We construct a two-period model of revolving credit with asymmetric information and adverse selection. In the second period, lenders exploit an informational advantage with respect to their own ...customers. Those rents stimulate competition for customers in the first period. The informational advantage the current lender enjoys relative to its competitors determines interest rates, credit supply, and switching behavior. We evaluate the consequences of limiting the repricing of existing balances as implemented by recent legislation. Such restrictions increase deadweight losses and reduce ex ante consumer surplus. The model suggests novel approaches to identify empirically the effects of this law. We find the pattern of changes to interest rates and balance transfer activity before and after the CARD Act are consistent with the testable implications of the model.
Housing finance markets have been changing dramatically in both emerging and developed economies. On the one hand, housing finance markets are expanding and represent a powerful engine for economic ...growth in many emerging economies. However, the unfolding sub-prime mortgage crisis highlights the risks and potential turbulence that this sector can introduce into the financial system when expanding without proper infrastructure and regulation. As housing finance keeps growing in emerging economies to match a rising demand for housing, new risk management approaches, business models, funding tools, and policy instruments can help. Yet many questions remain about the right balance between innovation and regulation, the extent of risks to the financial system, the appropriate role of the state to promote affordable housing, and the effects of the sub-prime crisis.This book provides a guide for policymakers dealing with housing finance in emerging markets. It highlights the prerequisites for an effective housing finance system; it lays out several policy alternatives and models of housing finance; and it explores the role of governments in expanding access to housing finance for lower-income households. There is no "best" model set out in this book. The aim is to provide a developmental roadmap that can be tailored and sequenced to each country's situation and timing.
Estimating the effect of Federal Reserve's announcements of Large-Scale Asset Purchase (LSAP) programs on corporate credit risk is complicated by the simultaneity of policy decisions and movements in ...prices of risky financial assets, as well as by the fact that both interest rates of assets targeted by the programs and indicators of credit risk reacted to other common shocks during the recent financial crisis. This paper employs a heteroskedasticity-based approach to estimate the structural coefficient measuring the sensitivity of market-based indicators of corporate credit risk to declines in the benchmark market interest rates prompted by the LSAP announcements. The results indicate that the LSAP announcements led to a significant reduction in the cost of insuring against default risk—as measured by the CDX indexes—for both investment- and speculative-grade corporate credits. While the unconventional policy measures employed by the Federal Reserve to stimulate the economy have substantially lowered the overall level of credit risk in the economy, the LSAP announcements appear to have had no measurable effect on credit risk in the financial intermediary sector.
We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn ...weakens the financial sector by eroding the value of its government guarantees and bond holdings. Using credit default swap (CDS) rates on European sovereigns and banks, we show that bailouts triggered the rise of sovereign credit risk in 2008. We document that post-bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank-level determinants of credit spreads, confirming the sovereign-bank loop.
We document substantial cross-individual dispersion in U.S. credit card borrowing costs, even after controlling for borrower risk and card characteristics. That remaining dispersion arises because ...cross-lender pricing heterogeneity generates dispersion in annual percentage rate (APR) offers to borrowers, and borrowers vary in shopping intensity. Our empirics match administrative data to self-reported card shopping intensity and use instruments suggested by fair lending law to account for the endogeneity between APRs and search. The results show that shoppers versus nonshoppers pay APRs as different as those paid by borrowers in the best versus worst credit score deciles. We discuss implications for policy and practice.
