João A. C. Santos

Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature

This paper reviews the theoretical literature on bank capital regulation and analyses some of the approaches to redesigning the 1988 Basle Accord on capital standards. The paper starts with a review of the literature on the design of the financial system and the existence of banks. It proceeds with a presentation of the market failures that justify banking regulation and an analysis of the mechanisms that have been suggested to deal with these failures. The paper then reviews the theoretical literature on bank capital regulation. This is followed by a brief history of capital regulation since the 1988 Basle Capital Accord and a presentation of both the alternative approaches that have been put forward on setting capital standards and the Basel Committees proposal for a new capital adequacy framework.

Bank Corporate Loan Pricing Following the Subprime Crisis

The massive losses that banks incurred with the meltdown of the subprime mortgage market have raised concerns about their ability to continue lending to corporations. We investigate these concerns. We find that firms paid higher loan spreads during the subprime crisis. Importantly, the increase in loan spreads was higher for firms that borrowed from banks that incurred larger losses. These results hold after we control for firm-, bank-, and loan-specific factors, and account for endogeneity of bank losses. These findings, together with our evidence that borrowers took out smaller loans during the crisis when they borrowed from banks that incurred larger losses, lend support to the concerns about bank lending following their subprime losses. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Bank Capital, Borrower Power, and Loan Rates

We test the predictions of several recent theories of how bank capital affects the rates that banks charge their borrowers. Consistent with previous studies, higher bank capital has a negative impact on loan rates, and this effect is focused on bank-dependent borrowers. Further investigation shows that borrower cash flow is a critical determinant of this relationship: compared to high-capital banks, low-capital banks charge more for bank-dependent borrowers with low cash flow, but offer greater discounts for bank-dependent borrowers with high cash flow. Our results support the bank-fragility theory, which argues that low bank capital generally toughens bank bargaining power, especially vis-a-vis low-cash-flow borrowers, but weakens bank bargaining power vis-a-vis high-cash-flow borrowers. By contrast, our results are not consistent with models where low-capital banks either consume reputational capital or are generally more risk averse than high-capital banks.

Banks' Liquidity and the Cost of Liquidity to Corporations

We consider the liquidity shock banks experienced following the collapse of the asset-backed commercial paper market in the fall of 2007 to investigate whether banks’ liquidity condition affect their ability to provide liquidity to corporations. We find that banks that borrowed more from the Federal Home Loan Bank system or the Fed’s discount window following that liquidity shock passed a larger portion of their borrowing costs onto corporations seeking access to liquidity in the fall of 2007 when compared to the pre-crisis period. This increase is larger among banks with a larger exposure to the asset-backed commercial paper market, credit lines that pose more liquidity risk to banks, and borrowers that are likely dependent on the credit-line provider. Our findings show that the crisis which affected the banking system had a negative effect not only on the price of credit to corporations, but also on the price corporations pay to guarantee access to liquidity.

Liquidity Risk, and Maturity Management over the Credit Cycle

We show that firm demand-side factors are strong drivers of procyclical refinancing be- havior over the credit cycle using novel data from the Shared National Credit program. Firms are more likely to refinance early when credit conditions are good to keep the ef- fective maturity of their loans long and hedge against having to refinance in tight credit conditions. High credit quality firms are better able to hedge, making their refinancing propensity more sensitive to credit cycles than less creditworthy firms. There is a strong relationship between refinancing a loan, and subsequent growth in capital expenditure, es- pecially when a loan is refinanced early.

Liquidity, Payment and Endogenous Financial Fragility

We study the fragility of the banking system and its implications for prudential regulation. In our framework, fragility stems from the interconnections banks establish to protect themselves from liquidity shocks. We show that when banks do not provide payment services they have an incentive to choose the optimal degree of mutual insurance. Under these conditions, the flexibility with which financial assets can be designed and priced causes all market participants to correctly to take into account the economic effects of their own interdependence. When banks provide payment services this flexibility is no longer available. In this case, we show that banks have an incentive to become too interdependent, since some of the beneficiaries of the payments arrangement are unable to compensate the banks for maintaining independence. This creates a justification for a regulatory intervention. We examine possible modes of intervention.

