Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending Standards potx

Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending Standards Angela Maddaloni and José-Luis Peydró * July 2009 Abstract We analyze the root causes of the current crisis (Allen, 2009; Diamond and Rajan, 2009) by studying the determinants of bank lending standards in the Euro Area. We use the answers from the confidential Bank Lending Survey where national central banks request banks quarterly information on their lending standards. We find robust evidence that low short-term interest rates soften standards for both businesses and households and – by exploiting cross-country variation of Taylor-rule implied rates – we find that rates too low for too long soften standards even further. The softening is over and above an improvement of the borrower’s collateral risk and outlook, thus suggesting higher loan risk-taking by banks. In addition, we find that weaker banking supervision standards and higher securitization activity amplify the softening of lending standards due to low short-term rates, even when we instrument securitization. Finally, low short-term rates have a stronger impact than long-term rates on the softening of standards. These results help shed light on the origins of the current crisis and have important policy implications. * The authors are at the European Central Bank, Kaiserstrasse 29, D 60311 Frankfurt am Main, Germany. Contact information: angela.maddaloni@ecb.europa.eu, and jose.peydro@gmail.com / jose- luis.peydro-alcalde@ecb.europa.eu. We thank Lieven Baert and Francesca Fabbri for excellent research assistance. Any views expressed are only those of the authors and should not be attributed to the European Central Bank or the Eurosystem. 2 “One (error) was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful We all bear a responsibility for that” … “The supervisory system was just way behind the curve. You had huge pockets of risk built up outside the regulatory framework and not enough effort to try to contain that. But even in the core of the system, banks got to be too big and overleveraged. Now again, here’s an important contrast. Banks in the United States, even with investment banks now banks, bank assets are about one times GDP of the United States. In many other mature countries - in Europe, for example – they’re a multiple of that. So again, around the world, banks got to just be too big, took on too much risk relative to the size of their economies.” Timothy Geithner, United States Secretary of the Treasury, Charlie Rose’s PBS, May 2009 “I believe the causes cannot be found in any one market, such as the US. Nor are they limited to a particular business, such as subprime mortgages. These triggered the crisis, but they did not cause it. The causes are the same as in any previous financial crisis: excesses and losing the plot in an extraordinarily favourable environment. Indeed, some fundamental realities of banking were forgotten: cycles exist; lending cannot grow indefinitely; liquidity is not always abundant and cheap; financial innovation involves risk that cannot be ignored” Emilio Botín, Chairman of Bank Santander, Financial Times, October 2008 I. Introduction The current financial crisis has had a dramatic impact on the banking sector of most developed countries, it has severely impaired the functioning of interbank markets, and it has triggered an economic crisis in these same countries. What are the root causes of this crisis? Several commentators and academics have suggested that the global financial crisis was originated by an excessive softening of lending standards. Three key elements were mentioned as drivers: too low levels of interest rates, high securitisation activity, and weak bank regulation supervision standards. 2 Therefore, the crisis that started in the subprime mortgage market in the US may have been the manifestation of deep rooted problems, which were not peculiar to one financial instrument and/or country but were present globally, albeit to different degrees (Allen, 2009, and Diamond and Rajan, 2009). 3 Moreover, these root causes may have also been interrelated and mutually amplifying in affecting the risk-taking of financial institutions (Rajan, 2005). In this paper, we empirically test these hypotheses. 2 See for example Allen (2009), Brunnemeier (2009), Calomiris (2008), Taylor (2007 and 2008), Engel (2009), and numerous articles in The Financial Times, The Wall Street Journal, and The Economist. Nominal rates were the lowest in almost four decades and below Taylor rates in many countries while real rates were negative (Taylor, 2008; and Ahrend, Cournède and Price, 2008). 3 Allen (2009), Rajan (2009) and Diamond and Rajan (2009) distinguish between proximate versus root causes of the current crisis. 3 Low interest rates, weaker bank regulation supervision standards and high securitization activity may imply higher loan risk-taking by banks. Moral hazard problems are severe in the banking industry due to e.g. deposit insurance, potential bail-outs and very high levels of leverage; hence, high levels of liquidity increase incentives for bank risk-taking (Allen and Gale, 2007). 