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Center for Financial Research

CFR Working Paper Series 2006


The CFR sponsors original research on issues associated with deposit insurance, banking performance, risk measurement and management, corporate finance, and financial policy and regulation. The results of CFR-sponsored research, FDIC staff research, and other invited papers on these CFR research lines appear in the CFR Working Paper Series.

Working Paper Series:
Working Paper NumberTitle
2006-13 Basel II: A Case for Recalibration
Paul H. Kupiec
2006-12 The Effect of Bank Supervision on Loan Growth
Timothy J. Curry, Gary S. Fissel and Carlos D. Ramirez
2006-11 Community Development Financial Institutions: Board Size and Diversity as Governance Mechanisms
Valentina Hartarska
2006-10 Financial Stability and Basel II
Paul H. Kupiec
2006-09 On the Market Discipline of Informationally-Opaque Firms: Evidence from Bank Borrowers in the Federal Funds Market
Adam B. Ashcraft and Hoyt Bleakley
2006-08 Capital Allocation for Portfolio Credit Risk
Paul Kupiec
2006-07 Did the Introduction of Fixed-Rate Federal Deposit Insurance Increase Bank Risk?
Gayle DeLong, Anthony Saunders
2006-06 Understanding the Role of Recovery in Default Risk Models:Empirical Comparisons and Implied Recovery Rates
Gurdip Bakshi, Dilip Madan, Frank Zhangc
2006-05 Multi-Period Corporate Default Prediction With Stochastic Covariates
Darrell Duffie, Leandro Saita, and Ke Wang
2006-04 Borrower-Lender Distance, Credit Scoring, and the Performance of Small Business Loans
Robert DeYoung, Dennis Glennon, Peter Nigro
2006-03 Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary With Market Conditions
Evan Gatev, Til Schuermann, Philip E. Strahan
2006-02 Interest Rate Risk Management at Commercial Banks: An Empirical Investigation
Amiyatosh Purnanandam
2006-01 Bank Lines of Credit in Corporate Finance: An Empirical Analysis
Amir Sufi

Basel II: A Case for Recalibration - PDF 240k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-13
Paul H. Kupiec
October 2006

    Abstract

    Objectives for Basel II include the promulgation of a sound standard for risk measurement and risk-based minimum capital regulation. The AIRB approach, which may be mandatory for large U.S. banks, will give rise to large reductions in regulatory capital. This paper assess whether the reductions in minimum capital are justified by improvements in the accuracy of risk measurement under Basel II. Review of credit loss data and analysis of the economics of capital allocation methods identify important shortcomings in the AIRB framework that lead to undercapitalization of bank credit risks.

    Key Words: credit risk measurement, credit risk capital allocation, Basel II

    JEL Classification: G12, G20, G21, G28

The Effect of Bank Supervision on Loan Growth - PDF 612k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-12
Timothy J. Curry, Gary S. Fissel and Carlos D. Ramirez
September 2006

    Abstract

    This paper quantifies the short-term and long-term impact of bank supervision (measured using CAMEL composite and component ratings) on different categories of loan growth: (a) commercial and industrial loans, (b) consumer loans, and (c) real estate loans. For each of these categories, we perform dynamic loan growth equations at the state level augmented by the inclusion of CAMEL ratings for all banks in the state, after controlling for banking and economic conditions. We perform these regressions for two distinct sub-periods: (1) 1985 through 1993 (which covers the credit crunch period), and (2) 1994 through 2004 (which covers the sustained recovery period).

    For the first period, 1985 to 1993, we find that out of the three loan categories considered, business lending is the most sensitive to changes in CAMEL ratings (both the composite and the components), although the other loan categories also show some sensitivity. Overall, however, we find little evidence suggesting that the effects of changes in any of the components of CAMEL ratings differ systematically from the effects of changes in the composite CAMEL. For the second period, we find little evidence that changes in CAMEL ratings (the composite or its components) had any systematic effect on loan growth for any of the loan categories considered.

    Keywords: Loan growth equations, CAMEL downgrades, banking sector conditions.

    JEL Classification Codes: E44, G21

Community Development Financial Institutions: Board Size and Diversity as Governance Mechanisms - PDF 189k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-11
Valentina Hartarska
October 12, 2006

    Abstract

    CDFIs serve an important social function because they provide access to financial services to underserved low-income individuals and households. Understanding which governance mechanisms promote efficient use of scarce resources that these organizations control is important because only sustainable institutions have the potential to revitalize low-income communities and change low-income individualsí lives in the long-term. The focus of this paper is on evaluating the impact of board size and diversity on the performance of two types of CDFIs: Community Development Credit Unions and Community Development Loan Funds. The results show that CD Credit Unions with larger boards are more efficient in delivering outreach, but board size is not related to CD Loan Fundsí performance. There is some evidence that CDCUs with boards dominated by women are more efficient in fulfilling their outreach missions but CDLFs with more gender and racially diverse boards achieve worse financial results suggesting that group cohesion may be important in organizations with multiple, especially non-complementary, objectives (such as outreach and financial self-sufficiency). The results also suggest that there is room for direct involvement of banks in community development activities rather than relying only on investment and lending to intermediaries such as CDFIs.

