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 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 Christinas 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 ( $1MM). Divide banks into 3 categories based on final period size: small ( $10B). [All values are 2006 dollars]

11 Results from the STBL BankBank sizesize BankBank sizesize

12 Results from the STBL: fast growing banks BankBank sizesize BankBank sizesize

13 Results from the STBL: number of loans BankBank sizesize BankBank sizesize

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.