Heterogeneous creditors and the market value of bank LDC loan portfolios

Journal

of Monetary

Economics

25 (1990) 325-346.

North-Holland

HETEROGENEOUS CREDITORS AND THE MARKET BANK LDC LOAN PORTFOLIOS* Christopher

JAMES

lJnil~er,Gty of Floridu, GainesdIe, Received

March

VALUE OF

FL 3261 I-201 7, USA

1989, final version

received

March

1990

A standard proposition used in many empirical studies is that the value of an LDC loan does not depend on the identity of the lender. I test this proposition using bank securities prices and prices for LDC loans trading in the secondary market. I find significant cross-sectional differences in the sensitivity of bank stocks to changes in the price of LDC loans. Differences in sensitivity appear to be related to changes in bank exposure to LDCs. I also find evidence consistent with the hypothesis that CDs are implicitly insured.

1. Introduction The debt crises of Mexico, Brazil, and other lesser developed countries (LDCs) have focused attention on the mechanisms used to enforce international loan agreements.’ International loan markets differ from domestic loan markets because access to the legal system to adjudicate disputes and enforce judgments is uncertain.’ For international lending to be feasible the failure to repay must impose costs on the defaulting country.” Default costs are assumed to take the form of impaired future access to credit markets or direct sanctions that disrupt the debtor country’s access to international trade. *This ence in Foreign referee

paper draws on an earlier paper that I presented at the Carnegie-Rochester ConferApril 1988, entitled ‘Empirical Evidence of Implicit Government Guarantees of Bank Loan Exposure’. Thanks to Peggy Wier for helpful comments. Special thanks to the for suggesting the model specification.

‘Eaton and Gerovitz (19811, Bulow and Rogoff (19881, Chowdry (1988), and others examine the feasibility of international lending when debtor nations have the option to repudiate their debt. Repudiation is defined as a default by a borrower that is able but unwilling to repay. ‘Most foreign borrowing by developing countries is either guaranteed by the borrower’s government or is done directly by the government. Therefore, so-called country risk is used to measure the default risk of LDC loans. See Saunders (1986). “Unlike a domestic borrower the solvency of a defaulting borrower is rarely an issue. As Bulow and Rogoff (1988) explain, for most LDCs loan payments are a trivial proportion of GNP for borrowing countries.

0304.3932/90/$3.50

0 1990, Elsevier

Science

Publishers

B.V. (North-Holland)

326

C. James, Heterogeneous creditors and LDC lending

Uncertainty concerning the enforceability of international loan contracts can also create conflicts among creditors. Unlike domestic loans, there is no systematic procedure, corresponding to bankruptcy, by which a country that has undertaken an excessive amount of debt can discharge its obligations. For example, creditors do not have access to bankruptcy courts to adjudicate conflicts concerning the priority of their claims. As a result of these potential conflicts most loans to developing countries are made by syndicates of banks. Loans by syndicates contain cross-default clauses that define default as default on any loan made by a syndicate member. Bank loans to developing countries also contain proportionality rules that require that all payments by the debtor country to creditors be shared in proportion to an individual banks exposure to the country. The existence of cross-default clauses and proportional sharing rules have contributed to the view that bank loans to LDCs are homogeneous, that is, the value of a loan to a particular country does not depend on the identity of the lender. The assumption that loans to an LDC are homogeneous is the basis for using secondary market prices of LDC loans to estimate the market value of bank LDC loan portfolios [see for example Sachs and Huizinga (198711. This assumption has also been used in recent studies by Cornell and Shapiro (1986) and Smirlock and Kaufold (1987) on the effect of the Mexican and Brazilian debt crisis on the stock returns of U.S. banks. These studies assume that the effect of information concerning loan repayments on bank share prices varies in proportion to a bank’s exposure to a given country. In this paper I examine whether the value of LDC loans varies among commercial banks, i.e., whether the identity of the lender impacts on the value of the loan.4 The value of an LDC loan may vary among banks for several reasons. First, smaller commercial banks may be able to avoid forced lending that is imposed upon larger creditors in debt restructurings. Second, banks may differ in their abilities to impose sanctions and bargain with LDCs.’ Third, large banks may have access to implicit deposit guarantees that are not made available to smaller institutions. I refer to the hypothesis that the value of LDC loans varies among banks as the Heterogeneous Creditor hypothesis. I test the Heterogeneous Creditor hypothesis in several ways. First, I examine the relation between changes in the market value of a bank’s equity and the return on its LDC loan portfolio. During the period 1986 through the second quarter 1987, I find a positive and statistically significant relation between bank stock returns and the return on bank LDC loan portfolios. However, the stock returns of banks

