The global financial crisis originated in the US sub-prime mortgage market, where banks had gradually relaxed their screening and monitoring standards (Keys et al., 2010). In a recent working paper, Neeltje van Horen (Dutch central bank) and myself analyse whether, when sub-prime losses materialised in the autumn of 2007, banks reassessed their screening and monitoring standards (De Haas and Van Horen, 2010). To answer this question we study changes in the syndicated loan market. This market is particularly well-suited to assess changes in screening and monitoring because the structure of lending syndicates reflects the importance that banks attach to the screening and monitoring of borrowers (Sufi, 2007). A short primer on syndications will make this clear.

Syndicated lending and “skin in the game”

Syndicated loans are provided by a group of financial institutions – the syndicate – to a single borrower. A typical syndicate consists of two tiers: arrangers and participants. The arrangers comprise the senior tier and negotiate the lending terms with the borrower. Arrangers usually allocate a substantial part of a loan to a junior tier of syndicate members, the participants. Participants have a more passive role: they buy a portion of the loan but are neither involved in its organisation nor in the screening and monitoring of the borrower.

Participants use arrangers as delegated monitors (Diamond, 1984). A downside of this functional division is that arranging banks have a reduced incentive to screen and monitor. To resolve this agency problem arrangers can retain a large enough loan portion on their own balance sheet (retention rate). Such “skin in the game” is an efficient mechanism to ensure that arrangers sufficiently screen and monitor (Pennacchi, 1988). We consequently argue that if participant banks became more concerned about screening and monitoring at the start of the crisis – a wake-up call – this should be reflected in a significant increase in retention rates.

By syndicating part of the loans they structure, arrangers free up space on their balance sheet. This allows them to originate additional loans and earn fee income. When arrangers only need to retain a small portion of each loan, they can originate many syndicated loans and the supply of lending is high. Conversely, when capital-constrained arrangers are required to retain a large loan portion, they can syndicate fewer loans and the supply of syndicated credit is lower. Fluctuations in retention rates may thus be inversely related to the supply of syndicated lending. Indeed, Chart 1 shows how at the onset of the crisis in mid-2007 a sharp increase in retention rates was accompanied by a steep decline in syndicated lending.#

  Graph 1. Retention rate and syndicated lending volume (click to expand)

Main findings

The econometric analysis in our paper shows that – even when we control for changes in inter-bank liquidity and borrower risk – the outbreak of the crisis led to a significant and robust increase in arrangers’ retention rates. This increase materialised during the early phase of the crisis – before the collapse of Lehman Brothers and the ensuing sharp output decline – and persisted over time.

In a next step we test whether loan retention increased in particular when information asymmetries between the syndicate and the borrower were large. Lenders likely became most concerned about adequate screening and borrowing in the case of such opaque loans. Similarly we expect that when information asymmetries were large within a syndicate – that is: between participants and arrangers – retention rates increased more as well. To analyse both layers of agency problems – between lenders and borrowers and among lenders – we exploit detailed information on market, borrower and lender heterogeneity.

As expected, we find that retention rates increased significantly more – both in statistical and economic terms – when information asymmetries were high. Table 1 shows the economic magnitude of some of the significant differences we document in the working paper. While the retention rate for loans to first-time borrowers increased by almost 11 per cent, arrangers of syndicated loans to borrowers with average borrowing experience (two and a half loans) only needed to increase their retention rate by 7.6 per cent. The necessary increase in loan retention was even much smaller in case either the arrangers or the participants themselves had previously lent to a specific borrower (or in case they had substantial prior experience in lending to a borrowers’ industry or country). Finally we find that experienced arrangers needed to increase their retention rates much less than less experienced arrangers. Reputation limited the crisis-related increase in agency problems within lending syndicates.

