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.
The use of risk-insensitive loan pricing by the Small Business Administration's disaster loan program leads to significantly higher loan denials in areas with greater need for price discrimination: high minority share, high subprime share, and high income inequality areas. Even though these borrowers are often the intended targets of government programs such as disaster lending, they end up with lower availability of credit in this program compared to private markets. Our findings highlight the importance of using market prices as a mechanism to allocate credit across borrowers, a feature that is often absent from government lending programs around the world. Applicants that would likely receive a loan at a higher interest rate under a risk-sensitive pricing mechanism are instead denied credit altogether. 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 to marginal borrowers.
The share of mortgage lending by four largest banks (Big4) dropped from about 30% to 23% of the market from 2009-2013 following the crisis-related fines and heightened regulatory burden. Aggregate patterns suggest this gap was filled by shadow banks and fintech lenders whose respective shares rose from 24% to 30% and from 2% to 7%. Despite this secular rise in nonbank lending, we present new cross-sectional facts showing that small banks were twice as responsive as shadow banks to fill the gap left by the Big4 retreat, and more than four-times more responsive than fintech lenders. Using granular lender-county data, we use within-bank variation and county fixed effects to show a strong reallocation of lending for small banks toward areas where the Big4 withdrew. We provide evidence that institutional features of the mortgage market and consumer preference for banks play important roles in our findings. Our results highlight the continued importance of small banks despite the rise of shadow banks and financial technology disruption.
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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