Does Securitization of Corporate Loans Lead to Riskier Lending

There is growing evidence that securitization adversely affected the screening incentives of mortgage lenders, contributing to a large increase in delinquencies in the U.S. subprime housing market during the crisis. In this paper we investigate whether the growth of securitization had also affected corporate lending. We find that during the boom years of the CLO business, loans sold to CLOs at the time of their origination underperform similar unsecuritized loans originated by the same bank. Banks account for this difference in performance because they charge higher interest rates on the loans they sell to CLOs than on their unsecuritized loans. The difference in performance between CLO credits and non-CLO credits appear to have resulted from banks’ use of laxer standards to underwrite the loans they sell to CLOs. Banks also retain lower “skin in the game” when they sell loans to CLOs, and it appears this too contributed for the underperformance of CLO credits.We investigate whether the securitization of corporate loans affected banks’ lending standards. We find that during the boom years of the CLO business, loans sold to CLOs at the time of their origination underperform matched unsecuritized loans originated by the same bank. This finding is robust to loan- and borrower-specific controls, as well as the lender’s skin in the game. Banks’ use of lax underwriting standards appears to have contributed to the worse performance of the loans they sell to CLOs. We find that banks put less weight on the hard information on borrower risk available to them when they set interest rates on the loans they sell to CLOs, and that they retain less skin in the game on these loans. We also find that the median non-CLO syndicate participant retains a lower stake in securitized loans when compared to loans that are not securitized, suggesting that these investors, like lead banks, expected securitized loans to perform worse.

Has the US Bond Market Lost its Edge to the Eurobond Market

The growth of the European financial markets, together with the new, stricter regulations on the US financial markets, has spurred a debate over the competitiveness of the US financial markets. In this paper, we contribute to this debate by investigating the relative competitiveness of the US bond market over the last 10 years. In the early 1990s, the gross spread in the US bond market were significantly lower than in the Eurobond market. While this spread continued to decline in the US bond market, it declined at an even faster rate in the Eurobond market, to the point of eliminating the wide cost differential that existed between the two markets in the early 1990s. These findings are robust and suggest that the relative costs of bond underwriting declined in the Eurobond market. We also find that US firms are increasingly opting to issue their bonds in the Eurobond market, and that this relocation is partly driven by the decline in the relative gross spreads in the Eurobond market. This finding adds support to our conclusion that the cost of bond underwriting declined faster in the Eurobond market, reinforcing the view that the US bond market is facing a greater challenge from the Eurobond market.

Allocating Lending of Last Resort and Supervision in the Euro Area

The Maastricht Treaty created the European System of Central Banks and the European Central Bank to head this system. The Treaty entrusted the European Central Bank with the responsibility for monetary policy, but it did not give this institution supervisory powers or an explicit mandate for providing emergency liquidity support to individual banks. National authorities remained responsible for financial stability. As a result, in the euro area some bank regulatory functions are centralized, while others are allocated to not one, but multiple, competing national regulators. Previous researchers have discussed the potential implications of this institutional allocation of regulation on the financial stability of the region. In this chapter, we investigate instead the potential efficiency implications. We focus on the consequences of the allocation of the lender of last resort and supervisory functions for the degree of forbearance in closing distressed banks and for the level of diligence in bank supervision. We conclude that the integration of banking markets without the integration of regulatory functions increases forbearance and decreases supervision. Centralizing regulatory functions will tend to reverse this decline. If only one of the two functions is centralized, then it will be more effective to centralize the supervisory function.

Banks' Incentives and the Quality of Internal Risk Models

This paper investigates the incentives for banks to bias their internally generated risk estimates. We are able to estimate bank biases at the credit level by comparing bank-generated risk estimates within loan syndicates. The biases are positively correlated with measures of regulatory capital, even in the presence of bank fixed effects, consistent with an effort by low-capital banks to improve regulatory ratios. At the portfolio level, the difference in borrower probability of default is as large as 100 basis points, which can improve the typical loan portfolio’s Tier 1 capital ratio by as much as 33 percent. Congruent with a regulatory motive, the sensitivity to capital is greater for larger, riskier, and more opaque credits. In addition, we find that low-capital banks’ risk estimates have less explanatory power than those of high-capital banks with regard to the prices set on loans, indicating that low-capital banks not only have downward-biased risk estimates but that they also incorporate less information.