Academic journal article NBER Reporter

Banks, Banking, and Crises

Academic journal article NBER Reporter

Banks, Banking, and Crises

Article excerpt

The subprime mortgage credit crisis demonstrates that while financial intermediaries have changed in many ways, at root their problems remain the same. Indeed, the old problem of banking panics can reappear in new guises.

In the subprime mortgage crisis, investors without information about exactly which bonds have declined in value have refused to reinvest in the short-term obligations of structured vehicles, including Structured Investment Vehicles (SIVs) and Asset-Backed Commercial Paper Conduits. And, without financing from capital markets, these intermediary vehicles either must sell assets, causing the prices of a range of assets to fall and resulting in widespread losses, or must receive financing from their sponsor banks, reabsorbing the vehicles onto the balance sheet and resulting in decreased capital for the sponsoring banks. In this report I review my research on banks and banking, and look at bank crises in particular.

Implicit Contracting in Banking

In a 2006 paper, Nicholas Souleles and I studied the role of off-balance-sheet vehicles, like those mentioned above). (1) Such "special purpose vehicles" (SPVs) are legal entities with narrowly circumscribed roles; they are essentially thinly capitalized robot asset management firms, with no employees and no physical location. The assets of SPVs are financial obligations, typically commercial or consumer loans or mortgages, or securities linked to such loans and mortgages. These assets may be originated by a single sponsoring financial institution, or may come from multiple originators. While the SPV owns the assets, the servicing of the assets (collecting the loan payments, repossessing the car, foreclosing on the house, and so on) is contracted out, commonly to the sponsor.

SPVs are a form of bank; they hold loans financed by short-term liabilities. The informationally opaque loans are originated by financial intermediaries and then sold to robot firms (SPVs) and financed in capital markets. Why don't banks just hold the loans, instead of selling them to SPVs? And, how can it be incentive-compatible for investors to buy SPV liabilities in capital markets, that is, why should investors in SPVs' liabilities believe that the loans held by SPVs are not lemons?

Souleles and I investigate these questions, arguing that the motivation for using SPVs is that they reduce bankruptcy costs because their assets avoid these costs. Off-balance-sheet financing is most advantageous for sponsoring firms that are risky or face large bankruptcy costs. Avoiding the potential "lemons problem" is more difficult because legal and accounting constraints require the SPV to be separate from the sponsor. SPVs are incentive-compatible because the sponsors can implicitly commit to subsidize or bail out their SPVs. In a repeated game context, this implicit contract can be supported by investors' threat not to invest in SPVs where the sponsor does not honor the implicit contract.

We test these predictions using a unique dataset on credit card securitizations and find that riskier firms securitize more and that the pricing on the SPV debt includes a premium related to the sponsor's risk of default, in addition to the risk of the SPV's assets. Thus, it is not a surprise in the current credit crisis that sponsors are tending to their SPVs, reabsorbing them on-balance sheet in some cases and buying their liabilities in other cases.

Implicit contracts also arise in the area of loan sales, a phenomenon that should not happen according to the standard theory. A central idea in the theory of financial intermediation is that intermediaries produce information about potential borrowers that does not become known to outsiders; that is, it is private information. (2) From this point of view, loans should not be saleable in the capital markets because of lemons problems. Yet, starting in the 1980s, a market for loans opened in the United States that is now quite well developed. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.