Anthony Saunders

Credit risk measurement: Developments over the last 20 years

Abstract This paper traces developments in the credit risk measurement literature over the last 20 years. The paper is essentially divided into two parts. In the first part the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans is traced by way of reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. In the second part, a new approach built around a mortality risk framework to measuring the risk and returns on loans and bonds is presented. This model is shown to offer some promise in analyzing the risk-return structures of portfolios of credit-risk exposed debt instruments.

The Determinants of Bank Interest Margins: Theory and Empirical Evidence

This paper has developed a model of bank margins or spreads in which the bank is viewed as a risk-averse dealer. It was demonstrated that an interest spread or margin would always exist, and that this was the result of transactions uncertainty faced by the bank. Moreover, it was shown that this pure spread depended on four factors: the degree of managerial risk aversion; the size of transactions undertaken by the bank; bank market structure; and the variance of interest rates. The model implied that liability and asset structures had to be analyzed together since they were directly interrelated through transactions uncertainty. It was shown that because of this transactions uncertainty, hedging behavior was perfectly rational within an expected utility maximizing framework. Extending the model from a structure with one kind of loan and deposit to loans and deposits with many maturities should lead to further interesting insights into margin determination especially as “portfolio†effects may become apparent.

Should Banks be Diversified? Evidence from Individual Bank Loan Portfolios

We study empirically the effect of focus (specialization) vs. diversification on the return and the risk of banks using data from 105 Italian banks over the period 1993-1999. Specifically, we analyze the tradeoffs between (loan portfolio) focus and diversification using a unique data set that is able to identify individual bank loan exposures to different industries, to different sectors, and to different geographical regions. Our results are consistent with a theory that predicts a deterioration in bank monitoring quality at high levels of risk and a deterioration in bank monitoring quality upon lending expansion into newer or competitive industries. Our most important findings are that industrial loan diversification reduces bank return while endogenously producing riskier loans for all banks in our sample (this effect being most powerful for high risk banks), sectoral loan diversification produces an inefficient risk-return tradeoff only for high risk banks, and geographical diversification results in an improvement in the risk-return tradeoff for banks with low levels of risk. A robust result that emerges from our empirical findings is that diversification of bank assets is not guaranteed to produce superior performance and/or greater safety for banks.

The determinants of foreign banking activity in the United States

Abstract The recent rapid growth of foreign banking activity in the United States has led to major changes in the regulation of foreign banks. This paper seeks to determine the factors causing this growth of foreign banks. Empirical tests were conducted employing quarterly time series data from 1972 through 1979. It is shown that the most important factors determining foreign bank growth were (i) the size of interest differentials between U.S. and foreign deposits and loans, (ii) the falling P/E ratios for U.S. bank stocks, (iii) the increased size of (net) foreign direct investment in the U.S., (iv) the persistent depreciation in the dollar, and (v) expectations that the International Banking Act of 1978 would have a restrictive affect on foreign bank activity in the U.S.

Financial institutions management : a modern perspective

The financial service industry - depository institutions the financial service industry - insurance companies the financial service industry - other financial institutions why are financial intermediaries special? measuring risk risks of financial intermediation interest rate risk - the maturity model interest rate risk - the duration model interest rate risk - the repricing model market risk credit risk - individual loan risk credit risk - loan portfolio risk off-balance sheet activities operating cost and technology risk foreign exchange risk sovereign risk liquidity risk managing risk liability and liquidity management deposit insurance and other liability guarantees capital adequacy product expansion geographic diversification futures and forwards options, caps, floors and collars saps loan sales.

Futures Price Variability: A Test of Maturity and Volume Effects

A number of previous studies have examined the contemporaneous relation between asset price variability and volume traded. For example, Clark (1973), Cornell (1981), and Tauchen and Pitts (1983) have investigated this relation for futures markets and Epps and Epps (1976), Harris (1984a, 1984b), and Smirlock and Starks (1984) for the stock market. Underlying this empirical research is a theoretical framework that suggests that price variability (or the absolute change in prices) and volume traded should be positively correlated. According to this theoretical framework, the so-called mixture of distributions hypothesis (MDH),1 the correlation between price variability and volume should be positive because of joint dependence on a common directing variable or event. This study uses contract disaggregated data on futures prices to obtain evidence on the relation between price variability and volume of trading. Strong positive contemporaneous correlations between trading volume and price volatility are documented consistent with the mixture of distributions hypothesis. It is concluded that maturity is not a suitable surrogate for the common directing variable. Specifically, while maturity has a strong effect on volume, no such relation is found for price variability. Finally, while in the majority of cases price variability and trading volume are contemporaneously correlated, there are a significant number of cases in which a sequential relation appears to be present. * An earlier version of this paper was presented at the 1984 meeting of the European Finance Association in Manchester, England, and at Southern Methodist University, the University of Wisconsin-Madison, Duke University, McGill University, and the University of Toronto. We wish to thank the seminar participants and an anonymous referee from this Journal for constructive comments and criticism. All remaining errors are, of course, our responsibility. We would also like to thank the Columbia Center for the Study of Futures Markets and the Interactive Data Corp. for providing some of the data used in the study. 1. See Clark 1973; and Harris 1984a, 1984b.

The Effects of Cross-Border Bank Mergers on Bank Risk and Value

This paper examines the effects of cross-border bank mergers on the risk and (abnormal) returns of acquiring banks. We find that overall, the acquirers risk neither increases nor decreases. In particular, on average neither their total risk nor their systematic risk falls relative to banks in their home banking market. The abnormal returns to acquirers are negative and significant, but are somewhat higher when risk increases relative to banks in the acquirer s home country.

Financial Distress and Bank Lending Relationships

We use a unique data set of bank loans to examine the wealth effects on lead lending banks when their borrowers suffer financial distress. We find a significant negative announcement return for the lead lending bank when a major corporate borrower announces default or bankruptcy. Banks with higher exposure to the distressed firm have larger negative announcement-period returns. The existence of a past lending relationship with the distressed firm results in larger wealth declines for the bank shareholders. Finally, financial distress also has a significant negative effect on borrowers returns.

A Survey of Cyclical Effects in Credit Risk Measurement Models

We survey both academic and proprietary models to examine how macroeconomic and systematic risk effects are incorporated into measures of credit risk exposure. Many models consider the correlation between the probability of default (PD) and cyclical factors. Few models adjust loss rates (loss given default) to reflect cyclical effects. We find that the possibility of systematic correlation between PD and LGD is also neglected in currently available models.

Credit Spreads in the Market for Highly Leveraged Transaction Loans

This paper is an empirical exploration of the determinants of the required credit spreads on highly leveraged transaction (HLT) loans. The analysis uses a multi-factor spread model to estimate the movement of loan spreads relative to spreads required in the (competing) corporate bond market as well as the significance of loan-specific characteristics in determining loan spreads. The empirical estimates are based on the Loan Pricing Corporation s database which consists of over 4000 loan transactions between 1987-1994. We find a positive HLT loan spread sensitivity to changes in spreads in the corporate bond market, but this sensitivity is significantly less than unity; indicating that the HLT loan market and high yield public debt market are not fully integrated. Furthermore, there is evidence that lenders augment, rather than substitute, loan yield spreads with additional fees for syndication, commitment and cancellation risks. In general syndicated loans have lower yield spreads than other HLT loan types.