4 Without bank agency problems, excess of liquidity would be given back to shareholders or central banks, but – due to bank moral hazard problems – banks may over-lend the extra-liquidity in bad projects. Allen (2009) and Allen and Gale (2007 and 2004) connect too high levels of liquidity with too low levels of short-term interest rates. 5 In fact, the level of overnight rates is a key driver of liquidity for banks since banks increase their balance sheets (leverage) when financing conditions through short-term debt are more favourable (Shin, 2009; Adrian and Shin, 2009; and Brunnermeier et al., 2009). Therefore, low short-term interest rates increase bank risk-taking through this channel and, hence, stronger banking supervision standards – via reducing bank agency problems – should reduce the higher risk-taking associated to low rates. 6 Finally, low levels of both short and long-term rates may induce a search for yield from financial intermediaries due to their moral hazard problems. Securitization of loans result in assets yielding attractive returns for investors, but the social cost may be lower screening and monitoring of securitized loans. Hence, the impact of low rates on the softening on standards is stronger with higher securitization activity (Rajan, 2005). 4 For the link between liquidity and loan risk-taking by banks, see Chuck Prince, Citigroup Chairman, when describing why his bank continued financing leveraged buyouts despite mounting risks, said: “When the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Financial Times, July 9, 2007). 5 Due to bank agency problems, short-term rates soften lending standards either by abating adverse selection problems in credit markets thereby increasing bank competition (Dell’Ariccia and Marques, 2007), or by reducing the threat of deposit withdrawals (Diamond and Rajan, 2006). 6 There are other channels by which low levels of interest rates affect bank (loan) risk-taking. First, lower risk-less rates increase the attractiveness of risky assets in a mean-variance portfolio framework. Second, in habit formation models agents become more risk-averse during economic slowdowns because their consumption decreases relative to their status-quo (Campbell and Cochrane, 1999), thus a tightening in monetary policy by depressing real activity may increase investors’ risk aversion. Third, low rates may decrease banks’ intermediation margins (profits), thus reducing banks’ charter value, increasing in turn incentives for risk-taking (Keeley, 1990). Fourth, there could also be monetary illusion with low levels of short-term rates which would make banks to desire riskier products to increase returns (Shiller, 1997; and Akerlof and Shiller 2009). Fifth, an environment in which central banks focus only on consumer goods price stability may make monetary policy rates too low, fostering in turn asset price and credit bubbles (Borio 2003; Borio and Lowe, 2002). For Acharya and Richardson (2009) the fundamental cause of the crisis was the credit boom and the housing bubble. These were largely developed by too low levels of monetary policy rates (Taylor, 2007). 4 We empirically analyze the following questions: Do low levels of both short and long-term interest rates soften bank lending standards? Are the effects stronger with higher securitization activity or weaker banking supervision standards? And, do results differ across type of loans, i.e. across business, house purchase, and households’ consumption loans? There are four major challenges to identify the previous questions. First, monetary policy rates are endogenous to the (local) economic conditions. Second, banking supervision standards may be endogenous to monetary policy especially in cases when the central bank is responsible for both. Third, securitization activity is endogenous to monetary (bank liquidity) conditions, since these affect the ability of banks to grant loans. Fourth, it is very difficult to obtain data on the pool of potential borrowers approaching a bank, to know their quality, and then to know whether, why and how banks change their lending standards to customers. Our identification strategy relies upon the data we use, the Euro Area Bank Lending Survey, which allows us to tackle the four previous identification challenges. 7 First, we use data from the Euro Area countries, where monetary policy rates are identical. However, there are significant cross-country differences in terms of GDP growth and inflation, implying in turn significant exogenous cross-sectional variation of Taylor-rule implied rates (Taylor, 2008). Second, banking supervision standards in the Euro Area are responsibility of the national supervisory authorities (often national central banks), whereas monetary policy is decided by the Governing Council of the Eurosytem. 8 Third, there is significant cross-sectional variation in securitization activity partly stemming from cross-country differences in the regulation of the market for securitization. Fourth, we have access to the confidential Bank Lending Survey database of the Eurosystem. National central banks request quarterly information on the lending standards they apply to customers and on the loan demand they receive. The rich information allows us to analyze whether banks 7 Banks are not only the key financial intermediaries that reduce the information problems which are crucial for the real effects of monetary policy through credit markets (Bernanke and Gertler, 1995), but banks are also the main providers of credit in most economies and, in particular, in the Euro Area (see for example Hartmann, Maddaloni, Manganelli, 2003, and Allen, Chui and Maddaloni, 2004). 