Working Papers presented as PDF files on this page reference Portable Document Format (PDF) files. Adobe Acrobat, a reader available for free on the Internet, is required to display or print PDF files. (PDF Help)
| Working Papers – 2006 |
|---|
Basel II: A Case for Recalibration FDIC Center for Financial Research Working Paper No. 2006-13 This Version: October 2006 Published as: Kupiec, Paul. "Basel II: A Case for Recalibration." Journal of Financial Services Research (2006). Abstract Objectives for Basel II include the promulgation of a sound standard for risk measurement and risk-based minimum capital regulation. The AIRB approach, which may be mandatory for large U.S. banks, will give rise to large reductions in regulatory capital. This paper assesses whether the reductions in minimum capital are justified by improvements in the accuracy of risk measurement under Basel II. Review of credit loss data and analysis of the economics of capital allocation methods identify important shortcomings in the AIRB framework that lead to undercapitalization of bank credit risks. JEL Classification: G12, G20, G21, G28 |
The Effect of Bank Supervision on Loan Growth FDIC Center for Financial Research Working Paper No. 2006-12 This Version: September 2006 Abstract This paper quantifies the short-term and long-term impact of bank supervision (measured using CAMEL composite and component ratings) on different categories of loan growth: (a) commercial and industrial loans, (b) consumer loans, and (c) real estate loans. For each of these categories, we perform dynamic loan growth equations at the state level augmented by the inclusion of CAMEL ratings for all banks in the state, after controlling for banking and economic conditions. We perform these regressions for two distinct sub-periods: (1) 1985 through 1993 (which covers the credit crunch period), and (2) 1994 through 2004 (which covers the sustained recovery period). For the first period, 1985 to 1993, we find that out of the three loan categories considered, business lending is the most sensitive to changes in CAMEL ratings (both the composite and the components), although the other loan categories also show some sensitivity. Overall, however, we find little evidence suggesting that the effects of changes in any of the components of CAMEL ratings differ systematically from the effects of changes in the composite CAMEL. For the second period, we find little evidence that changes in CAMEL ratings (the composite or its components) had any systematic effect on loan growth for any of the loan categories considered. JEL Classification Codes: E44, G21 |
Community Development Financial Institutions: Board Size and Diversity as Governance Mechanisms FDIC Center for Financial Research Working Paper No. 2006-11 This Version: October 12, 2006 Abstract CDFIs serve an important social function because they provide access to financial services to underserved low-income individuals and households. Understanding which governance mechanisms promote efficient use of scarce resources that these organizations control is important because only sustainable institutions have the potential to revitalize low-income communities and change low-income individuals lives in the long-term. The focus of this paper is on evaluating the impact of board size and diversity on the performance of two types of CDFIs: Community Development Credit Unions and Community Development Loan Funds. The results show that CD Credit Unions with larger boards are more efficient in delivering outreach, but board size is not related to CD Loan Funds performance. There is some evidence that CDCUs with boards dominated by women are more efficient in fulfilling their outreach missions but CDLFs with more gender and racially diverse boards achieve worse financial results suggesting that group cohesion may be important in organizations with multiple, especially non-complementary, objectives (such as outreach and financial self-sufficiency). The results also suggest that there is room for direct involvement of banks in community development activities rather than relying only on investment and lending to intermediaries such as CDFIs. JEL Classification: JEL: G2, G3 |
Financial Stability and Basel II FDIC Center for Financial Research Working Paper No. 2006-10 This Version: September 2006 Published as: Kupiec, Paul H. "Financial Stability and Basel II." Annals of Finance 3, no. 1 (2007): 107-130. Abstract The Basel II Advanced Internal Ratings (AIRB) approach is compared to capital requirements set using an equilibrium structural credit risk model. Analysis shows the AIRB approach undercapitalizes credit risk relative to regulatory targets and allows wide variation in capital requirements for a given exposure owing to ambiguity in the definitions of loss given default and exposure at default. In contrast, the Foundation Internal Ratings Based (FIRB) approach may over-capitalize credit risk relative to supervisory objectives. It is unclear how Basel II will buttress financial sector stability as it specifies the weakest risk regulatory capital standard for large complex AIRB banks. JEL Classification: G12, G20, G21, G28 |
