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

Outline Introduction Main hypothesis Data Empirical strategy Results Conclusions

Outline Introduction Main hypothesis Data Empirical strategy Results Conclusions

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

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?

1.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 2.Growing literature on structure of syndicated lending Others 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 Introduction: contribution to literature

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 Introduction: why 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’: 1.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 2.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 Introduction: syndicated lending

Introduction: a stylized lending syndicate

Outline Introduction Main hypothesis Data Empirical strategy Results Conclusions

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

We expect that during the crisis: 1. Arrangers retain a larger share of each loan to convince participants that they properly screen and monitor 2. The number of arrangers remains stable or increases and the number of participants remains stable or decreases 3. Syndicates become more concentrated 4. 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 Main hypothesis

Increased monitoring

Outline Introduction Hypothesis Data Empirical strategy Results Conclusions

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 Data

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

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 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% 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 Data

Outline Introduction Hypothesis Data Empirical strategy Results Conclusions

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 Empirical strategy

Outline Introduction Hypothesis Data Empirical strategy Results Conclusions

Results: basic regression 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) Results

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 Results: control variables

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 Results

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

Results: emerging markets

Results: financial firms

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 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 Results: moral hazard or adverse selection?

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

Outline Introduction Hypotheses Data Empirical strategy Results 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 Conclusions

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Additional slides

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 Results driven by decrease in participants’ liquidity during crisis?

Controlling for participant liquidity

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 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 Hypotheses

Hypotheses: diversification