’ capital expenditures are distributed evenly above and below the restriction. Our results are consistent with control-based theories of financing in which creditors retain control rights over investment policy as a second-best solution to agency conflicts.
KEY WORDS: Control Rights, Investment Policy, Financial Contracting, Financial Covenants, Capital Expenditures, Creditor Control
JEL CODES: D23, G31, G32