On the Market Discipline of Informationally-Opaque Firms: Evidence from Bank Borrowers in the Federal Funds Market FDIC Center for Financial Research Working Paper No. 2006-09 This Version: September 2006 Published as: Ashcraft, Adam B. and C. Hoyt Bleakley. "On the Market Discipline of Informationally-Opaque Firms: Evidence from Bank Borrowers in the Federal Funds Market." FRB of New York Staff Report 257 (2006). Abstract Using plausibly exogenous variation in demand for federal funds created by daily shocks to reserve balances, we identify the supply curve facing a bank borrower in the inter-bank market, and study how access to overnight credit is affected by changes in public and private measures of borrower creditworthiness. While there is evidence that lenders respond to adverse changes in public information about credit quality by restricting access to the market in a fashion consistent with market discipline, there is also evidence that borrowers are able to respond to adverse changes in private information about credit quality by increasing leverage as if to offset the future impact on earnings. While the responsiveness of investors to public information is comforting, we document evidence which suggests that banks are able to manage the real information content of these disclosures. In particular, public measures of loan portfolio performance have information about future loan charge-offs, but only in quarters when the bank is examined by supervisors. However, the loan supply curve is not any more sensitive to public disclosures about non-performing loans in an exam quarter, suggesting that investors are unaware of this information management. JEL Classification: G14, G18, G21 |
Capital Allocation for Portfolio Credit Risk FDIC Center for Financial Research Working Paper No. 2006-08 This Version: August 2006 Published as: Kupiec, Paul H. "Capital Allocation for Portfolio Credit Risk." Journal of Financial Services Research 32, no. 1-2 (2007): 103-122. Abstract Capital allocation rules are derived that maximize leverage while maintaining a target solvency rate for credit portfolios where risk is driven by a single common factor and idiosyncratic risk is fully diversified. Equilibrium conditions ensure that capital allocations depend on interest earnings as well as credits probability of default, endogenous loss given default, and asset correlation. Capitalization rates exceed those estimated using Gaussian credit loss models. Results demonstrate that credit risk is undercapitalized by the Basel II AIRB approach in part because of ambiguities regarding the definition of loss given default. An alternative proposed capital rule removes this bias. JEL Classification: G12, G20, G21, G28 |
Did the Introduction of Fixed-Rate Federal Deposit Insurance Increase Bank Risk? FDIC Center for Financial Research Working Paper No. 2006-07 This Version: August 2006 Published as: DeLong, Gayle and Anthony Saunders. "Did the Introduction of Fixed-Rate Federal Deposit Insurance Increase Bank Risk?" Journal of Financial Stability 7, no. 1 (2011): 19-25. Abstract We investigate whether the introduction of fixed-price U.S. federal deposit insurance increased the risk-taking of banks. We examine 70 financial institutions and find that banks in general became more risky after the introduction of deposit insurance. However, a subset of well-performing banks reduced their risk. Deposit insurance helped to bring about stability in that depositors did not discriminate between weaker and stronger banks. Although investors did not see deposit insurance as a net subsidy to the banking industry, investors believed deposit insurance would allow smaller banks to compete better against bigger banks. While deposit insurance allowed greater risk-taking among some banks, it also brought more stability and competition within the banking industry. JEL Classification: G18 and G21 |
Understanding the Role of Recovery in Default Risk Models: Empirical Comparisons and Implied Recovery Rates FDIC Center for Financial Research Working Paper No. 2006-06 This Version: August 2006 Abstract This article presents a framework for studying the role of recovery on defaultable debt prices (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employed to infer the market expectation of recovery rates implicit in bond prices. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices. JEL Classification: G0, G10, G11, G12, G13, C5 |
Multi-Period Corporate Default Prediction With Stochastic Covariates FDIC Center for Financial Research Working Paper No. 2006-05 This Version: September 2005 Published as: Duffie, Darrell, Leandro Saita, and Ke Wang. "Multi-Period Corporate Default Prediction With Stochastic Covariates." Journal of Financial Economics 83, no. 3 (2007): 635-665. Abstract We provide maximum likelihood estimators of term structures of conditional probabilities of corporate default, incorporating the dynamics of firm-specific and macroeconomic covariates. For U.S. Industrial firms, based on over 390,000 firm-months of data spanning 1980 to 2004, the level and shape of the estimated term structure of conditional future default probabilities depends on a firm's distance to default (a volatility-adjusted measure of leverage), on the firm's trailing stock return, on trailing S& P 500 returns, and on U.S. interest rates, among other covariates. Variation in a firm's distance to default has a substantially greater effect on the term structure of future default hazard rates than does a comparatively significant change in any of the other covariates. Default intensities are estimated to be lower with higher short-term interest rates. The out-of-sample predictive performance of the model is an improvement over that of other available models. JEL Codes: C41, G33, E44 |