Chart 1. Economic significance of crisis impact on retention rates (click to expand)

Policy implications

We find that more transparent borrowers, more experienced participants, and more reputable arrangers all helped to contain the crisis-related correction in screening and monitoring intensity and thus in retention rates. This strong link between the severity of information asymmetries and the increase in retention rates further underlines that the overall increase in retention rates at the onset of the crisis, and the subsequent decline in syndicated lending, was at least partially caused by stricter screening and monitoring. To the extent that this reflects a reversal of the pre-crisis loosening of lending standards, banks’ continuing reluctance to lend may prove to be quite persistent even when banks’ own funding constraints would gradually become less binding.

Our findings also bear on the current regulatory debate about minimum “skin in the game” retention rates for originating banks. In July 2009 the European Parliament amended the Capital Requirements Directive by including a 5 per cent retention requirement for securitisations, while in May 2010 the US Senate passed the Financial Reform Bill which announces the introduction of similar regulations. Earlier plans to let minimum retention requirements not only apply to securitisations but also to syndicated loans have (at least for the time being) been shelved. At first sight our results confirm that regulatory retention requirements may indeed not be necessary for syndicated loans. After all, we document a strong, broad-based but market-driven increase in retention rates among syndicate arrangers. Participants, concerned about arrangers’ lax screening and monitoring, were in many cases able to take corrective action without regulatory intervention. Although syndicated lending declined sharply, the market did not break down. This stands in contrast to the securitisation market, where the link between the originator and the ultimate investors was too severed to make any corrective (and collective) action possible.

However, when the market for syndicated lending will expand again, and financial institutions once more start to compete heavily to participate in (oversubscribed) syndicated loans, the pressure on arrangers to retain loan portions that are high enough to guarantee sufficient screening and monitoring may gradually erode. Without the introduction of some form of mandatory retention rates for syndicated loans, the risk exists that old practices will soon return. This may in particular be the case if the secondary market for syndicated loans, where both arrangers and participants can offload their loan stakes, revives again. One way to reduce such a negative impact of subsequent loan sales is to require arrangers to hold on to the loan portion they retained at origination. Although such a requirement could be introduced through legislation, participants themselves could also more often demand that restrictions on subsequent loan sales by arrangers are included in loan contracts.

References

De Haas, R.T.A. and N. Van Horen (2010), The crisis as a wake-up call. Do banks tighten screening and monitoring during a financial crisis? EBRD Working Paper No. 117, London.

Keys, B.J., Mukherjee, T., Seru, A. and V. Vig (2010), “Did securitization lead to lax screening? Evidence from subprime loans”, Quarterly Journal of Economics 125, 307-362.

Pennacchi, G. (1988), “Loan sales and the cost of bank capital”, Journal of Finance 43, 375-396.

Sufi, A. (2007), “Information asymmetry and financing arrangements: Evidence from syndicated loans”, Journal of Finance 62, 629-668.

First, one needs to make a clear distinction between cross-border foreign bank lending and local lending. In the former case, multinational banks lend from their headquarters to a company abroad. In the latter case, they use a local network of branches and subsidiaries. The latter form of foreign bank lending is much more stable than the former (García Herrero and Martinez Peria, 2007). Peek and Rosengren (2000) find for Latin America that cross-border lending did in some cases diminish during economic slowdowns, whereas local lending by foreign banks was much more stable. For Central and Eastern Europe, De Haas and Van Lelyveld (2004) find that reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries, either because new subsidiaries were established or because the lending of existing affiliates increased.

Emerging markets that allow cross-border bank lending, but put up (in)formal barriers to brick-and-mortar foreign bank entry thus do themselves a disservice. Of course, such countries could choose to not allow any form of foreign bank lending, neither cross-border nor through local affiliates. This brings me to a second important issue.

Discussions about the supposed fickleness of foreign banks often ignore the question of what is an adequate comparison group or counterfactual. Since all bank lending tends to be procyclical, in particular during crisis periods, an important question is whether foreign bank lending is less (or more) stable compared to lending by domestic banks. It may be less stable, because parent banks reallocate capital to other countries when an emerging market goes through a business cycle downturn. Parent banks redistribute group capital across various subsidiaries on the basis of expected investment opportunities (De Haas and Naaborg, 2006). It may be more stable, because parent banks usually can support subsidiaries that somehow get into financial difficulties (domestic banks lack such parents with deep pockets). This latter argument has often been used to argue why foreign bank entry in transition countries has contributed to more stable financial systems in this region.

