Knowledge that Transforms

Currency and interest rate swaps are subject to a complex, two-sided default risk. Although several theoretical papers have recently addressed the problem of pricing swap credit risk, the empirical literature is almost non-existent. This is the only study we know which uses actual transaction data to document the effect of credit risk on swap spreads. We provide results for both interest rate and currency swaps.

The behavior of a risk neutral corporation in selection of a line of credit is modeled in a new framework where demand for credit lines by a firm arises from the stochastic arrival in continuous time of short-lived opportunities to capture investment projects. The firm needs speed and secrecy to capture projects before competitors. The firm chooses a credit line that balances its up-front commitment cost against the expected extra cost of borrowing in the spot market upon exhaustion of its credit line. The firm's demanded credit line depends upon both relative pricing within the contract and the nature of the firm's growth opportunities. Interestingly, while credit line demand is positively related to business growth prospects, it is potentially negatively related to uncertainty in those prospects.

In this article we have reviewed “Modern Portfolio Analysis” and outlined some important topics for further research. Issues discussed include the history and future of portfolio theory, the key inputs necessary to perform portfolio optimization, specific problems in applying portfolio theory to financial institutions, and the methods for evaluating how well portfolios are managed. Emphasis is placed on both the history of major concepts and where further research is needed in each of these areas.

Many regulations use private sector credit ratings to determine investment prohibitions and capital requirements for institutional portfolio investments. These regulations implicitly assume that different agencies have equivalent rating scales, despite the fact that some agencies assign systematically higher ratings than others. We assess the appropriateness of these regulatory practices by testing whether observed rating differences reflect different rating scales or simply result from sample selection bias. Our analysis reveals only limited evidence of selection bias. We also ask what types of firms of firms are most likely to seek ratings from the agencies with higher rating scales. Our analysis uncovers no evidence that firms seek ratings from these agencies to clear specific regulatory hurdles or to reduce ex ante uncertainty about default risk.

This paper examines the wealth effects of a decision by the Office of Thrift Supervision (OTS) to permit interstate branching for federally chartered savings and loan associations (SLAs). An event study of key OTS announcements in 1991 and 1992 is conducted based on samples of 38 federally chartered SLAs and 88 commercial banks. Large SLAs and commercial banks generally experienced significant positive wealth effects but little or no reaction was found for smaller depository institutions. These findings provide early evidence that interstate branching powers for depository institutions under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 will tend to benefit large institutions accelerating the trend toward consolidation, though without necessarily compromising the viability of smaller institutions.

Economies of scale and scope in Finnish non-life insurance are studied. The production process is separated into cost and portfolio management functions. Firms expand their branch network to either gain market power or informational advantages. There are diseconomies of scale at firm and economies of scale at branch level, and economies of scope in production. Large firms in the non-life insurance industry pay a substantial premium to gain market power via branch networks. The retained premiums-curve of portfolio management is U-shaped and a positive function of the number of branches.

This paper addresses a little examined intersection between the problem loan literature and the bank efficiency literature. We employ Granger-causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital. The data suggest that problem loans precede reductions in measured cost efficiency; that measured cost efficiency precedes reductions in problem loans; and the reductions in capital at thinly capitalized banks precede increases in problem loans. Hence, cost efficiency may be an important indicator of future problem loans and problem banks. Our results are ambiguous concerning whether or not researchers should control for problem loans in efficiency estimation.

Research on bank efficiency has developed in two separate streams: econometric studies and Data Envelopment Analysis, a linear programming technique. These two branches of literature have developed quickly, but separately; in this paper these two approaches have been tested on a common panel of 270 Italian banks, and this has suggested the following: (i) econometric and linear programming results do not differ dramatically, when based on the same data and conceptual framework; (ii) when differences arise, they can be explained by going back to the intrinsic features of the models. Moreover, some findings on Italian banks may be of interest also to the international reader: (i) efficiency scores show a high variance; (ii) the banking system is split in two, between northern and southern banks; (iii) there is a direct (rather than inverse) relationship between productive efficiency and asset quality; (iv) the efficiency of Italian banks did not increase over the period 1988–1992.