Credit rating agencies have been criticized for their role in the financial crisis by understating credit risk. The US subprime mortgage crisis highlighted the systemic relevance of the rating ...agencies and the deficiencies in their activities; this led to an international consensus to regulate the rating business. Written by those involved in developing European Legislation, this book explains EU Regulation in the context of global initiatives undertaken by the G-20, the Financial Stability Board, and IOSCO to address failures within the rating industry. Through an in-depth analysis of the EU Regulation's requirements on governance, conflicts of interest, methodologies, and transparency, the book provides a clear explanation of how rating agencies operate and how the identified failures have been addressed. Moreover, it examines the supervisory and enforcement powers of ESMA, the EU authority in charge of the registration and oversight of rating agencies. This is complemented with an analysis of guidance from supervisors (ESMA and EBA), IOSCO's recommendations, and US legislation. The book discusses possible new regulatory developments in areas such as the agencies' business model, competition, civil liability, and ratings of sovereign debt, in light of the Euro debt sovereign crisis. It concludes with the authors' support for an enhanced regulatory and oversight coordination at international level and for the implementation of the necessary steps to reduce the existing over-reliance on ratings.
The use of credit scoring - the quantitative and statistical techniques to assess the credit risks involved in lending to consumers - has been one of the most successful if unsung applications of ...mathematics in business for the last fifty years. Now with lenders changing their objectives from minimising defaults to maximising profits, the saturation of the consumer credit market allowing borrowers to be more discriminating in their choice of which loans, mortgages and credit cards to use, and the Basel Accord banking regulations raising the profile of credit scoring within banks there are a number of challenges that require new models that use credit scores as inputs and extensions of the ideas in credit scoring. This book reviews the current methodology and measures used in credit scoring and then looks at the models that can be used to address these new challenges. The first chapter describes what a credit score is and how a scorecard is built which gives credit scores and models how the score is used in the lending decision. The second chapter describes the different ways the quality of a scorecard can be measured and points out how some of these measure the discrimination of the score, some the probability prediction of the score, and some the categorical predictions that are made using the score. The remaining three chapters address how to use risk and response scoring to model the new problems in consumer lending. Chapter three looks at models that assist in deciding how to vary the loan terms made to different potential borrowers depending on their individual characteristics. Risk based pricing is the most common approach being introduced. Chapter four describes how one can use Markov chains and survival analysis to model the dynamics of a borrower's repayment and ordering behaviour . These models allow one to make decisions that maximise the profitability of the borrower to the lender and can be considered as part of a customer relationship management strategy. The last chapter looks at how the new banking regulations in the Basel Accord apply to consumer lending. It develops models that show how they will change the operating decisions used in consumer lending and how their need for stress testing requires the development of new models to assess the credit risk of portfolios of consumer loans rather than a models of the credit risks of individual loans. Available in OSO: http://www.oxfordscholarship.com/oso/public/content/maths/9780199232130/toc.html
We study the effects of physical distance on the acquisition and use of private information in informationally opaque credit markets. Using a unique data set of all loan applications by small firms ...to a large bank, we show that borrower proximity facilitates the collection of soft information, leading to a trade-off in the availability and pricing of credit, which is more readily accessible to nearby firms albeit at higher interest rates ceteris paribus. Analyzing loan rates and firms' decision to switch lenders provides further evidence for banks' strategic use of private information. However, distance erodes our lender's ability to collect proprietary intelligence and to carve out local captive markets, suggesting that the requisite soft information is primarily local.
This study empirically examines the impact of the interaction between market and default risk on corporate credit spreads. Using credit default swap (CDS) spreads, we find that average credit spreads ...decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta, with the effect of cash flow beta varying with market conditions. We identify implied volatility as the most significant determinant of default risk among firm-level characteristics. Overall, a major portion of individual credit spreads is accounted for by firm-level determinants of default risk, while macroeconomic variables are directly responsible for a lesser portion.
An exogenous expansion in mortgage credit has significant effects on house prices. This finding is established using US branching deregulations between 1994 and 2005 as instruments for credit. Credit ...increases for deregulated banks, but not in placebo samples. Such differential responses rule out demand-based explanations, and identify an exogenous credit supply shock. Because of geographic diversification, treated banks expand credit: housing demand increases, house prices rise, but to a lesser extent in areas with elastic housing supply, where the housing stock increases instead. In an instrumental variable sense, house prices are well explained by the credit expansion induced by deregulation.
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