Loan Technology Causes “Bad Banks” To Take on More Risk
Sophisticated technology-based banking techniques cause financial institutions to lend more, often beyond their profit-maximizing capability, according to a new Working Paper published by the International Monetary Fund. What’s more, it is the “bad banks” that extend the most credit and take on more risk than they would otherwise.
The paper, Innovation in Banking and Excessive Loan Growth, does not represent the IMF’s official view, but provides interesting reading. Authors, Daniel C. Hardy and Alexander F. Tieman write that with hindsight, it appears that the uncertainty of technology-based models was under-estimated in the case of subprime mortgages, and too much reliance was placed on data gathered in a period of unusually favorable macroeconomic conditions
Innovations in loan technology may lead even reputable, good banks to expand lending excessively in order to demonstrate their confidence in their loan technology, and weaker banks may be tempted to imitate then in order not to reveal their weaknesses.
A bank may be especially loath to reveal that it has less confidence in its skills than its rivals by being reluctant to extend large amounts of credit on this basis. Thus, credit volume becomes a signal of a bank’s confidence in its loan technology, and funding costs increase for banks that do not demonstrate this confidence.
Banks employ different levels of loan technologies, such as credit screening and risk management models, techniques, and procedures, characterized by a general loan portfolio parameter. Better loan technologies increase the marginal value of extending credit, i.e., that banks with higher loan technology parameters (“good banks”) have better screening and management techniques and benefit from those by generating on average higher returns.
Financiers (wholesale and depositors), however, have only an estimate of the true loan portfolio parameter, which can be informed by, e.g., reports from rating agencies and historical data. Banks perceived by financers as having a higher loan portfolio parameter are able to pay less for their funding, both on the wholesale credit markets, as well as for deposits.
Then, banks have an incentive to signal good screening techniques and solid risk
management practices. This holds for banks that indeed have such top-of-the-line loan technologies in place, but also for the banks that do not possess these technologies (“bad banks”). Hence, in order to distinguish itself from the signal a bad bank might produce, a good bank might need to extend more credit than it would in the full-information situation.
As marginal costs for the bad bank are always higher than for the good bank, a separating point will always exist. In case the profits beyond this point remain higher than the profits the good bank could reap when the market cannot distinguish it from other bank (as is the case in a pooling equilibrium), the good bank will rationally extend credit and take on more risk over and above its full-information level.
In a pooling equilibrium, it is the bad banks that extend more credit and take on more risk than they would otherwise.
The authors write that banking supervisors can play an important role in mitigating these effects of asymmetric information on financial system soundness. Banks will be loath to reveal their proprietary loan technology, so a full market-based or self-regulatory approach will not be effective.
However, supervisors can influence credit decisions through moral suasion, or by imposing additional capital and general provisioning requirements. They can also require a bank to improve its loan technology. Furthermore, supervisors can compel banks to disclose information about their loan technology, and check that this information is accurate.
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