Knowledge that Transforms

We study the efficiency of banking regulation under financial integration. Banks freely choose the jurisdiction where to locate their activities and have private information about their efficiency level. Regulators non-cooperatively offer any regulatory contract that satisfies information and participation constraints of banks. We show that the unique Nash equilibrium of the regulatory game is a simple pooling contract: financial integration is characterized by the inability for regulators to discriminate between banks with different efficiency levels. This result is driven by the endogenous restriction caused by regulatory arbitrage on the capacity of regulators to use several regulatory instruments.

We study how a bank allocates capital across its business units when facing multiple constraints over several periods. If a constraint tightens – be it because of stricter regulation or higher risk – capital flows to the more efficient unit, i.e. the unit offering a higher marginal return on required capital. Relative efficiency helps explain how a policy measure targeting a specific business unit – e.g. imposing requirements for market risk, or ring-fencing lending – spills over to another, seemingly unrelated unit. It also helps explain the bank’s response to the tightening of a constraint that is contemporaneously slack but likely to bind later on.

We show that local banks provide corporate recovery lending to firms affected by adverse regional macro shocks. Banks that reside in counties unaffected by the natural disaster that we specify as macro shock increase lending to firms inside affected counties by 3%. Firms domiciled in flooded counties, in turn, increase corporate borrowing by 16% if they are connected to banks in unaffected counties. We find no indication that recovery lending entails excessive risk-taking or rent-seeking. However, within the group of shock-exposed banks, those without access to geographically more diversified interbank markets exhibit more credit risk and less equity capital.

The purpose of this paper is to evaluate the effectiveness of two macroprudential policies in Colombia: marginal reserve requirements and dynamic provisions. The first measure was implemented to control excessive credit growth, while the latter was designed to increase systemic resilience by establishing a countercyclical buffer through loan loss provision requirements. To perform this analysis, a rich dataset based on loan-by-loan information for Colombian banks during the 2006–2009 period is used. Our identification strategy closely follows Khwaja & Mian (2008), so that only those observations with multiple banking relations are considered. Estimations are performed applying firm and firm-time fixed effects to control for demand factors, thus appropriately isolating loan demand from credit supply. Results from the econometric model suggest that dynamic provisions, the countercyclical reserve requirement and an aggregate measure of the macroprudential policy stance had a negative effect on credit growth, which varies according to bank and debtor-specific characteristics. Particularly, effects are intensified for riskier debtors, suggesting that the aggregate macroprudential policy stance in Colombia has worked effectively to stabilize credit cycles and reduce risk-taking.

This paper investigates the information spillover effect of government bailouts. Analyzing money market funds’ dynamic enrollment status in the U.S. Treasury Temporary Guarantee Program in 2008, this paper finds that enrolled funds had overall positive fund flows, implying that the stability effect of bailouts outweighed the negative stigma effect. However, the already-enrolled funds experienced a relative reduction in fund flows after investors learned their funds had enrolled earlier than other peer funds (i.e., stigma effect). I address the endogeneity issue of funds’ enrollment status based on an instrumental variable approach. Overall, results show that investors extract useful information about financial institutions’ underlying stability from their demand for bailouts.

Contingent convertibles (CoCos) are intended to either convert to new equity or be written down prior to failure while a bank is a going-concern. Yet, in the first actual test case, CoCos never converted before its bank failed. We develop a model that predicts that CoCos lead to less (more) extreme stock returns and have yields greater than (similar to) standard subordinated debt yields if investors do (do not) expect them to convert or be written down prior to failure. These predictions are tested using data on CoCos issued by European banks during 2011 to 2017. We find evidence that equity conversion CoCos reduce stock return variance and several other measures of downside risk, consistent with the perception that they are going-concern capital. However, we also provide event study evidence that recent regulatory actions reduced the CoCo–subordinated debt yield spread, which indicates a diminished investor belief that CoCos are going-concern capital.

A unique legal reform in 2004 in Sweden redistributed collateral rights from banks holding floating liens to unsecured creditors without changing the value of assets on firms’ balance sheets. Using a country-wide panel of all incorporated firms, we document that a zero-sum redistribution of collateral rights and the resulting reduction in collateral capacity towards banks contracts the amount and maturity of corporate debt and leads firms to slow investment and forego growth. Altering their allocation of assets, firms reduce particularly those assets with a low collateralizable value for banks and also hoard more cash. However, the reform has no impact on corporate capital intensity or efficiency, suggesting that under these newly binding credit constraints firms simply shrink their operations.

Theory suggests that government aid to banks may either reduce or increase systemic risk. We are the first to address this issue empirically, analyzing the Troubled Assets Relief Program (TARP). Analysis suggests that TARP significantly reduced contributions to systemic risk, particularly for larger and safer banks, and those in better local economies. This occurred primarily through a capital cushion channel that reduced market leverage by increasing the value of common equity. Results are robust to endogeneity and selection bias checks. Findings yield policy conclusions about whether to aid banks, the best targets for future assistance, and short-term versus long-term effects.

This paper studies bank learning through repeated interactions with borrowers from a new perspective. To understand learning by lending, we adapt a methodology from labor economics to analyze how loan contract terms evolve as banks acquire new information about borrowers. We construct “proxy” variables for this information using data from borrowers’ out-of-sample, future credit performance. Due to the timing of their construction, banks could not have used these variables directly to price loans. We nonetheless find that these proxies increasingly predict loan prices as relationships progress, even after controlling for possible omitted variable bias. Our methodology provides strong evidence that: (a) bank learning affects loan prices, and (b) relationship benefits are heterogeneous. In particular, higher quality borrowers face differentially lower spreads as their relationship with lenders develop – and banks learn about their quality – while lower quality borrowers see loan prices increase and their loan amounts fall. We further find suggestive evidence that banks incorporate CEO-specific information into loan prices.