    Key Words:

    JEL Classification: JEL: G2, G3

Financial Stability and Basel II - PDF 148k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-10
Paul H. Kupiec
September 2006

    Abstract

    The Basel II Advanced Internal Ratings (AIRB) approach is compared to capital requirements set using an equilibrium structural credit risk model. Analysis shows the AIRB approach undercapitalizes credit risk relative to regulatory targets and allows wide variation in capital requirements for a given exposure owing to ambiguity in the definitions of loss given default and exposure at default. In contrast, the Foundation Internal Ratings Based (FIRB) approach may over-capitalize credit risk relative to supervisory objectives. It is unclear how Basel II will buttress financial sector stability as it specifies the weakest risk regulatory capital standard for large complex AIRB banks.

    Key Words: credit risk measurement, credit risk capital allocation, Basel II

    JEL Classification: G12, G20, G21, G28

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On the Market Discipline of Informationally-Opaque Firms: Evidence from Bank Borrowers in the Federal Funds Market - PDF 1023k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-09
Adam B. Ashcraft
Hoyt Bleakley
September 2006

    Abstract

    Using plausibly exogenous variation in demand for federal funds created by daily shocks to reserve balances, we identify the supply curve facing a bank borrower in the inter-bank market, and study how access to overnight credit is affected by changes in public and private measures of borrower creditworthiness. While there is evidence that lenders respond to adverse changes in public information about credit quality by restricting access to the market in a fashion consistent with market discipline, there is also evidence that borrowers are able to respond to adverse changes in private information about credit quality by increasing leverage as if to offset the future impact on earnings. While the responsiveness of investors to public information is comforting, we document evidence which suggests that banks are able to manage the real information content of these disclosures. In particular, public measures of loan portfolio performance have information about future loan charge-offs, but only in quarters when the bank is examined by supervisors. However, the loan supply curve is not any more sensitive to public disclosures about non-performing loans in an exam quarter, suggesting that investors are unaware of this information management.

    Key words: Earnings management, market discipline, opaqueness

    JEL Classification: G14, G18, G21

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Capital Allocation for Portfolio Credit Risk - PDF 805k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2006-08 (revision of CFRWP 2005-04)
Paul Kupiec
August 2006

    Abstract

    Capital allocation rules are derived that maximize leverage while maintaining a target solvency rate for credit portfolios where risk is driven by a single common factor and idiosyncratic risk is fully diversified. Equilibrium conditions ensure that capital allocations depend on interest earnings as well as creditsí probability of default, endogenous loss given default, and asset correlation. Capitalization rates exceed those estimated using Gaussian credit loss models. Results demonstrate that credit risk is undercapitalized by the Basel II AIRB approach in part because of ambiguities regarding the definition of loss given default. An alternative proposed capital rule removes this bias.

    Key words: economic capital, credit risk internal models, Basel II Internal Ratings Approach

    JEL Classification: G12, G20, G21, G28

    Did the Introduction of Fixed-Rate Federal Deposit Insurance Increase Bank Risk? - PDF 728k (PDF Help)

    FDIC Center for Financial Research Working Paper No. 2006-07
    Gayle DeLong, Anthony Saunders
    August 2006

      Abstract
      We investigate whether the introduction of fixed-price U.S. federal deposit insurance increased the risk-taking of banks. We examine 70 financial institutions and find that banks in general became more risky after the introduction of deposit insurance. However, a subset of well-performing banks reduced their risk. Deposit insurance helped to bring about stability in that depositors did not discriminate between weaker and stronger banks. Although investors did not see deposit insurance as a net subsidy to the banking industry, investors believed deposit insurance would allow smaller banks to compete better against bigger banks. While deposit insurance allowed greater risk-taking among some banks, it also brought more stability and competition within the banking industry.

      Keywords: Government Policy and Regulation; Banks; Deposit Insurance

      JEL Classification: G18 and G21

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    Understanding the Role of Recovery in Default Risk Models:Empirical Comparisons and Implied Recovery Rates 842k (PDF Help)

    FDIC Center for Financial Research Working Paper No. 2006-06
    Gurdip Bakshi, Dilip Madan, Frank Zhangc
    August 2006

      Abstract
      This article presents a framework for studying the role of recovery on defaultable debt prices (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employed to infer the market expectation of recovery rates implicit in bond prices. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices.

      Keywords: Recovery; default risk; defaultable coupon bonds, corporate bond pricing, recovery payout as a fraction of face, recovery as a fraction of pre-default debt values, recovery as a fraction of the present value of face, implied recovery.

      JEL Classification: G0, G10, G11, G12, G13, C5.

