To-Distribute Model and the Role of Banks in Financial Intermediation

Vitaly M. Bord and João A. C. Santos The Rise of the Originate- to-Distribute Model and the Role of Banks in Financial Intermediation 1.Introduction banks with yet another venue for distributing the loans that they originate. In principle, banks could create CLOs using the istorically, banks used deposits to fund loans that they loans they originated, but it appears they prefer to use collateral Hthen kept on their balance sheets until maturity. Over managers—usually investment management companies—that time, however, this model of banking started to change. Banks put together CLOs by acquiring loans, some at the time of began expanding their funding sources to include bond syndication and others in the secondary loan market.2 financing, commercial paper financing, and repurchase Banks’ increasing use of the originate-to-distribute model agreement (repo) funding. They also began to replace their has been critical to the growth of the syndicated loan market, traditional originate-to-hold model of lending with the so- of the secondary loan market, and of collateralized loan called originate-to-distribute model. Initially, banks limited obligations in the United States. The syndicated loan market the distribution model to mortgages, credit card credits, and rose from a mere $339 billion in 1988 to $2.2 trillion in 2007, car and student loans, but over time they started to apply it the year the market reached its peak. The secondary loan to corporate loans. This article documents how banks adopted market, in turn, evolved from a market in which banks the originate-to-distribute model in their corporate lending participated occasionally, most often by selling loans to other business and provides evidence of the effect that this shift has banks through individually negotiated deals, to an active, had on the growth of nonbank financial intermediation. dealer-driven market where loans are sold and traded much Banks first started “distributing” the corporate loans they like other debt securities that trade over the counter. The originated by syndicating loans and also by selling them in the volume of loan trading increased from $8 billion in 1991 to secondary loan market.1 More recently, the growth of the $176 billion in 2005.3 The securitization of corporate loans also market for collateralized loan obligations (CLOs) has provided experienced spectacular growth in the years that preceded the financial crisis. Before 2003, the annual volume of new CLOs 1 In loan syndications, the lead bank usually retains a portion of the loan and places the remaining balance with a number of additional investors, usually issued in the United States rarely surpassed $20 billion. After other banks. This arrangement is made in conjunction with, and as part of, the loan origination process. In contrast, the secondary loan market is a 2 According to the Securities Industry and Financial Markets Association, seasoned market in which a bank, including lead banks and syndicate 97 percent of corporate loan CLOs in 2007 were structured by financial participants, can subsequently sell an existing loan (or part of a loan). institutions that did not originate the loans. Vitaly M. Bord is a former associate economist and João A. C. Santos The authors thank Nicola Cetorelli, Stavros Peristiani, an anonymous reviewer, a vice president at the Federal Reserve Bank of New York. and participants at a Federal Reserve Bank of New York seminar for useful comments. The views expressed are those of the authors and do not necessarily Correspondence: [email protected] reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. FRBNY Economic Policy Review / July 2012 21 that, loan securitization grew rapidly, topping $180 billion loans over time, and it has complete information on investors’ in 2007. loan shares over the life of the credit. We discuss the SNC Investigating the extent of U.S. banks’ adoption of the database in more detail in the data section. originate-to-distribute model in corporate lending has proved Our study of the change in banks’ corporate lending model difficult because of data limitations. Thomson Reuters Loan yields a number of significant findings. Although the data Pricing Corporation’s DealScan database, arguably the most indicate that lead banks increasingly used the originate-to- comprehensive data source on the syndicated loan market and distribute model from the early 1990s on, we conclude that this the source used by many researchers in the past, imposes increase was limited to a large extent to term loans; in their serious limitations on the investigation of this issue. This credit-line business with corporations, banks continued to rely database includes information available only at the time of loan on the traditional originate-to-hold model. Further, we find origination, making it impossible to use it to investigate what that lead banks increasingly “distributed” their term loans by happens to the loan after origination. Furthermore, DealScan selling larger portions of them not only at the time of the loan has very limited information on investors’ loan shares at the origination, but also in the years after origination. For example, time of origination. The information on the credit shares in 1988, the first year of our sample, lead banks retained in that each syndicate participant holds is sparse, and even the aggregate 21 percent of the term loans they originated that year. information on the share that the lead bank—the bank that sets In 2007, lead banks retained only 6.7 percent of the term loans the terms of the loan—retains at origination is missing for originated in that year. By 2010, lead banks had managed to 71 percent of all DealScan credits. further lower their share in the credits they had originated in The Loan Syndication Trading Association database 2007 to 3.4 percent. contains micro information on the loans traded in the Our investigation into the entities investing in bank loans secondary market, but it has no information about the identity confirms that other banks were not quick to step in and take of the seller(s) or buyer(s), ruling out its use to close the over as lead banks reduced their stake in the loans they information gaps in DealScan. Financial statements filed with originated. Instead, we find that new loan investors, including the Federal Reserve, in turn, contain information only on the investment managers and CLOs, increasingly assumed credit that banks keep on their balance sheets and thus cannot control of the credit business. In 1993, all together, nonbank be used to ascertain the volume of credit that banks originate. investors acquired 13.2 percent of the term loans originated These statements contain information on the loans that banks that year. In 2007, they acquired 56.3 percent of the term hold for sale, but, as Cetorelli and Peristiani (2012) explain in loans originated in that year, a 327 percentage point increase detail elsewhere in this volume, this variable provides limited from fifteen years earlier. information on the extent to which banks have replaced the The trends documented in this article have important originate-to-hold model with the originate-to-distribute implications. Banks’ increasing use of the originate-to- model in their lending business.4 distribute model in their term-lending business will lead to a We rely instead on a novel data source, the Shared National transfer of important portions of credit risk out of the banking Credit program (SNC) run by the Federal Deposit Insurance system. In the process, however, it will contribute to the growth Corporation, the Board of Governors of the Federal Reserve of financial intermediation outside the banking system, System, and the Office of the Comptroller of the Currency. Like including a larger role for unregulated “shadow banking” DealScan, the SNC program is dominated by syndicated loans. institutions.5 It will also, over time, make the credit kept by In contrast to DealScan, however, the SNC program tracks banks on their balance sheets less representative of the still- essential role they perform in financial intermediation. 3 Researchers have suggested several explanations for the development of the In addition, banks’ increasing use of the originate-to- secondary market, including the capital standards introduced with the 1988 Basel Accord (Altman, Gande, and Saunders 2004), the standardization of distribute model could lead to some weakening of lending loan documentation and settlement procedures that came about with the standards. According to several theories—including those of establishment of the Loan Syndication Trading Association in 1995 (Hugh and Ramakrishnan and Thakor (1984), Diamond (1984), and Wang 2004), and the increase in demand and liquidity resulting from the increasing involvement of institutional investors (Yago and McCarthy 2004). Holmström and Tirole (1993)—banks add value because of See Gorton and Haubrich (1990) for a detailed description of the loan-sales their comparative advantage in monitoring borrowers. To market in the 1980s. carry out this task properly, banks must hold the loans they 4 This variable does not distinguish corporate loans from all the other loans originate until maturity. If they instead anticipate keeping only that banks may intend to sell. Further, since there is no information on when the loans held for sale were originated, ascertaining banks’ relative use of the a small portion of a loan, their incentives to screen loan originate-to-distribute model based on this variable is difficult. Lastly, the variable reports only the loans that banks “intend” to sell, not the actual 5 See Pozsar et al. (2010) for a detailed account of the growth of shadow loans that they sold. banking in the United States. 22 The Rise of the Originate-to-Distribute Model applicants properly and to design the terms of the loan contract 2.

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