The crisis as a wake-up call Do banks increase screening and monitoring during a financial crisis?

1. The crisis as a wake-up callDo banks increase screening and monitoring during a financial crisis? Ralph de Haas (EBRD)Neeltje van Horen (De Nederlandsche Bank) 15th Dubrovnik Economic Conference 24-26 June 2009

2. Outline • Introduction • Main hypothesis • Data • Empirical strategy • Results • Conclusions

3. Outline • Introduction • Main hypothesis • Data • Empirical strategy • Results • Conclusions

4. Total syndicated lending (billion US$) Crisis Introduction 2008: new syndicated lending down by 41%

5. Introduction • Crisis: increased uncertainty about borrower quality • Banks sharply reduced lending to new borrowers • Reducing credit to existing clients is costly: • Previous gathering of proprietary information (Rajan 1992) • Acceptance of short-term losses in anticipation of long-term profitable relationships (Boot, 1990) • Was lending decreased across the board or did banks also step up efforts to pick better customers and monitor them more carefully? • If so: did this impact certain borrowers in particular?

6. Introduction: contribution to literature • Literature on impact of crises on bank behavior • Considerable evidence on impact of crises on amount of bank lending (e.g. Calomiris and Wilson, 2004; Ivashina and Sharfstein, 2008; De Haas and Van Lelyveld, 2009) • But not much empirical evidence on the underlying strategies of banks • Growing literature on structure of syndicated lendingOthers looked at the structure of lending syndicates to analyze how banks deal with: • asymmetric information (Dennis and Mullineaux, 2000; Sufi, 2007) • weak creditor rights (Esty and Megginson, 2003) • risk of strategic defaults (Preece and Mullineaux, 2003) • cultural differences (Giannetti and Yafeh, 2008) We look at the structure of lending syndicates to analyze how banks deal with a financial crisis and the associated increase in uncertainty about borrower quality

7. Introduction: why syndicated lending? • Large market used by a wide variety of firms (publicly listed and private, rated and unrated) in a large number of countries • Hybrid character: combination of public financing and traditional bank lending • Detailed loan information is publicly available (which allows us to control for loan and borrower characteristics) • Most importantly: structure of syndicate provides information about bank behavior during a crisis

8. Introduction: syndicated lending • A syndicated loan is a loan jointly provided by at least two lenders to a single borrowing firm • Typically a syndicate consists of two tiers of ‘banks’: • Arranging banks • Senior tier who negotiate the lending terms with borrower • Mandated by the borrower to structure, organize and market the loan • Responsible for ex ante due diligence/screening and ex post monitoring • Participating banks • Junior tier who buy a portion of the loan. Not involved in loan organization • The structure of lending syndicates varies substantially: • (Relative) number of arrangers and participants • Share of the loan that arrangers retain (i.e. not sell down) • Concentration of the syndicate

9. Arrangers Participants Introduction: a stylized lending syndicate

10. Introduction: a stylized lending syndicate Arrangers Participants

11. Outline • Introduction • Main hypothesis • Data • Empirical strategy • Results • Conclusions

12. Main hypothesis • Screening and monitoring reduces credit risk (Allen, 1990; Broecker, 1990) • Crisis: screening and monitoring more beneficial as proportion of borrowers with high default probability increases • Syndicate: arrangers screen and monitor on behalf of participants • Because the arrangers sell most of the loan, their incentives to screen and monitor – which is costly – are diluted • Participants can prevent arrangers from shirking by forcing them to increase the part of the loan they retain (cf. Holmström and Tirole, 1997) • Need to prevent shirking more urgent during crisis

13. Main hypothesis • We expect that during the crisis: • Arrangers retain a larger share of each loan to convince participants that they properly screen and monitor • The number of arrangers remains stable or increases and the number of participants remains stable or decreases • Syndicates become more concentrated • The above holds in particular for loans where agency problems are severe • Without increased screening and monitoring we would expect less, but similarly structured loans

14. Increased monitoring Arrangers Participants

15. Outline • Introduction • Hypothesis • Data • Empirical strategy • Results • Conclusions

16. Data Detailed info on 21,343 syndicated loans to private borrowers in 65 countries • Source: Dealogic Loan Analytics • All loans signed between January 2005 and April 2009 • Information about • Borrower: country of incorporation, industry, credit rating • Loan terms: maturity, volume, currency, spread, fee structure, and loan purpose • Structure of syndicate: no. arrangers, no. participants, share held by each lender (only for 20% of loans) • Keep only loans with complete and consistent information. Excluded project finance loans, loans to (quasi-)government entities, loans where an IFI is among syndicate members • Multiple tranches: loan variables are weighted averages of the tranches

17. Data: Syndicated lending pre-crisis (Jan 2005 - Sept 2007) versus during the crisis (Oct 2007 - April 2009)

18. Data Main changes in loan characteristics during crisis: • Loans become on average 7% smaller • Maturity drops by 6 months on average • Percentage of loans secured by collateral drops by a fifth

19. Data Changes in syndicate structure during crisis: • Mean number of arrangers unchanged; mean number of participants declines from 4.2 to 3.2 • Total share retained by arrangers increases by 15% • Syndicates more concentrated: share of five largest lenders increases by 4% and the Herfindahl index by 3%

