The traditional role of a bank is to transfer funds from savers to investors, engaging in maturity transformation, screening for borrower risk, and monitoring for borrower effort in doing so. Until not so long ago, a traditional loan contract included as salient dimensions its amount, the interest rate, its expected credit risk, the required collateral, and the currency in which the loan was granted, all “wrapped” up in a singular way of the bank-firm engagement that occurred mainly through the loan officer. However, the scope of the modern banking industry today is much broader, offering a range of sophisticated financial products, a wider geography-including exposure to countries with various currencies, regulation, and monetary policy regimes-and an increased reliance on financial innovation and technology.
The new bank business models have had repercussions for the traditional loan contract and ways of doing business as well. In particular, the main components and risks of a loan contract can now be altered and hedged on the market, by means of securitization, interest rate swaps, credit default swaps, and foreign exchange transactions. Securitized loans can often be pledged as collateral, thus facilitating new lending. And the lending technology is evolving from one-to-one dialogues between a loan officer and a borrower, at a bank branch, towards more informationally neutral technologies such as peer-to-peer lending or crowd funding.
This book outlines in detail this transition from traditional to modern banking. In six different chapters, we explore the effects of increased financial sophistication on a particular dimension of the loan contract: amount, interest rate, credit risk, collateral, currency, and lending technology. We evaluate the economic benefits and costs of this new financial ecosystem, by relying on recent empirical research in banking and finance.
In Chap. 2, we address the impact on the loan amount that the phenomenon of loan securitization has had. Securitization implies that financial intermediaries that grant illiquid loans subsequently pool them together, diversifying risks and converting them into liquid assets or asset-backed securities (ABSs). These assets are then sold to outside investors, in exchange for wholesale funding. While the largest share of ABSs cover home mortgage loans, other types of loans have also been securitized, including automobile credit, student loans, or corporate loans.
A liquid market for securitized assets has recognized benefits for the banking industry, such as improving risk-sharing and reducing banks’ cost of capital. The volume of credit to both households and firms should increase as a result. However, the global financial crisis of 2007-2009 started in the securitized subprime mortgage market, which collapsed after having accumulated unmanageable amounts of risks. The academic literature has since sought to understand this fact. The explanations advanced include market imperfections such as increased informational frictions or banks’ search for yield. Chapter 2 reviews the theories and estimates put forward in the recent banking literature, to quantify these benefits and costs of securitization on the volume and the quality of credit.
In Chap. 3, we study how modern finance has affected the interest rates charged on loans, by enabling banks to hedge interest rates. In an interest rate swap, banks exchange floating for fixed interest rates, against a fee. Financial intermediation often exposes banks to interest rate risks by creating mismatches in the maturity structure and repricing terms of their assets and liabilities. To reduce these risks, banks use two types of risk management practices: on-balance sheet and off-balance sheet risk management. Through on-balance sheet risk management, banks actively seek to match the maturities of their assets and liabilities. This chapter is concerned with off-balance sheet risk management, which occurs when banks trade derivatives in order to hedge interest rate risk.
The ability to use swaps to hedge against interest rate risks improves the intermediation efficiency of banks, as it allows them to take on more credit risk. However, the flip side is that hedging activities might also make banks’ lending policies less sensitive to changes in monetary policy. Understanding to what extent hedging affects the transmission of monetary policy is crucial for both market players and regulators. Chapter 3 reviews the existing evidence and points towards areas where the interaction between hedging activities and credit is still to be researched.
Chapter 4 discusses how banks these days can trade away credit risk (i.e., the risk that the loan amount will not be returned due to borrower financial distress), by using the Credit Default Swaps (CDS) market. This is an over-the-counter market, where a limited number of large investment banks create markets for buyers and sellers of credit risk, such as banks, insurance companies, and mutual funds. Banks trade in the CDS market for two reasons: to hedge existing credit exposures and to speculate on credit risk. We review recent academic contributions that have sought to explore the interaction between CDS and credit markets, mainly through banks participation in both.
Empirical evidence shows that when liquidity in the CDS market improves, banks use more swaps to hedge risky credit exposures. This enables banks to engage in risk shifting and free up bank capital. Both effects increase bank credit supply. However, allowing banks to trade in both markets also generate negative externalities. Because banks become “empty” creditors when they hedge loan exposures with CDS, accessing bank credit ex ante might become more difficult or more expensive for companies that are referenced in the CDS market. Finally, trading in the CDS derivatives might also suffer if banks trade on private information, which they acquire by forming relationships with borrowers. Chapter 4 assesses the empirical relevance of these hypotheses.
Chapter 5 reviews the different forms of collateral pledged in bank loans and their role in easing transactions. The primary reason for the use of collateral when banks grant loans is to reduce the effects of information asymmetry between the bank and its borrower. In this case, the collateral is usually made up of the borrowers’ tangible assets which the bank can take possession of in case of default. At the core, banks offer different collateral menus to screen for borrower risk: the lower the probability to default on a loan, the more substantial the collateral the entrepreneur is willing to pledge. Further, the collateral attached to a loan provides an incentive for the bank to more diligently monitor the borrower. This, in turn, increases the likelihood that the project is successful. Recently, also intangible assets (e.g., intellectual property rights) have been pledged as collateral and have improved access to credit markets. In Chap. 5, we assess the empirical importance of real estate and movable and intangible collateral for loans to households and firms.
Chapter 6 concerns the currency in which the loan amount is denominated. When banks conduct business globally, both their sources of funding, as well as their volumes of credit, can be expressed in a foreign currency. Therefore, in addition to supply and demand shocks at home, global banks are also exposed to economic fluctuations in foreign exchange markets. Typically, banks hedge this risk ex ante by engaging in cross-currency FX swaps. These swaps are simultaneous spot purchases and forward sales of foreign currency, at the prevailing FX forward rates. However, changes in the forward rates will still affect bank lending decisions, because they affect the cost of hedging of new loans. Increases in forward FX rates will make lending in the foreign currency less attractive, with the reverse being true for domestically headquartered banks. Moreover, trading frictions and the liquidity of FX markets will also determine the price and the availability of a hedge, with a direct impact on the relative cost of lending in foreign markets. In Chap. 6, we review recent empirical evidence linking the functioning of the FX market to bank lending activity.
In Chap. 7, we address the role of Fintech platforms, which are innovations to the lending technology characterized by dynamiting traditional customer relationships. Banks gather hard and soft information on their borrowers, by establishing relationships in which they screen and monitor their borrowers. This can have both negative effects-when the bank charges excessive interest rates due to informational rents-and positive effects-by guaranteeing access to credit to relationship borrowers, even in times of distress. These two sides of bank-customer interactions are under challenge by FinTech. A range of innovative platforms, including payment service providers, aggregators and robo advisors, and peer-to-peer lenders have the potential to interfere with these traditional links.
On the one hand, the increased competition that FinTech brings might reduce excessive bank rents. For example, peer-to-peer lending provides a direct alternative to retail banking, with the potential to increase affordable credit to small businesses. On the other hand, while FinTech might decrease transaction costs and borrower choice, it might lead to less relationship lending in the economy. This could hurt bank profitability, but, more importantly, it could also hurt access to credit, particularly in downturns, when stable credit is needed the most. Chapter 7 reviews recent academic and policy thinking on how FinTech might affect the creation of value within the bank-borrower relationship.