8 International guidelines like Basel are also very important for bank regulation, but there is rule for discretion in supervision standards, in particular for banking capital see Laeven and Levine (2009) and Barth, Caprio and Levine (2006). 5 change their lending standards, to whom (average or riskier borrowers), how (loan spreads, size, collateral, maturity or covenants), and why (due to changes in borrower risk, or in bank balance-sheet strength, or in bank competition). The evidence we provide suggests that banks take on higher risk when overnight rates are lower. This conclusion arises from the combination of the following robust results: First, a softening of lending standards is associated to low overnight rates. The association is highest for business loans. 9 Second, higher GDP growth also implies a softening of standards, i.e. standards are pro-cyclical. Our findings are economically relevant: taking into consideration the standard deviation of overnight rates and GDP growth, the impact of a change in the overnight rate doubles a change in GDP growth both for business and households’ consumption loans, but it is similar for loans for house purchase. Third, by exploiting cross-country variation of Taylor-rule implied rates, we find – especially for loans for house purchase – that a softening of lending standards due to short-term rates too low for too long (measured as the number of periods when short-term rates are lower than Taylor-rule implied rates). Fourth, low overnight rates have a stronger impact than low long-term rates on the softening of standards. 10 Fifth, all the lending standards are softened when short-term rates are low, both for average and for riskier borrowers. The softening implies lower loan margins, lower collateral requirements, longer loan maturity, less covenants and larger loan size. Finally, and more importantly, there is a softening of standards even when changes in standards are not associated to improvements in borrowers’ credit- 9 Jiménez, Ongena, Peydró and Saurina (2009) and Ioannidou, Ongena and Peydró (2009) are the first to investigate the impact of short-term (monetary policy) rates on loan risk-taking by banks. They use comprehensive credit registers for business loans from Spain and Bolivia respectively. They find that low levels of overnight rates increase loan risk-taking by banks. Our results complement these papers by analyzing not only business loans but also loans for house purchase and consumption, and also by analyzing all Euro Area countries. In addition, we do not have the comprehensive credit register but we have the potential pool of borrowers and we know whether, how and why banks change their lending standards. For indirect evidence on short-term rates and risk-taking, see Bernanke and Kuttner (2005), Rigobon and Sack (2004), Manganelli and Wolswijk (2007), Axelson, Jenkinson, Strömberg and Weisbach (2007), Den Haan, Sumner, and Yamashiro (2007), and Calomiris and Pornrojnangkool (2006). 10 Due to the saving glut and the existence of current account “imbalances”, savers were looking for investment opportunities abroad. However, they were seeking short-term assets (Gross, 2009) and, in fact, Brender and Pisani (2009) reports that about one third of all foreign exchange reserves are in the form of bank deposits. Little is known about the maturity composition of the remainder, most of which is invested in interest-bearing securities. The scarce available data on the composition of USD foreign exchange reserves that can be gleaned from the US Treasury International Capital data suggests that over half of foreign official holdings of US securities had a maturity of less than three years (see Gross, 2009). 6 worthiness, but due to improvements in bank balance-sheet constraints (higher bank liquidity or capital, or better bank access to market finance) and also due to higher banking competition, especially from non-banks and market finance. Hence, the softening of standards is over and above an improvement of the borrower’s collateral risk/ value and outlook, thus suggesting higher loan risk-taking by banks when short- term rates are low. 11 Using time-varying measures of banking supervision standards for bank capital, we find that the impact of low short-term rates on the softening of lending standards over and above improvements in borrower’s credit-worthiness is larger when supervision standards are weaker, both for loans for house purchase and for consumption. However, the level effect of supervision standards is not as significant as the direct effect of rates on lending standards. The lack of strong significance of the direct effect of banking supervision on lending standards may be consistent with the arguments made by Allen (2009) and Rajan (2009) concerning the need for “good” supervision regulation, which does not necessarily mean more stringent supervision. 12 Finally, in contrast with short-term rates, we don’t find that the impact of low long- term rates on the softening of standards depends on banking supervision standards. Finally, we analyze securitization activity. 