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Measuring Moral Hazard: the Impact of Systemic Risk on Bank Loan Portfolios Yu Shan

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Measuring Moral Hazard: the Impact of Systemic Risk on Bank Loan Portfolios Yu Shan Measuring Moral Hazard: The Impact of Systemic Risk on Bank Loan Portfolios Yu Shan Abstract This paper examines the endogenous adjustments in the risk of bank’s loan portfolio in response to systemic risk levels. In particular, I consider whether individual banks increase or decrease their loan portfolio risk when systemic risk levels vary. I examine the tightness of loan covenants and loan spreads to determine bank responses to systemic risk at microlevel (Δ퐶표푉푎푅) and macrolevel (CATFIN). I find that banks require tighter loan covenants and higher loan spreads following high Δ퐶표푉푎푅 and high CATFIN, indicating that banks increase loan portfolio risk when microlevel and macrolevel systemic risks are high. These are consistent with moral hazard hypothesis. I also find that loan spreads are less sensitive to Δ퐶표푉푎푅 after the financial crisis, suggesting weaker moral hazard by systemic important banks after the crisis. I also find that loan covenants and loan spreads are less sensitive to Δ퐶표푉푎푅 for those TARP recipients during periods of recession, or periods when CATFIN exceeds the early warning threshold. This suggests lower loan portfolio risk and weaker moral hazard effects, and indicates that systemic important banks adjust the risk of their loans in order to pull back from the brink of delinquency and bailout. 1. Introduction Banks are special because they are critically important to the capital allocation process inherent in a well- functioning financial system. Individual bank behavior has systemic implications on overall macroeconomic conditions. Concerns about adverse macroeconomic consequences justify the vast array of regulatory policies and governmental safety nets designed to bail out banking systems in crisis. However, it is well known that while these policies may reduce the severity of macroeconomic downturns during financial crises, they induce banks to engage in strategic behavior that results in moral hazard risk. In this paper, I examine the role of bank-level systemic risk on the basic characteristics of the loan portfolio. In particular, I examine bank responses to moral hazard temptations to measure their responses as reflected in their loan portfolios. I focus on two fundamental bank choice variables: loan risk exposure and the tightness of loan covenants. How does the bank’s systemic risk impact the portfolio characteristics of the bank’s loan portfolio? There are two possible channels. The first is the moral hazard channel, which implies that TBTF safety nets and subsidies encourage bank risk taking behavior. Failures of systemically important banks may cause significant disruptions to the financial system and economic activity. Therefore, upon a financial crisis, governments usually don’t have many options but to reach out to bail out systemically important banks to recover lending activities and restore economic growth. Although governments wouldn’t like to make any explicit 1 commitment to these actions to prevent moral hazard, there still exists an expectation of implicit public guarantee among banks and banks’ creditors. The expectation of “implicit public guarantee” weakens market discipline (Acharya, Anginer, and Warburton, 2016) and may induce systemically important banks to shift their lending toward higher-risk, higher-return projects. Expectation of bailout also incentivizes borrowers to choose banks with higher bailout expectations because they are perceived as safer and are more able to provide stable liquidity during economic downturn when liquidity is scarce. Berger and Roman (2015) suggest that because TARP banks gained market share and market power because they are perceived as safer and are less likely to fail, and are associated with larger loan or deposit growth after TARP. Koetter and Noth (2015) find that higher bailout expectations for the unsupported banks increase loan rates, reduce deposit rates. Overall, the moral hazard channel indicates that banks with higher bailout expectation will shift their lending to riskier loans, and therefore ask for higher loans spread and set tighter covenants. The second channel is the systemic risk response channel. The explicit and implicit cost of funds from government support may be high. First, the injected preferred equity has priority over common equity, which may amplify the losses of common equity holders in the event of failure, resulting in falls in the value of common equity, and increasing the difficulty of raising equity (Berge, Roman and Sedunov, 2016). Berger and Roman (2015) suggest that the TARP funds may be relatively expensive. If banks’ shareholders are concerned about the negative implications of