Fed Researcher Thinks Banks Are Getting Lazier
I enjoyed this blog post by the New York Fed's João A.C. Santos, and this related paper by Santos and two other authors, 1 about how banks are getting lazier about lending. The story is that in recent years there's been a trend toward market-based pricing in bank loans to large investment-grade companies: Instead of saying "you can borrow at Libor plus 1 percent," banks will tell those companies "you can borrow at Libor plus your one-year credit default swap spread."
This looks win-win. The advantage of this for borrowers is that it's cheaper: "Market-based pricing loans have interest rate spreads that are approximately 32 basis points lower than those on similar standard loans" at origination, and continue to be cheaper over time: 2
The advantage for banks is equally obvious: It reduces the risk of their loans. They avoid the risk that what looked like a safe credit at origination will turn out to contain uncompensated risks, because the compensation will automatically shift with the risk. As the authors put it, "market-based pricing adjusts loan interest rates according to the evolution of borrower CDS spreads and in essence it gives the lender a long exposure to a credit default swap on the borrower."
Except that's not actually the advantage for banks: The researchers look at the data and find that they "do not appear to support the hypothesis that the additional protection market-based pricing offers lenders against borrower default risk explains why banks are able to extend these loans at lower interest rates." I am not absolutely convinced by this? 3 But anyway.
They find instead that market-based loans are cheaper because they reduce banks' costs of monitoring the loans: Instead of keeping track of what companies are up to, and having covenants to restrict them from getting up to risky stuff, banks can just outsource all of their worrying to CDS markets. If CDS gets wider, then the company must be doing risky stuff, and you should charge them more. No need to figure out what the stuff is. 4 And the authors find evidence of that; in particular, "market-based pricing loans are associated with fewer total covenants."
This is ... a little awkward. Banks are relying on market price signals to do their credit monitoring for them. Meanwhile, the markets are relying on banks to do their credit monitoring for them. Bonds, for instance, often have weaker covenants than bank loans because bond investors rely on the banks to keep the issuers honest:
In addition, information obtained from the CDS market is unlikely to be a perfect substitute for bank monitoring because banks have better access to borrower information and possibly greater monitoring incentives than other claimholders. As a result, the adoption of market-based pricing, by reducing banks' monitoring incentives, might have a negative effect on investors that free ride on bank monitoring, and consequently on the cost of non-bank funding sources.
A story you could tell about the recent history of financial markets is the decline of traditional gate-keeping businesses: Functions that were once performed by hand by trusted institutions are now performed facelessly and automatically by diffuse markets. It used to be that your bank determined your borrowing cost; now the CDS market does. It used to be that your creditworthiness was determined by your credit rating, but the ratings agencies' failures in the last crisis have led to both public mockery and official derecognition of their importance. It used to be that investment banks were expected to do due diligence on the companies they took public, but now even that is a disputed proposition. Also, crowdfunding is a thing.
This makes a lot of sense, a lot of the time. If you're a believer in efficient markets, you get suspicious of people whose business model revolves around them being smarter than the market. And that suspicion is increasingly well grounded: Mutual funds, for instance, are getting worse at outperforming passive benchmarks. 5 (Also hedge funds.) It makes sense that banks would gradually have less of an advantage over diffuse public markets, even in their core business of, like, making and pricing loans to companies. And I guess it's nice for them to recognize that and just defer to markets.
And, look: It's more efficient! It makes lending cheaper! Good job all around. Still, one can feel a little nostalgia for the traditional gate-keeping roles. For one thing, it's not obvious that transparency is always and everywhere good. Part of the advantage of traditional banking is its opacity, its ability to put risk-averse capital to work funding risky ventures. It's quite possible that non-mark-to-market relationship loans with banks are less flighty than market funding, and that making those loans more market-ish will also make them less stable. 6
Also, it is just a little nervous-making when everyone is relying on everyone else to monitor risk: "The market says it" is both globally more reassuring, and locally less reassuring, than "I did a bunch of work on this borrower and here's what I think." It's nice to imagine that banks have a special social function, and that we put up with their occasional foibles because it's uniquely their job to figure out who deserves credit and how much that credit should cost. If they don't have that, then what do they have?
Ivan Ivanov of the SEC and Thu Vo of the University of Rochester.
Don't ask me why that chart doesn't say 32 basis points at day 0. The idea is they build a "counterfactual" fixed-spread loan and see which is cheaper over time, to control for the possibility that the market-based loan is initially cheaper but gets wider over time.
Actually, you'd expect something like what you see here, which is that the market-based loan gets (a little) tighter over time. All else being equal -- and it's not, but whatever -- a company that can borrow for 3 or 5 years at Libor plus a fixed spread has incentives to take risks with its credit, while a company that can borrow at Libor plus its own credit spread internalizes more of the costs of blowing out its credit spread. So market-based pricing should have (tiny, tiny) positive incentive effects, and that's sort of what this chart looks like. There's also some amount of exogenous timing though; the period is like 2008 to 2012 so there are some general credit tailwinds too.
Like here is the reasoning: "If this hypothesis is supported by the data, we expect to find that the decline in interest rate spreads is larger for riskier borrowers because the long position in a borrower credit default swap is more valuable than in the case of a stable firm." So they look and see that there's no statistically significant interaction between (1) how risky a firm is (measured by leverage, stock volatility, etc.) and (2) how big the firm's savings are by using a CDS-priced loan.
But that logic seems odd, no? Yes, CDS on a firm with a 500 basis point CDS spread is worth more than CDS on a firm with a 100 basis point CDS spread. Like 400 basis points more? But that firm would have a higher loan spread to begin with, whether it's a flat spread or a CDS-based moving spread. What they want to measure here is not "how risky is your credit," but "how asymmetrically likely is it that your credit will get worse in the next 5 years."
In other words, in each case the bank gets to choose between (1) getting paid the actual CDS spread over the life of the loan and (2) getting paid up front a flat amount equal to the "expected" CDS spread. I'm not sure why the expected spread would exceed the actual spread by more for companies whose expected spreads were higher, though I guess there's some intuitive reason to think that it might.
Also there is the fact that these loans started to become a thing in 2008. Qualitatively you'd characterize that as a time when banks were worried about credit risk becoming vastly worse in the near future, not a time where banks were just feeling lazy about monitoring.
Anyway. The writers add: "It is also possible that we are unable to find support for this explanation because most market-based loans belong to safe borrowers."
From the article:
Bank monitoring entails screening borrowers ex ante in order to identify good credits. It also entails both setting covenants, to prevent borrowers from undertaking opportunistic behavior during the realization of projects, and penalizing borrowers when they fail to meet contractual obligations. These activities are costly because they require banks to get detailed information on borrowers prior to loan origination and to follow borrowers closely during the life of the loan.
Since CDS prices reflect the compensation investors require to bear a firm's default risk, the development of the CDS market has provided banks with an opportunity to use information on CDS to price loan contracts. If the interest cost reduction of MBP borrowers stems from lenders' savings on monitoring costs, then we should find a decline in banks' monitoring intensity whenever contract pricing is tied to CDS.
Here is a new paper finding that, "As the size of the active mutual fund industry increases, a fund's ability to outperform passive benchmarks declines."
As Santos puts it in his blog post: "Further, market-based pricing has the potential for creating spirals in the cost of bank credit. Adverse shocks to the CDS market could lead to an increase in the cost of bank credit, putting pressure on the financial condition of borrowers. This outcome could, in turn, lead to further increases in borrowers' CDS spreads and another wave of increases in the cost of bank credit."
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