20. Data Changes in borrower and lender characteristics: • Decline in the percentage of rated borrowers • Increase in the proportion of borrowers in emerging markets (from 10% to 15%) • Mean ‘reputation of borrower’ (number of previous loans the borrower raised successfully) decreases during crisis • Mean ‘arranger reputation’ (market share in previous year) decreases during crisis

21. Outline • Introduction • Hypothesis • Data • Empirical strategy • Results • Conclusions

22. Empirical strategy • Regress syndicate structure measures on crisis dummy • Include loan-specific and borrower specific control variables: (1) loan volume (5) maturity (2) (un)rated (6) (not) guaranteed (3) loan purpose (7) borrower and arranger reputation (4) sovereign rating (8) regional dummies • Control for participant liquidity • Separate regressions / interaction terms for loans with above/below average expected information asymmetries • Dependent variables are either one-sided or two-sided censored: Tobit • Standard errors clustered at borrower level

23. Outline • Introduction • Hypothesis • Data • Empirical strategy • Results • Conclusions

24. Results: basic regression results

25. Results Basic results all point to a strategy of increased screening and monitoring by lending syndicates: • Small increase in number of arrangers • Drop number of participants of 20% of pre-crisis mean • Total share of arrangers increased by about 16% • Average share held by each arranger increased by 5% • Stronger concentration of syndicate (increase of 5% for share held by Top 5 and 10% for HHI)

26. Results: control variables • Rated companies: Less screening and monitoring due to availability of public information • Borrowers with better reputation: Less screening and monitoring • Arrangers with better reputation: Less screening and monitoring • Secured loans: More screening and monitoring

27. Results Results are robust to various regression techniques and specifications: • Longer crisis period (August 2007 – April 2009) • Clustering by bank • Additional regressors (i.e. sectoral dummies) • OLS and Poisson (where relevant) • Controlling for liquidity of participants

28. Crisis has no differentiated impact on rated versus unrated companies → screening and monitoring has become more intense for both types of borrowers Results: differentiated impact of crisis

29. During crisis loans to repeat borrowers are granted by less concentrated syndicates → loans are perceived as less risky and plagued by fewer agency problems Results: differentiated impact of crisis

30. During crisis secured loans are granted by less concentrated syndicates → secured loans are perceived as less risky and plagued by fewer agency problems Results: differentiated impact of crisis

31. Results: emerging markets

32. Results: financial firms

33. Results: moral hazard or adverse selection? • Results so far interpreted as a reflection of increased need to contain moral hazard with regard to screening and monitoring effort on part of arrangers • Arrangers need to signal to participants that they step up screening and monitoring efforts during crisis • Alternative ‘agency’ interpretation is one of adverse selection: • Arranger has private information not known to participant and has incentive to syndicate out more of ‘bad’ loans • So increase in share held by arranger might reflect that participants force arrangers to signal that arranger do not sell off “bad” loans

34. Results: moral hazard or adverse selection? These two effects can be disentangled (Sufi, 2007): • Previous lending relationships between borrower and arranger capture information advantage of arranger • Moral hazard: arranger already knows the borrower through previous deals, so less need for additional screening and monitoring: → arranger needs to retain less of loans to repeat borrowers • Adverse selection: arranger already knows the borrower through previous deals, so needs to show to participant that (s)he will not abuse it → arranger needs to retain more of loans to repeat borrowers

35. Results Change in syndicate structure is due to participants aiming to contain moral hazard, not adverse selection

36. Outline • Introduction • Hypotheses • Data • Empirical strategy • Results • Conclusions

37. Conclusions • During the crisis banks did not indiscriminately reduce their lending but stepped up screening and monitoring: • Especially for less reputable borrowers • Especially for borrowers in the financial sector • Especially for unsecured loans • Especially for unrated borrowers (in emerging markets rating does not alleviate agency problems) • Especially in case of less reputable arrangers (in emerging markets arranger reputation does not alleviate agency problems) • Future work: impact on borrowers

38. THANK YOU

39. Additional slides

40. Results driven by decrease in participants’ liquidity during crisis? • Would not be an equilibrium outcome • We have information on whether the loan volume has decreased during negotiations (likely first step). During crisis, slight increase compared to normal times but still < 1% of loans • We show that crisis impact on syndicate structure is not homogenous but higher for loans where agency problems can be expected to be particularly severe • We explicitly control for participant liquidity

41. Controlling for participant liquidity

42. Hypotheses Diversification • Diversification across imperfectly correlated projects decreases aggregate portfolio risk (Markowitz 1959; Hart and Jaffee 1974) • Helps banks to reduce threat of insolvency and to act as better delegated monitors (Boyd and Prescott 1986) • Well-diversified loan portfolio will make it easier to convince depositors and other creditors to keep funding banks during a crisis

43. Hypotheses If this strategy is dominant we expect that: • all syndicate members (arrangers and participants) have reacted to the crisis by spreading their lending over a larger number of syndicated loans • each member will have reduced the average share of each syndicated loan it retained or bought • all else equal, increase in number of arrangers and participants per syndicate and less concentrated syndicates

44. Hypotheses: diversification

45. Hypotheses: diversification