In a forthcoming article, Iman van Lelyveld and myself analyse a large bank-level dataset of foreign bank subsidiaries across the world, to compare lending by foreign bank subsidiaries with lending by domestic banks. The dataset includes 45 multinational banks from 18 home countries with 194 subsidiaries across 46 countries (see figure 1). For each host country, we also collect data for a benchmark group of up to five of the largest domestic banks. In the empirical analysis, we look at how yearly credit growth is affected by a number of bank-specific financial variables, macroeconomic determinants, as well as an indicator of whether the host country is experiencing a banking crisis.

We find that subsidiaries of stronger parent banks – with high net interest margins or low loan loss provisioning – grow faster and that parent banks trade off lending across countries. Importantly, as a result of parental support, foreign bank subsidiaries do not typically rein in their lending during a financial crisis. In sharp contrast, we find that domestic bank lending decreases substantially during local banking crises. Apparently, subsidiaries can rely on parental support during a financial crisis, a form of support that is not available to domestic banks. This finding confirms similar results reported by De Haas and Van Lelyveld (2006) for a sample of transition countries.

Figure 1: Parent banks (black) and their foreign subsidiaries (white)

(click to enlarge)

These findings imply that across the board, openness to multinational bank subsidiaries may actually benefit host countries. Multinational banks provide a stabilizing factor during local financial turmoil in particular. Our results also show, however, that the health of parent banks matters a lot: weak parent banks can provide less support and their subsidiaries grow more slowly. Lending by foreign subsidiaries may even be scaled back in order to free up capital for the parent bank, leading to contagion from home to host countries. Of course, this caveat has become quite acute during the current global financial crisis, which has clearly been testing the resilience of the support effects that we document in our research.

So far, however, the anecdotal evidence suggests that multinational banks and their foreign subsidiaries have been behaving more or less as can be expected on the basis of historical patterns. That is, cross-border lending – in particular syndicated lending – has decreased significantly, but many multinational banks have so far continued to support foreign subsidiaries. Given the extreme circumstances of the current crisis, in some cases this parental support has been complemented by coordinated efforts of a number of International Financial Institutions. And, as in earlier crises, lending by domestic banks seems to have been hit equally hard, if not harder. Across many transition countries – from Latvia, to Hungary, Ukraine, and Kazakhstan – the domestic shareholders of some of the largest domestic financial institutions have been unable to come up with the additional capital support that these systemic banks needed. As a result, bank lending by these banks has contracted severely, some of them (almost) defaulted, and local governments needed to step in. While foreign bank entry is not a panacea to all banking problems emerging markets struggle with, the empirical evidence seems to suggest that the presence of foreign bank subsidiaries may add to financial stability rather than reduce it.

References

De Haas, Ralph and Iman van Lelyveld (2004), Foreign bank penetration and private sector credit in Central and Eastern Europe, Journal of Emerging Market Finance, 3(2), 125-151.

De Haas, Ralph and Iman van Lelyveld (2006), Foreign banks and credit stability in Central and Eastern Europe. A panel data analysis, Journal of Banking and Finance, 30, 1927-1952.

De Haas, Ralph and Iman van Lelyveld (2009), Internal capital markets and lending by multinational bank subsidiaries, Journal of Financial Intermediation, forthcoming.

De Haas, Ralph and Ilko Naaborg (2006), Foreign banks in transition countries: To whom do they lend and how are they financed?, Financial Markets, Institutions and Instruments, 15(4), 159-199.

García Herrero, Alicia and Maria Soledad Martínez Pería (2007), The mix of international banks’ foreign claims: determinants and implications, Journal of Banking and Finance, 31(6), 1613-1631.

Peek, Joe and Eric Rosengren (2000), Implications of the globalization of the banking sector: The Latin American experience, New England Economic Review, September/October, 45-63.

• Click here – to be notified each time a new article is posted to the EBRD blog.