13 We find that the impact of low short- term rates on the softening of standards for all type of loans is larger when securitization activity is higher. However, if we consider the tightening of standards only related to bank balance-sheet’s constraints, securitization activity in conjunction with overnight rates has a significant impact only for loans for house purchase and consumer credit. Moreover, we find significant effects for short-term rates but not for long-term rates. Finally, instrumenting securitization activity by the regulation of the market for securitization in each country does not significantly modify the results, where the instrument has a t-stat higher than 8 in the first-stage regression and, hence, 11 That is, the effect of low rates on the softening of standards is over and above the firm balance sheet channel of monetary policy (Bernanke and Gertler, 1995). Because of imperfect information, incomplete contracts and imperfect bank competition, expansive monetary policy increases banks’ loan supply (Bernanke, Gertler and Gilchrist, 1996; Bernanke, 2007; Kashyap and Stein, 2000; Diamond and Rajan, 2006; Stiglitz, 2001; and Stiglitz and Greenwald, 2003). 12 See also Barth, Caprio and Levine (2006). 13 For evidence of excessive softening of lending standards due to securitization, see Keys et al. (2008), Mian and Sufi (2009), and Dell'Ariccia, Laeven and Igan (2008). 7 it does not suffer from weak instrument concerns (Staiger and Stock, 1997). In consequence, the previous set of results suggests higher loan risk-taking by banks when securitization activity is high and short-term rates are low. The analysis of conditions and terms of the loans suggest that when short-term rates are low and securitization activity is high margins on loans to riskier firms are not affected while margins on riskier households – either for house purchase or for consumption – are softened. In addition, collateral requirements, covenants, maturity and loan-to-value ratio restrictions are softened. When analyzing at the factors by which banks change the standards, in a situation with low short-term rates and high securitization activity, the results we find highlight: (i) the importance of the “shadow banking system” in setting of the softening of bank lending standards (both stemming from higher competition from non-banks and from market finance, which both have a different level of regulation and supervision than banks), (ii) the importance of bank balance-sheet liquidity in the softening of standards, and (iii) the risk transfer effects linked to securitization in the sense that the collateral risk and value may matter less for banks when granting loans if banks can transfer these risks off. All in all we find that low short-term rates soften lending standards. The softening is over and above improvements in borrower’s collateral risk/ value and outlook, and all the relevant standards are softened. Hence, our results suggest that banks take on higher loan risk when overnight rates are low. In addition, the impact of low short-term rates on the softening of standards is stronger when securitization is high or banking supervision standards are weak, thus suggesting that low levels of short-term rates may create excessive bank risk-taking (Allen and Gale, 2007; Rajan, 2005). 14 Finally, low short-term rates matter statistically and economically more than 14 From Allen and Gale (2007) for example, low short-term interest rates create high risk-taking by banks because of moral hazard problems in banks. Hence, since we find that softer banking supervision standards make stronger the impact of low rates on higher risk-taking, the evidence suggests excessive risk-taking due to low short-term rates. In addition, since – as explained earlier – the higher impact of low rates on the softening of standards due to high securitization, that we find, may also be due to moral hazard problems (Rajan, 2005); our evidence, therefore, suggests excessive risk-taking when short-term rates are low as compared to a situation with low agency problems in the banking sector (i.e., banks grant more loans when short-term 8 low long-term rates on the softening of standards, both directly and indirectly via softer bank supervision standards and higher securitization levels. These results help shed light on the root causes of the current global crisis (Allen, 2009; Rajan, 2009; and Diamond and Rajan, 2009) and have important policy implications for monetary policy, banking regulation and supervision, and for financial stability. The rest of the paper proceeds as follows. Section II describes the data, introduces the variables employed in the empirical specifications, and reviews the empirical strategy. Section III discusses the results and Section IV concludes. II. Data and Empirical Strategy A. The Bank Lending Survey (BLS) dataset The main dataset used in the paper are the answers from the Euro Area BLS. The national central banks of the Eurosystem request information on bank lending standards since 2002 through the Euro Area BLS, a quarterly survey on banks' lending practices based on the answers of a representative sample of banks in each country. The questions asked were chosen on the basis of theoretical considerations related to the monetary policy transmission channels and on the experiences of other central banks running similar surveys, in particular in the US and in Japan. The main set of questions did not change since the start of the survey in 2002:Q4. 