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Conference on Financial Innovations and the Real Economy November 2006 Discussion by:

Financial Innovations, Idiosyncratic Risk, and the Joint Evolution of Real and Financial Volatilities by Christina Wang. Conference on Financial Innovations and the Real Economy November 2006 Discussion by: Richard Rosen FRB Chicago. Big issues.

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Conference on Financial Innovations and the Real Economy November 2006 Discussion by:

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  1. Financial Innovations, Idiosyncratic Risk, and the Joint Evolution of Real and Financial Volatilities by Christina Wang Conference on Financial Innovations and the Real Economy November 2006 Discussion by: Richard Rosen FRB Chicago

  2. Big issues • The volatility of financial variables has increased at the same time as the volatility of real variables has decreased. • How can we explain this? • Jermann and Quadrini point out that new financial markets give firms more flexibility in financing. • This paper focuses more tightly on bank lending. Changes in information and communication technology have made financial markets more complete and have lowered the cost of analyzing risk. • How has this affected bank lending?

  3. How might technological change affect bank lending? • Risks can now be disaggregated (securitization). • The role of public markets has increased. • This may affect intertemporal smoothing (Allen & Gale). • Entry barriers are lower (for new banks and for geographic expansion). • Local banking market structure affects industry concentration and growth (Cetorelli & Gambera, 2001).

  4. Where firms get financing Source: Chase, Paine Webber as reported in the Economist (1987, 1997) and Thomson Financial (2005)

  5. Where firms get financing (“all ABS” version) Source: Chase, Paine Webber as reported in the Economist (1987, 1997) and Thomson Financial (2005)

  6. The (first) model • Christina’s model examines an alternative impact of technological change on the pattern of bank lending. • Banks screen borrowers at a cost. • Technological change reduces the cost. • Banks have a required return that depends on their overall systematic and idiosyncratic risk. • The premium on idiosyncratic risk declines with monitoring costs. This allows banks of a given scale to make more small loans.

  7. The evidence, part I • An interesting possibility drawn from the model is that: • the degree of diversification at banks of a given size may have fallen as the efficient scale has increased over time. • At the same time: • idiosyncratic risk should have increased at banks (in contrast to decreases observed at non-financial firms). • The regressions in the paper find support for these.

  8. The evidence, part II • Page 15: “More importantly, most of the additions to the loan pool [from bank mergers] are small loans.” Is this true? • It may depend on which loans we are talking about. • We can test this for commercial loans.

  9. The evidence, part II • To test using commercial loans: • The Survey of Terms of Bank Lending (STBL) is a quarterly survey of about 300 banks. The banks report every commercial loan they make during a short window (one week each quarter). Since many banks are in the sample for a repeated period, we can look at how the size distribution of loans changes over time.

  10. Results from the STBL • The sample period is 1982Q3 – 2006Q1. • I examine changes at banks which are in the survey for at least 10 years. • Divide loans into 3 categories: small (<$100K), medium ($100K-$1MM), and large (>$1MM). • Divide banks into 3 categories based on final period size: small (<$1B), mid-size ($1B-$10B), and large (>$10B). • [All values are 2006 dollars]

  11. Results from the STBL Bank size Bank size

  12. Results from the STBL: fast growing banks Bank size Bank size

  13. Results from the STBL: number of loans Bank size Bank size

  14. What this means for the paper • Lower monitoring costs mean that banks can take more idiosyncratic risk. • How this affects this affects lending is model specific. • By changing the screening cost function, but still consistent with the spirit of the model, I suspect that you can get a result that lower screening costs increase the share of large loans. • The distribution of loan sizes at a bank changes over time. What can we learn from this?

  15. Final thoughts • Are banks (still) special? • Financial innovation (and deregulation) have changed the structure of banks and financial markets. • This paper points out that this matters for lending: • Lower screening costs allow banks to lend to borrowers with more idiosyncratic risk. • This adds to our understanding of how banks have reacted to their changed environment.

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