research interests
financial intermediation and regulation, corporate finance, financial contracting, information economics.
published/forthcoming papers
We study the key drivers of security design in the residential mortgage-backed security (RMBS) market during the run-up to the subprime mortgage crisis. We show that deals with a higher level of equity tranche have a significantly lower delinquency rate that cannot be explained away by the underlying loan pool's observable credit risk factors. The effect is concentrated within pools with a higher likelihood of asymmetric information between deal sponsors and potential buyers of the securities. Further, securities that are sold from high-equity-tranche deals command higher prices conditional on their credit ratings. Overall our results show that the goal of security design in this market was not only to exploit regulatory arbitrage, but also to mitigate information frictions that were pervasive in this market.
The Strategic Underreporting of Bank Risk. [Review of Financial Studies, 2017]
(with Amiyatosh Purnanandam and KC Zheng) [ssrn version]We show that banks significantly under-report the risk in their trading book when they have lower equity capital. Specifically, a decrease in a bank's equity capital results in substantially more violations of its self-reported risk levels in the following quarter. The under-reporting is especially high during the critical periods of high systemic risk and for banks with larger trading operations. We exploit a discontinuity in the expected benefit of under-reporting present in Basel regulations to provide further support for a causal link between capital-saving incentives and under-reporting. Overall, we show that banks' self-reported risk measures become least informative precisely when they matter the most.
working papersThe incidence of mis-selling, fraud, and poor customer service by retail banks is significantly higher in markets with lower income and educational attainment. Further, areas with a higher share of minority population experience significantly worse outcomes even after controlling for factors such as income, education, and house price changes. Regulations aimed at improving access to credit to such areas are partly responsible for these findings. Specifically, low-to-moderate-income (LMI) areas targeted by the Community Reinvestment Act have significantly worse outcomes and this effect is magnified further for LMI areas with high-minority population. The results highlight an unintended adverse consequence of such quantity-focused regulations on the quality of credit to poor and minority customers.
Residents of areas with a greater proportion of minorities are denied credit through the Small Business Administration's (SBA) disaster lending program at a significantly higher rate than areas with a lower proportion of minorities. This difference in denial rates is not explained by observable differences in credit risk and is larger than the corresponding difference in denial rates in private lending markets. We find no evidence that taste-based discrimination is driving this result. Rather, we find the difference in denial rates is likely driven by the SBA's use of risk-insensitive loan pricing, where the same interest rate is offered to all approved borrowers irrespective of their relative creditworthiness. This leads to outcomes where borrowers that would likely receive a loan at a higher interest rate are instead denied credit altogether. Overall, our findings highlight the importance of using market prices as a mechanism to allocate credit across borrowers. Programs that limit the use of this mechanism to ensure a "fair" price of credit across borrowers may have unintended "unfair" consequences on the quantity of credit.
Credit rating agencies emphasize the importance of specific financial ratio thresholds in their rating process. Firms on the favorable side of these thresholds are more likely to receive higher ratings than similar firms that are not. I show that firms near these salient thresholds respond to the incentive to improve their appearance on this dimension by distorting real investment activities during periods leading up to bond issuance. These firms are significantly more likely to reduce R&D and SG&A expenditures compared to observationally similar firms not near a threshold. Subsequently, they are more likely to experience declines in innovation output, profitability, and Tobin's Q. These distortions highlight an important cost of arms-length financing and an adverse consequence of transparency in credit rating criteria.
Signaling, Financial Constraints, and Performance-Sensitive Debt. This paper examines how good borrowers use the design of performance sensitive debt contracts to alleviate financial constraints. I show that borrowers use a convex pricing grid (i.e., a contract where the increase in the loan spread following a decline in performance exceeds the decrease in the spread following a performance improvement) to signal their unobservable creditworthiness and receive better bank loan terms. I find that constrained firms that use convex pricing grids receive loans that are 21-28% larger with a spread that is 31-37 basis points lower than observationally similar borrowers that use fixed spread loans. Consistent with the notion that a costly signal should positively correlate with future financial health, I find that constrained borrowers that use a loan with a convex pricing grid are one third less likely to experience financial distress during the term of their loans.
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