15 The survey contains 18 specific questions on past and expected credit market developments. Past developments refer to credit conditions over the past three months, while expected developments focus on the next three months. There are two main borrower sectors that are the focus of the survey: enterprises and households. Loans to households are further disentangled in loans for house purchase and for consumer credit, consistently with the classification of loans in the official statistics for the Euro Area. rates are low and may care less about the standards they set if they can securitize the loans thereby transferring the risk off). 15 Berg, van Rixtel, Ferrando, de Bondt and Scopel (2005) describe in detail the setup of the survey. Sauer (2009) provides an update of the most recent developments and the few changes to the survey (request of additional information via ad-hoc questions). 9 The backward-looking questions cover the period from the last quarter of 2002 to the first quarter of 2009. In order to use a balanced panel, the analysis is restricted to the 12 countries which comprised the Euro Area in 2002:Q4. Over this period we consistently have data for 12 Euro Area countries (Austria, Belgium, France, Finland, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain). The sample of banks is representative of the banking sector in each country. Therefore it comprises banks of different size, although national guidelines on the formation of the sample expressed a preference to include the largest banks in each country. The questions imply only qualitative answers and no figures are required. The survey is carried out by the national central banks of the Euro Area countries. Typically the questionnaire is sent to senior loan officers, like for example the chairperson of the bank’s credit committee. The response rate has been virtually 100% all the time. The questionnaire covers both supply and demand factors. Concerning the supply factors, which are addressed in ten different questions, attention is given to changes in lending standards, to the factors responsible for these changes and to the credit conditions and terms applied to customers. Lending standards are defined as the internal guidelines or criteria that guide a bank's loan policy and are addressed in two questions, each referring to a different borrower (enterprises and households, further disentangled in loans for house purchase and consumer loans). 16 The question asked is: “Over the past three months, how have your bank’s lending standards as applied to the approval of loans (to enterprises or to households) changed?” Banks can chose their answers among five choices, ranging from “eased considerably” to “tightened considerably.” (See Appendix for a detailed description of the questions used in the paper). 17 The successive set of questions gives respondents the opportunity to assess how specific factors affected lending standards as applied to the approval of loans to both 16 In cases when foreign banks are part of the sample, the lending standards refer to the loans' policy in the domestic market which may differ from guidelines established for the headquarter bank. 17 See http://www.ecb.int/stats/money/lend/html/index.en.html for all the information related to the BLS. 10 enterprises and households. In particular whether the changes in standards were due to changes in bank balance-sheet strength (either bank liquidity, capital, or access to market finance), to changes in competitive pressures (either from other banks or from non-banks), to changes in expected general economic conditions or changes in borrower risk (borrower’s collateral risk/ value or borrower’s outlook). We will use this information to assess whether the changes of standards are just due to changes in borrower credit-worthiness to assess bank risk-taking and also to understand the channels by which low rates, high securitization and weak supervision affect loan risk-taking by banks. Finally, we have information on the changes in the terms and conditions of a loan. These are the contractual obligations agreed upon by the lender and the borrower, such as the interest rate (both for average and for riskier borrowers), the loan collateral, size, maturity and covenants. We use this information to assess whether the different standards are adjusted for the risk taken. Concerning demand factors, which are the topic of seven questions, various factors related to financing needs and the use of alternative finance are mentioned. Three questions look at borrowing demand from enterprises and four at demand from households. Finally, the survey also allows participating banks to give free-formatted comments in response to an open-ended question. 