Knowledge that Transforms

We document that reliance on internal ratings-based (IRB) models to compute credit risk and capital requirements reduces bank opacity. Greater reliance on IRB models is associated with lower absolute forecast error and reduced disagreement among analysts regarding expected bank earnings per share. These results are stronger for banks that apply internal ratings to the most opaque loans and adopt the advanced version of IRB models, which entail a more granular risk assessment and greater disclosure of risk parameters. The results stem from the higher earnings informativeness and the more comprehensive disclosure of credit risk in banks adopting internal ratings. We employ an instrumental variables approach to validate our findings.

We present a model in which intermediaries create liquidity by issuing safe debt. Two types of intermediaries emerge: Traditional banks that create liquidity by issuing equity and holding assets to maturity, and market-based intermediaries that create liquidity by selling assets in fire sales in downturns. We show that the reliance on market-based intermediation is necessarily too high, but liquidity creation is not. It can also be too low as the endogenous fire-sale risk can push liquidity creation below its optimum. We argue that standard capital or liquidity regulation are ineffective, and optimal macroprudential regulation should instead target market-based intermediation.

We study restructuring solutions to the debt overhang problem faced by banks with a deteriorated loan portfolio in the presence of asymmetric information on loan quality. Classical liability restructuring solutions fail to work because banks can overstate the severity of their bad loan problem to obtain additional concessions from existing creditors. A sufficiently large loan sale requirement to the restructuring banks discourages such an opportunistic behavior, so a suitably chosen menu of loan sales cum liability restructuring is able to solve the debt overhang. We discuss the implementation of such a solution for banks funded with insured deposits through loan sales to outside investors supported by an asset protection scheme sponsored by the deposit insurance fund.

We review the literature on financial intermediation in the process by which new medical therapeutics are financed, developed, and delivered. We discuss the contributing factors that lead to a key finding in the literature—underinvestment in biomedical R&D—and focus on the role that banks and other intermediaries can play in financing biomedical R&D and potentially closing this funding gap. We conclude with a discussion of the role of financial intermediation in the delivery of healthcare to patients.

Firms insure themselves from liquidity shocks by contracting on credit lines from banks. I document novel empirical evidence on how the risk of contract nonperformance by banks is priced. Firms pay a higher price for loan commitments from safer banks. A one standard deviation increase in the cross-sectional mean of bank capital increases the commitment fees by 5%. To investigate a potential causal effect of lender stability on commitment fees, I exploit exogenous variation in the market value of banks’ assets from natural disasters. The sensitivity of the fees is higher for firms with higher short-term liabilities and higher income uncertainty.

Using unique administrative data on firm-to-firm payments and bank-to-firm lending, we investigate how lending to a firm is affected by same-bank lending to the firm's customers and suppliers. We show that the supply of loans to a firm increases when the firm's customers have loans from the same bank. We also find that negative information about a firm's top customer causes banks to tighten the loan supply to the firm, and particularly more so when the firm's sales are concentrated on this customer. These results suggest that lending to firms connected through the supply chain conveys valuable information to banks.

In 1936–37, the Federal Reserve doubled member banks’ reserve requirements. Friedman and Schwartz (1963) famously argued that the doubling increased reserve demand and forced the money supply to contract, which they argued caused the recession of 1937–38. Using a new database on individual banks, we find that higher reserve requirements did not generally increase banks’ reserve demand or contract lending because reserve requirements were not binding for most banks. Aggregate effects on credit supply from reserve requirement increases were therefore economically small and statistically zero.

We address whether politics played important roles in allocating Paycheck Protection Program (PPP) bailout funds, and whether PPP allocations effectively bailed out small businesses vs. banks. Our econometric evidence suggests that politicians/other government agents at national and local levels effectively steered PPP funds toward small businesses and banks based on their locations to try to influence election outcomes. We also uncover evidence that some PPP funds were effectively allocated by lobbying efforts of certain banks. Findings are confirmed by a novel mediation analysis and numerous robustness checks. We also find banks profited from PPP through multiple channels, adding to extant findings, and suggesting that PPP may have effectively bailed out banks as well as small businesses, but through different political influences.

The Jobs Growth and Tax Relief Reconciliation Act of 2003 cut the top dividend tax rate in the U.S. by more than half, yet numerous studies of nonfinancial firms have failed to detect the expected supply-side stimulus to capital investment. We test the impact of this tax cut on U.S. commercial banks and find that bank lending responded differently, conditional on banks’ access to external capital as well as their reliance on internal liquidity. Our heterogeneous results include support for all three branches of dividend tax theory. Loan growth increased the most at publicly traded banks with relatively illiquid balance sheets and increased by the least (or not at all) at untraded banks with relatively liquid balance sheets. Consistent with previous studies, we find increased dividend payouts at all subsets of banks. We conjecture that the effectively short maturities of bank loan contracts made banks better able to respond positively to this tax cut and provide some suggestive evidence in support of this conjecture.

Increasing the cost associated with gathering information can hamper the monitoring activity of the market even when information remains public. Using the 2015 US money market funds (MMFs) reform as a quasi-natural experiment, I find a positive effect of removing information requirements over credit ratings on the allocation by MMFs toward securities rated as second tier. The effect is driven by monitored MMFs catering to retail investors and by monitored MMFs that do not voluntarily report credit ratings after the reform. The verfied increase in the relative demand by MMFs for second tier securities is associated with a decrease in the spread paid at issuance by second tier commercial paper.