Do banks give adequate consideration to risks?

Although the 2008 financial crisis is already more than a decade ago, it is still fresh in our minds. Irresponsible lending behaviour by the banks was identified as its leading cause. What determines such behaviour? For his PhD thesisThomas Matthys investigated the lending behaviour of banks in three different contexts using data analysis and statistical models. We talked to him about borrowing in the interbank market, the impact of activist hedge funds and expansive monetary policy.

Private information is a competitive advantage

Banks do not only lend money to individuals and companies. On the international interbank markets, banks that have liquidity surpluses also lend money to banks with liquidity shortfalls. These are usually short-term loans from one day to three months. It is an unregulated market that works on the basis of trust, which is where the problem lies: “This interbank market was a significant catalyst for the financial crisis.  The fall of Lehman Brothers also meant the loss of confidence,” says Thomas. “What is the quality of the assets on the counterparty’s balance sheet? What about risk concentration? There is information asymmetry, and borrowing in the interbank market has become more difficult. Nevertheless, interbank lending has not dried up. Although the markets are nervous, some banks are still lending to each other. So why are those banks doing it whereas others are not? Apparently they have access to private information, among other things from participating in syndicated loans, which are loans to companies provided by banking consortiums. The fact is that the company concerned, the borrower, will disclose confidential information in the informative memorandum that is not publicly available.”

Thomas has studied a comprehensive dataset of interbank transactions in the Eurozone. “We found that banks get better terms for their interbank loans from other banks with whom they have formed a credit consortium. The analysis also showed that these terms did indeed relate to access to this private information and were not simply attributable to their business relationship. In other words, the more syndicated loans a bank shared with another bank, the lower the interbank interest rate that the other bank would charge and the higher the amount that could be borrowed. However, this only applied to a certain extent, as the quality of those syndicated loans also played a role in the final terms.”

This initial study offers banks tools for better liquidity management. By joining credit consortiums, banks can reduce information asymmetry and improve their access to the interbank market.

How do banks view activist hedge funds?

Activist hedge funds are investment funds that are only available to institutional investors. They typically take minority shareholdings but use them to exert a significant influence on the policies of the companies involved. Their objectives are to maximise shareholder value. They do this by ensuring that the CEO is replaced, the cash is distributed to the shareholders, part of the company is sold and so on.

“As soon as an activist hedge fund announces its participation, the share price tends to rise significantly,” says Thomas. “Why? Some believe that it is about investors anticipating the changes the fund wants to bring about. They expect these changes to be beneficial to performance and thus to the value of the company. Others, however, see the change of course as a form of expropriation of other stakeholders, including the lenders. In other words, the value is not created but transferred. What point of view do the banks hold? If they are favourably disposed towards the former, you would expect them to lower the interest rates on loans to the company concerned. If not, they would raise their interest rates to compensate for the expropriation.”

In a second study, Thomas examined the impact of the participation of activist hedge funds on the credit terms of US-listed companies in the period 1996-2013. He found that, on average, the terms would tighten up. The most substantial noticeable impact was on the interest rates and the required collateral, with higher interest rates and greater collateral or guarantees required. This confirms that banks interpret a change of course as expropriation. However, closer examination showed that the interest rate increases did not apply to all companies. “When we look at the 20-day period around the announcement of the participation of an activist hedge fund and the price reaction or the cumulative abnormal return (CAR), we can divide the companies surveyed into two groups: those with a CAR of less than 10% and those with a CAR of more than 10%. The lending rates only increased significantly in the latter group, compared to those of the loans taken out before the hedge fund’s participation.”

What can listed companies learn from this? “In view of the negative impact on their credit terms, they would do well to protect themselves against the interventions of activist leverage funds. Such funds typically attack companies with a lot of cash on their balance sheets, organisations that have been doing less well for a while or that have become unwieldy, making them candidates for demergers. Therefore, you need to make your company less attractive to them.”

Does expansive monetary policy encourage risk-taking?

Since 2008-2009, the central banks have resorted to more flexible monetary policies and unconventional policy measures. They generally limit themselves to interest rate adjustments and open market operations but, under pressure from the financial crisis, they have also bought up government securities, corporate bonds and liquidity injections (“quantitative easing”). A consequence of such expansive monetary policy is that money has become cheap, which is reflected in the interest rates on savings accounts and mortgage loans.

“There are now discussions about the impact of expansive monetary policy on the banks’ attitudes to risk. In their quests for additional income, they supposedly take greater risks by providing cheaper loans to less creditworthy companies. But is that really the case?” Thomas outlines the problem.

He continues: “Previous studies have looked at the evolution of monetary policy rates to assess their impacts on the financial markets and the risk taken by banks, but since these rates have been flirting with the zero mark for some time, changes to them are no longer useful measures of the direction of monetary policy. Therefore, we have constructed a new benchmark based on an econometric model that takes many other variables into account. That was also the first technical contribution of this third study.”

Thomas then examined what happened to the credit terms of syndicated loans provided by American banks in the period 2008-2015 in view of this unconventional, expansive monetary policy. He found, somewhat logically, that the credit interest rates fell during that period. “But that is no evidence of the fact that banks were taking more risks,” he says firmly. After all, further research has shown that the borrowers’ profiles were indeed taken into account and that with the higher risks, interest rates were also higher. In addition, there were also differences depending on the banks’ characteristics. “Smaller banks, banks with lower capital buffers and higher degrees of diversification, discounted the most, but only for safe businesses. In other words, we have found no evidence that expansive monetary policy encourages risk-taking, at least not for the syndicated loans market,” he concluded.

Source: ‘Topics in Financial Economics’ by Thomas Matthys. PhD in Applied Economics at Ghent University in 2018. Supervisor: Professor Rudi Vander Vennet (Ghent University).

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