UC Santa Cruz

In this dissertation I explore how credit risk and bank lending standards affect financial markets and the greater economy. Credit risk refers to the probability that a borrower will be unwilling or unable to repay debt liabilities. Lending standards take on a broader interpretation: they may refer to the types of borrowers who access debt markets and other non-price loan terms such as loan covenants and other screening or monitoring activities. In addition, credit risk and lending standards are intrinsically linked: to the extent they affect asset quality, lending standards may have significant effects on the risk of default for both borrowers and banks alike. This point is well illustrated by the rise of, and subsequent crisis in, the subprime mortgage market during the mid-- to late--2000s.

In chapter one, I construct a theoretical model to investigate the impact of credit default risk on the terms and provision of unsecured interbank credit. Bank-specific interest rates are derived via a Nash bargaining solution. However, interbank lending transactions are prone to counterparty default risk where the risk of default depends on both aggregate and bank-specific factors. Given the result of the bargaining problem, a cut-off borrower default risk is derived which determines participation in interbank lending markets. The average interbank interest rate is also derived.

After a deterioration of the aggregate factor affecting default risk, participation in interbank lending markets declines and both individual and the average interbank loan rates rise. Monetary policies are also examined: individual and the average interbank loan rates rise when the cost of borrowing from the central bank's lending facility or the return on holding reserves rise. However, an increase in the cost of funds borrowed from central bank increases participation in interbank markets while an increase in the return on reserves reduces participation. The results are discussed in the context of the distress and policy actions taken in the federal funds market during the financial crisis of 2008.

In chapter two, I explore the relationship between monetary policy, commercial bank lending standards, and the probability of bank default. In a partial equilibrium model of the commercial loan market, borrowers with heterogeneous abilities receive loans from financial intermediaries if they satisfy bank lending standards. These lending standards take the form of a minimum ability requirement: only borrowers with abilities that are at least as large as the minimum threshold receive a loan; the rest are rationed. After loans are made, a negative aggregate shock results in unexpected loan losses for the bank which may push them into default.

In the baseline model, the probability of bank default and the policy rate are negatively correlated: after a decrease in the policy rate, lending standards loosen and the probability of bank default rises. However, both the sign and magnitude of this correlation depends on the extent of bank capitalization: the risk of default is positively correlated when banks have sufficiently low capital ratios, while strongly capitalized banks' risk of default falls with the policy rate. Additionally, this correlation grows stronger as bank capital ratios increase relative to the baseline level. These results imply that the nature and size of the trade-off between financial stability and traditional monetary policy objectives depends crucially on bank capital ratios. This also suggests that optimal monetary policy that incorporates financial stability objectives is linked to bank capital structure and, by extension, bank capital regulation.

In chapter three, I investigate the impact of costly bank monitoring on the spread between the loan rate and the risk-free rate and the response of output after a negative bank liquidity shock. A simple RBC model of an economy with a commercial loan market is constructed where financial transactions are characterized by moral hazard on the part of borrowers that ultimately restricts borrower leverage. However, lenders can alleviate the severity of the moral hazard problem by monitoring borrowers' projects after a loan has been made. The intensity of monitoring is optimally chosen by lenders: while more intense monitoring lessens the borrower's moral hazard problem, it is costly.

Compared to an economy without costly endogenous monitoring, costly monitoring results in a less severe drop in capital and output after a surprise increase in the cost of bank deposits. This is driven by the loan rate spread: this spread falls and leads to a larger rise in the excess return to capital over the cost of bank loans which contributes to a faster recovery in borrower net worth, capital, and output.