bailouts, they may adjust the risk of their loans in order to pull back from the brink of delinquency and bailout. Second, the supported banks may have to undertake certain social welfare responsibilities through lending expansion, which may not be an equilibrium choice from shareholders’ perspective. The initial objective of bailouts is to stabilize the financial system and macroeconomy, but public also often expect the bailed-out banks may expand their lending. However, during financial crisis, safe and profitable projects are very rare and expanding lending in this circumstances may be at shareholders’ best interest. Due to all these potential costs, systemically risk banks may try to avoid bailouts by reducing the bank’s systemic risk exposure. This could take the form of adjustments to the risk of the bank’s loan risk. I denote this the systemic risk response channel1. 1 Another channel that is not captured in this paper but could be very important in the future is the systemic risk pricing channel. The systemic risk pricing channel implies that as regulations have imposed greater regulatory costs, stricter security, and higher disciplinary pressure on systemically important banks, the opportunity for moral hazard risk shifting may be reduced. For example, G-SIBs are subject to higher capital buffer requirement, Total Loss-Absorbing Capacity (TLAC) standard, resolvability requirement, and higher supervisory expectations. With all these higher regulatory requirements, systemically important banks are at a competitive disadvantage relative to other banks, so they have to charge higher loan spreads and require tighter covenants per unit of borrower risk in order to reduce the bank’s systemic risk levels. 2 Under the moral hazard channel, systemically risky banks would have incentives to increase the risk of their loans as the likelihood of bailout increases. In contrast, under the systemic risk response channel, systemically risky banks would reduce their risk exposures in order to reduce the likelihood that their bank would require a bailout. In this paper, I examine the risk characteristics of the bank loans using loan spreads and covenant tightness. That is, I relate overall systemic risk and each bank’s microlevel systemic risk exposure to the bank loan risk and find support for the moral hazard hypothesis. In this paper, I test these hypotheses using two complementary measures of systemic risk. I consider overall systemic risk, as well as microlevel systemic risk imposed by each individual bank. To measure the macro- level aggregate systemic risk, I utilize CATFIN (Allen, Bali and Tang (2012)). This is a cross-sectional measure that identifies the overall level of systemic risk in the financial system at each point in time. To measure the micro-level systemic risk, I utilize Δ퐶표푉푎푅 (see Adrian and Brunnermeier (2016)) to determine the impact of an individual bank’s insolvency on overall systemic risk. The greater the contribution of an individual bank’s insolvency to market-wide systemic risk, the greater the individual bank’s imposition of systemic risk onto the macroeconomy. First, I look at how the two systemic risks individually and jointly determine the loan spread and covenant strictness. Systemically risky banks increase their loan spreads as well as their covenant tightness as the risk of their loans increases. My empirical results first indicate that microlevel systemic risk is positively associated with loan spread and covenant tightness when financial system and macroeconomy are in health states. This is consistent with moral hazard hypothesis. With the expectation of bailout, systemically important banks shift their lending towards riskier loans. I also find that loan spread is positively associated with the likelihood of bailout, as measured by the overall systemic risk levels (CATFIN), indicating that banks generally increase their risk taking when the overall systemic risk is high. However, I also find that both loan spread and covenant strictness are negatively associated with the interaction of microlevel and overall systemic risk. The results are similar if I replace the overall systemic risk with an early-warning dummy determined by the overall systemic risk. These results indicate that when systemic risk is system-wide, the systemic risk response effect dominates the moral hazard effect for systemically risky banks, who reduce their risk exposure by reducing the loan spreads and relaxing the strictness of covenants. That means, when the whole financial system is risky, for those banks who are more likely to be bailed out, instead of participating in more moral hazard activities, they are trying hard to reduce their risk-taking and pull back from the brink of delinquency and bailout. Then I conducted a diff-in-diff analysis to investigate how the relationship between bank risk taking and systemic
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