18 The Euro Area results of the survey (which are a weighted average of the results obtained for each Euro Area country) are published every quarter on the website of the ECB. In few countries, the answers from the Survey at the national level are published by the respective national central banks. However, the overall sample including all the answers at the country and bank level is confidential. For the purpose of this paper we concentrate only on few questions from the BLS that we describe in detail in Appendix I. The questions are related either to the previous three months or to the expected change in lending standards for the next three months. We find very similar results using either of the two set of questions and 18 For the purpose of this paper we do not use the answers to questions related to the demand; however, in non-reported regressions we control for demand answers. The results are qualitatively similar. [...]... Maddaloni and Peydró, 2009) 23 national central banks request from banks quarterly information on the lending standards they apply to customers and on the loan demand they observe We find robust evidence that low short-term interest rates soften standards for loans to both business and households, and the softening is over and above an improvement of the borrower’s collateral risk/ value and outlook,... change in lending standards due to changes in banks’ balance sheet constraints, i.e changes in standards not associated to borrowers’ quality (it corresponds to Question 2 and 9 of BLS, see Appendix) From column 7 to 12 we see that low overnight rates softens lending standards because of improvements in banks’ balance sheet position In this case lending standards are softened because of “pure” bank- supply... results highlight: (i) the importance of the “shadow banking system” in setting of the softening of bank lending standards (both stemming from higher competition from non-banks and from market finance, which both have a different level of regulation and supervision than banks), (ii) the importance of bank balance-sheet liquidity in the softening of standards, and (iii) the risk transfer effects linked to... As explained earlier, national central banks request from banks quarterly information on the lending standards they apply to customers and on the loan demand they receive The survey started in 2002:Q4 and it collects the answers from a representative sample of around 90 banks This rich information allow us to analyze not only whether banks change the lending standards for the pool of borrowers they... shortterm rates are low and securitization activity is high 36 Bank risk problems may transmit through the system through interbank contagion and other mechanisms, see Iyer and Peydró (2009) and Bandt, Hartmann and Peydró (2009) Once the banking system is in trouble, a credit crunch stemming from low bank capital and liquidity has a high likelihood to happen (see Jiménez, Ongena, Peydró and Saurina, 2009b)... consider changes in lending standards due to bank balance-sheet constraints We find that higher securitization activity makes stronger the impact of low short-term rates on the softening of lending standards both for loans for house purchase and for consumption This implies that there is softening of standards over and above improvements of borrower risk due low short-term rates and high securitization... Area, and also in banking supervision standards All in all, the dynamics of the lending standards, of the securitization activity, supervision and of the business cycles show significant heterogeneity across Euro Area countries from 2002 to 2009 C Empirical strategy We want to empirically address the impact on the softening of lending standards of both short and long-term rates, of securitization and. .. the impact of low short-term rates on the softening of standards is stronger when securitization is high or banking supervision standards are weak It suggests excessive risk-taking as compared to a situation with zero or low bank agency problems: From Allen and Gale (2007) for example, low short-term interest rates create high risk-taking by banks 22 because of moral hazard problems in banks Hence,... short-term rates are low, as compared to a situation with low agency problems in the banking sector.35 All in all, we find that low short-term interest rates, high securitization, and weaker banking regulation directly and in conjunction soften the lending standards This softening is over and above improvements in the borrowers’ credit-worthiness, thus indicating higher loan risk-taking by banks Moreover,... growth, inflation, securitization and bank regulation We use the answers from the confidential Bank Lending Survey where 35 As explained earlier, banks grant more loans when short-term rates are low and banks may care less about the lending standards they set if they can securitize the loans thereby transferring the risk outside In addition, the competition from the non-banking sector may intensify this . Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending Standards Angela Maddaloni and José-Luis Peydró * . banks request banks quarterly information on their lending standards. We find robust evidence that low short-term interest rates soften standards for both businesses and households and – by exploiting. whether, how and why banks change their lending standards. For indirect evidence on short-term rates and risk-taking, see Bernanke and Kuttner (2005), Rigobon and Sack (2004), Manganelli and Wolswijk