The crisis as a wake-up call

By: Ralph De Haas Deputy Director of Research

This post argues that the outbreak of the sub-prime mortgage crisis prompted banks to screen and monitor their corporate borrowers more carefully. This “wake-up call” was particularly strong for relatively opaque loans. It already materialised before the Lehman Brothers collapse and the subsequent decline in global growth and may have contributed to the reduction in corporate lending during the later phases of the crisis.

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.

Share on Facebook

Comments

• Tags

  Add new tag analysis banks Belarus bis blog Bourneville Cadbury central banks cold war communism corporate blogging credit crunch currencies EBRD ECB economic diversification economic growth economics emerging markets EU European Central Bank forecasts Georgia history Hungary IFI IMF industrial policy Kazakhstan Latvia Manufacturing media Mining Mongolia non-performing loans One-company towns Port Sunlight Press press freedom rail Russia stress testing TVE Ukraine

• Recent Posts

  • Postcard from Davos
  • Where does the Eurasian economic community stand?