Knowledge that Transforms

We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.

The asymptotic single risk factor approach is a framework for determining regulatory capital charges for credit risk, and it has become an integral part of the second Basel Accord. Within this approach, a key parameter is the average asset correlation. We examine the empirical relationship between this parameter, firm probability of default and firm asset size measured by the book value of assets. Using data from year-end 2000, credit portfolios consisting of US, Japanese, and European firms are analyzed. The empirical results suggest that average asset correlation is a decreasing function of probability of default and an increasing function of asset size. The results suggest that these factors may need to be accounted for in the final calculation of regulatory capital requirements for credit risk.

This paper analyzes the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. It is shown that capital structure dynamics lower optimal initial leverage ratios but increase both, fair credit spreads and expected default probabilities for moderate levels of transactions costs. Numerical examples demonstrate that expected default frequencies do not decrease monotonically in the traditional distance to default measure. The magnitude of the effect of capital structure dynamics depends on firm characteristics such as asset volatility, the growth rate, the effective corporate tax rate, debt call features and transactions costs. We find that the underestimation of credit spreads and expected default frequencies is exacerbated when the risk-adjusted drift of the underlying stochastic process is inferred from a model which ignores the opportunity to recapitalize. Finally it is shown that the value-at-risk of corporate bonds increases with the distance to default (DD) both for very low and for very high values of DD whereas it decreases for intermediate values.

This paper investigates a firm's choice between borrowing from a single bank and from two banks. The focus is on how this decision affects banks' equilibrium monitoring intensities and loan rates. Two-bank lending suffers from duplication of effort and sharing of monitoring benefits, but it benefits from diseconomies of scale in monitoring. Thus, two-bank lending involves lower monitoring but not necessarily higher loan rates than single-bank lending. The optimal borrowing structure balances the benefit of monitoring for the firm in terms of higher success probability of the project against its drawbacks of lower expected private return and higher total monitoring costs. In contrast to the previous theoretical literature, the model lays down an explanation for the empirical observation that multiple-bank lending does not unambiguously increase loan rates or firms' quality, in particular in small business lending.

This paper investigates the existence of cross-sectional differences in the response of lending to monetary policy and GDP shocks owing to differences in bank capitalization. It adds to the literature by using the excess capital-to-asset ratio, which can better control the riskiness of banks' portfolios, and by disentangling the effects of the “bank lending channel” from those of the “bank capital channel.” The results, based on a sample of Italian banks, indicate that bank capital matters in the propagation of different types of shocks to lending, owing to the existence of regulatory capital constraints and imperfections in the market for bank fund-raising.

The empirical evidence on initial returns in IPOs reveals average overpricing as well as underpricing, depending on the type of security offered for sale. Consistent with this evidence, the present paper develops a model in which an IPO may be overpriced in equilibrium relative to its expected (or average) aftermarket price. Overpricing disappears, however, once the offer price is compared to a ‘float-weighted’ expectation, where the weights are given by the extent to which the number of securities that are floated in the offering (at the posted price) is positively related to the demand for allocations. Empirically, the model implies that equally-weighted returns underestimate initial returns in IPOs, and hence that inferences based on equally-weighted returns may be misleading.