Borrower-Lender Distance, Credit Scoring, and the Performance of Small Business Loans FDIC Center for Financial Research Working Paper No. 2006-04 This Version: March 2006 Abstract We develop a theoretical model of decision-making under risk and uncertainty in which bank lenders have both imperfect information about loan applications and imperfect ability to make decisions based on that information. We test the loan-default implications of the model for a large random sample of small business loans made by U.S. banks between 1984 and 2001 under the SBA 7(a) loan program. As predicted by our model, both borrower-lender distance and credit-scoring contribute to greater loan defaults; the former finding suggests that distance interferes with information collection and monitoring, while the latter finding implies production efficiencies that encourage credit-scoring lenders to make riskier loans at the margin. However, we also find that credit-scoring dampens the harmful effects of distance, consistent with the conjecture that information generated by credit scoring models improves the ability of lenders to assess and price default risk. JEL Codes: D81, G21, G28 |
Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary With Market Conditions FDIC Center for Financial Research Working Paper No. 2006-03 This Version: December 2005 Published as: Gatev, Evan, Til Schuermann, and Philip E. Strahan. "Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary With Market Conditions." Review of Financial Studies 22, no. 3 (2009): 995-1020. Abstract Unused loan commitments expose banks to systematic liquidity risk, but this exposure can be reduced by combining loan commitments with transactions deposits. We show that bank equity volatility increases with unused loan commitments, but this increase is reduced for banks with high levels of transaction deposits. This deposit-lending synergy becomes even more powerful during periods of tight liquidity, when nervous investors move funds into their banks. Thus, the simultaneous taking of deposits and lending may be thought of as a liquidity hedge. JEL Codes: G18; G21 |
Interest Rate Risk Management at Commercial Banks: An Empirical Investigation FDIC Center for Financial Research Working Paper No. 2006-02 This Version: May 2005 Published as: Purnanandam, Amiyatosh. "Interest rate derivatives at commercial banks: An empirical investigation." Financial Review 24, no. 3 (1989): 431-455. Abstract I analyze the effects of bank characteristics and macroeconomic shocks on interest rate risk management behavior of commercial banks. My findings are consistent with hedging theories based on cost of financial distress and costly external financing. As compared to the derivative users, the derivative non-user banks adopt conservative asset-liability management policies in tighter monetary policy regimes. Finally, I show that the derivative non-user bank's lending volume decline significantly with the contraction in the money-supply. Derivative users, on the other hand, remain immune to the monetary policy shocks. My findings suggest that a potential benefit of derivatives usage is to minimize the effect of external shocks on a firm's operating policies. JEL Codes: G21, G32, G33 and E5 |
Bank Lines of Credit in Corporate Finance: An Empirical Analysis FDIC Center for Financial Research Working Paper No. 2006-01 This Version: December 2005 Published as: Sufi, Amir. "Bank Lines of Credit in Corporate Finance: An Empirical Analysis." Review of Financial Studies 22, no. 3 (2009): 1057-1088. Also available online. Abstract I use novel data collected from annual 10-K SEC filings to examine the role of bank lines of credit in the liquidity management of public corporations. I find that bank lines of credit account for a large share of liquidity only for firms with a historical record of profitability. Firms with low profitability that are unable to obtain a line of credit more heavily use cash in their corporate liquidity management; they hold higher balances of cash and save more cash out of cash flow than firms that are able to obtain a line of credit. Even among firms that obtain lines of credit, banks use financial covenants on profitability to restrict access when firms experience drops in performance. The credit restriction is temporary and firms eventually regain full access to their line of credit. JEL Codes: G20, G21, G32, G31 |
The Center for Financial Research (CFR) Working Paper Series allows CFR staff and their coauthors to circulate preliminary research findings to stimulate discussion and critical comment. Views and opinions expressed in CFR Working Papers reflect those of the authors and do not necessarily reflect those of the FDIC or the United States. Comments and suggestions are welcome and should be directed to the authors. References should cite this research as a “FDIC CFR Working Paper” and should note that findings and conclusions in working papers may be preliminary and subject to revision.