Mark J. Flannery

What Caused the Bank Capital Build-Up of the 1990s?

Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties’ incentive to monitor and price default risk. We find no evidence that a bank holding company’s market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the markets increased demand that large banks’ default risk be priced.

Financial Crises, Payment System Problems, and Discount Window Lending

In a developed economy, financial crises are rapidly conveyed to the payment system, which tends to rely on private credit extensions in most countries. While many authors recommend that the central bank do no more than provide adequate aggregate liquidity during a crisis, this policy requires well-functioning private credit markets to channel liquidity to solvent, but illiquid, firms. This paper presents a model of private lending which defines a crisis as a time when lenders become uncertain about how to assess financial risks and, therefore, rationally withdraw from making new loans. In such an environment, a government lender of last resort can improve social welfare. Copyright 1996 by Ohio State University Press.

Capital regulation and insured banks choice of individual loan default risks

Abstract How bankers choose the riskiness of their individual assets is an important question. It is well known that fixed-premium deposit insurance leads a bank to prefer a high-variance asset portfolio, but its effect on individual asset choice has not been carefully evaluated. This paper demonstrates how bank examination procedures and capital adequacy standards can make the value of a banks deposit insurance contract concave in individual asset risks. Insured bankers may therefore have a rational preference (ceteris paribus) for relatively safe individual loans, even while they prefer risky portfolio returns. The models implications for loan securitization and the Federal regulators new risk-based capital standards are discussed.

Are Bank Loans Special? Evidence on the Post-Announcement Performance of Bank Borrowers.

Unlike seasoned equity or public debt offerings, bank loan financing elicits a significantly positive announcement return, which has led financial economists to characterize bank loans as “special.” Here, we find that firms announcing bank loans suffer negative abnormal stock returns over the subsequent three years. In the long run, bank loans appear no different from seasoned equity offerings or public debt issues. Our evidence suggests that larger loans (relative to borrower equity) are followed by worse stock performance. We also find that lender protection is negatively related to borrower performance, suggesting the lender is somewhat shielded from the poor performance.

Asset pricing, time-varying risk premia and interest rate risk

Abstract This paper investigates the role of interest rate risk in explaining security price changes. We develop and test a two-factor linear beta pricing model of security returns in which the factors are the excess returns on the long-term, riskless bond and the equal-weighted equity market index. We find that time-variation in the interest rate and market risk premia influence expected security returns. Furthermore, conditional interest rate volatility affects security returns, particularly during periods of substantial interest rate movements.

Pricing deposit insurance when the insurer measures bank risk with error

Abstract If the deposit insurance agency (‘FDIC’) can observe bank risks without error, it can attain actuarial soundness equally well with either risk-related premium assessments or risk-related capital standards. However, many bank assets are difficult and expensive to evaluate, so their true value and risk cannot be ascertained without error. These risk measurement errors cause the FDIC to misprice its deposit insurance, which can be analyzed as a put option written on assets with uncertain volatility and current value. This paper evaluates the optimal means of pricing deposit insurance in such an environment. Because FDICs insurance pricing errors increase with bank leverage, the impact of these errors on private-sector allocations can be minimized with a combination of risk-related capital standards and risk-related premia.

Leverage Expectations and Bond Credit Spreads

In an efficient market, spreads will reflect both the issuer’s current risk and investors’ expectations about how that risk might change over time. Collin-Dufresne and Goldstein ( 2001 ) show analytically that a firm’s expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors’ expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.

Modernizing Financial Regulation: The Relation Between Interbank Transactions and Supervisory Reform

“Modernized” financial firms are larger than traditional institutions, and they provide a broader range of services. Although the individual regulatory issues raised by modernization are not new, the pace and scope of these market changes may imply a qualitative change in the ability of governments to guarantee financial system stability. Private market discipline is more flexible, and the value of flexibility seems to have risen. In order to elicit private monitoring, however, governments must credibly eschew “too-big-to-fail” policies. Toward this end, national regulators should encourage ongoing efforts to implement secure interbank settlement systems.

The Effect of Fiduciary Standards on Institutions' Preference for Dividend‐Paying Stocks

Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the “prudent man” (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent “prudent investor” (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.

Correspondent services and cost economies in commercial banking

Abstract Prior bank cost function studies have ignored the fact that some banks obtain a substantial amount of services from their correspondents. If these services are paid for with compensating deposit balances, their cost to the purchasing bank is not reflected in standard expense reports. This paper investigates whether explicit consideration of theese correspondent costs materially affects estimated bank returns to scale. The results indicate that the level of banksoperating costs is underreported by as much as 15%. While scale economy estimates for unit banks are not significantly affected by the addition of correspondent service costs, prior studies have overestimated branch bank scale economies by a small but statistically significant amount.