      Multi-Period Corporate Default Prediction With Stochastic Covariates - PDF 970k (PDF Help)

      FDIC Center for Financial Research Working Paper No. 2006-05
      Darrell Duffie, Leandro Saita, and Ke Wang
      September 2005

        Abstract
        We provide maximum likelihood estimators of term structures of conditional probabilities of corporate default, incorporating the dynamics of firm-specific and macroeconomic covariates. For U.S. Industrial firms, based on over 390,000 firm-months of data spanning 1980 to 2004, the level and shape of the estimated term structure of conditional future default probabilities depends on a firmís distance to default (a volatility-adjusted measure of leverage), on the firmís trailing stock return, on trailing S& P 500 returns, and on U.S. interest rates, among other covariates. Variation in a firmís distance to default has a substantially greater effect on the term structure of future default hazard rates than does a comparatively significant change in any of the other covariates. Default intensities are estimated to be lower with higher short-term interest rates. The out-of-sample predictive performance of the model is an improvement over that of other available models.

        Keywords: default, bankruptcy, duration analysis, doubly stochastic, distance to default

        JEL Codes: C41, G33, E44

        Borrower-Lender Distance, Credit Scoring, and the Performance of Small Business Loans - PDF 901k (PDF Help)

        FDIC Center for Financial Research Working Paper No. 2006-04
        Robert DeYoung, Dennis Glennon, Peter Nigro
        March 2006

          Abstract
          We develop a theoretical model of decision-making under risk and uncertainty in which bank lenders have both imperfect information about loan applications and imperfect ability to make decisions based on that information. We test the loan-default implications of the model for a large random sample of small business loans made by U.S. banks between 1984 and 2001 under the SBA 7(a) loan program. As predicted by our model, both borrower-lender distance and credit-scoring contribute to greater loan defaults; the former finding suggests that distance interferes with information collection and monitoring, while the latter finding implies production efficiencies that encourage credit-scoring lenders to make riskier loans at the margin. However, we also find that credit-scoring dampens the harmful effects of distance, consistent with the conjecture that information generated by credit scoring models improves the ability of lenders to assess and price default risk.

          JEL Codes: D81, G21, G28.

          Key words: borrower-lender distance, credit scoring, small business loans.

          Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary With Market Conditions - PDF 817k (PDF Help)

          FDIC Center for Financial Research Working Paper No. 2006-03
          Evan Gatev, Til Schuermann, Philip E. Strahan
          December 2005

            Abstract
            Unused loan commitments expose banks to systematic liquidity risk, but this exposure can be reduced by combining loan commitments with transactions deposits. We show that bank equity volatility increases with unused loan commitments, but this increase is reduced for banks with high levels of transaction deposits. This deposit-lending synergy becomes even more powerful during periods of tight liquidity, when nervous investors move funds into their banks. Thus, the simultaneous taking of deposits and lending may be thought of as a liquidity hedge.

            JEL Codes: G18; G21

            Key Words: Liquidity; banking; financial crisis.

            Interest Rate Risk Management at Commercial Banks: An Empirical Investigation - PDF 366k (PDF Help)

            FDIC Center for Financial Research Working Paper No. 2006-02
            Amiyatosh Purnanandam
            May 2005

              Abstract
              I analyze the effects of bank characteristics and macroeconomic shocks on interest rate riskmanagement behavior of commercial banks. My findings are consistent with hedging theories based on cost of financial distress and costly external financing. As compared to the derivative users, the derivative non-user banks adopt conservative asset-liability management policies in tighter monetary policy regimes. Finally, I show that the derivative non-user bankís lending volume decline significantly with the contraction in the money-supply. Derivative users, on the other hand, remain immune to the monetary policy shocks. My findings suggest that a potential benefit of derivatives usage is to minimize the effect of external shocks on a firmís operating policies.

              JEL Codes: G21, G32, G33 and E5

              Keywords: Hedging, Derivatives, Bankruptcy, Credit-Channel.

              Bank Lines of Credit in Corporate Finance: An Empirical Analysis - PDF 193k (PDF Help)

              FDIC Center for Financial Research Working Paper No. 2006-01
              Amir Sufi
              December 2005

                Abstract
                I use novel data collected from annual 10-K SEC filings to examine the role of bank lines of credit in the liquidity management of public corporations. I find that bank lines of credit account for a large share of liquidity only for firms with a historical record of profitability. Firms with low profitability that are unable to obtain a line of credit more heavily use cash in their corporate liquidity management; they hold higher balances of cash and save more cash out of cash flow than firms that are able to obtain a line of credit. Even among firms that obtain lines of credit, banks use financial covenants on profitability to restrict access when firms experience drops in performance. The credit restriction is temporary and firms eventually regain full access to their line of credit.

                JEL Codes: G20, G21, G32, G31

                Keywords: Bank Debt, Lines of Credit, Revolving Credit Facilities, Flexibility, Leverage, Liquidity, Cash-flow sensitivity of cash.