41 focus in this paper on sovereign the government of the LDC.

debt, i.e., loans made to the government

or guaranteed

by

5For example, Citibank may be in a better position to seize assets or track down bank accounts than a smaller regional bank. See W&l StreetJournal, July 28, 1988.

C. James, Heterogeneous

creditors and LDC lending

327

with the highest levels of LDC loan exposure are significantly less sensitive to changes in the value of LDC loan trading in the secondary market than are the stocks of banks with relatively small levels of exposure. This evidence is consistent with the Heterogeneous Creditor hypothesis and it suggests that secondary market prices understate the value of LDC loans held by heavily exposed commercial banks. The second test involves an examination of the relation between the rate paid on large CDs and bank exposure to LDCs. If large bank CDs are implicitly insured against losses arising from defaults on LDC loans, an increase in LDC loan exposure will have no significant effect on the interest paid on large CDs. The rate on large CDs will, however, vary directly with the ratio of domestic loans to bank capital as well as other measures of bank risk. I find evidence consistent with the hypothesis that bank CDs are implicitly insured against LDC loan losses. However, access to implicit guarantees does not appear to vary with bank size or with growth in LDC loan exposure. Therefore, the differences in the sensitivity of bank stock returns to changes in LDC loan prices does not appear to result from differential access to implicit deposit guarantees. The remainder of the paper is organized as follows. Section 2 provides background on bank LDC lending. In section 3, I examine the reasons why the value of LDC loans may vary among banks. In section 4, I describe my data and the nature of the empirical tests. The results of the empirical analysis are presented in section 5. Section 6 provides a brief summary.

2. Background Since the announcement by Mexico in 1982 that it would be unable to meet its currently due debt obligations, more than 40 developing countries have rescheduled their debts with commercial banks. During this period the exposure of large U.S. commercial banks to troubled LDCs has remained at relatively high levels. For example, table 1 classifies the exposure of U.S. banks to troubled LDCs according to bank size over the period 1977 through 1987.(’ Two institutional characteristics of the LDC loan market are worth noting. First, for the nine money center banks, exposure increased through 1984. Moreover, the proportion of LDC loans held by the largest banks has increased since 1982 from 56 to 64 percent. During the same period the share held by the smallest banks fell from 24 to 17 percent of total U.S. bank exposure. Second, exposure by U.S. banks represents a substantial proportion ‘1 use the same definition of troubled LDCs as Bennett borrowers are defined as LDCs involved in reschedulings, Institutional Incestor credit ratings, or countries with bank secondary market.

and Zimmerman (1988). Troubled countries with less than average loans selling at a discount in the

C. James, Heterogeneous creditors and LDC lending

328

Table 1 Share of troubled Total

LDC loans held by type of bank, 1978 through Nine money center

Next largest

14

1987.” All other

Year

Mil. $

Mil. $

%

Mil. $

%

Mil. $

1978 1979 1980 1981 1982 1983 1984 1985

54116 63715 74728 87707 92033 93896 93819 87257 81112 76611

32583 39482 44388 50099 51925 53571 56004 54084 50884 49173

60.3 62.0 59.4 57.1 56.4 57.1 59.7 62.0 62.7 64.0

10155 11320 13273 16565 18249 18594 18492 15496 14521 14523

18.8 17.8 17.8 18.9 19.8 19.8 19.7 17.8 17.9 19.0

11375 17077 17077 21043 21731 21856 19328 17676 15707 12915

1987 “Source: Country

Lending

Exposure

% 21.8 22.8 22.8 24.0 23.1 23.8 20.6 20.3 19.4 17.0

Survey.

of their regulatory capital.’ For example, the exposure of the nine money center banks to troubled LDCs averaged approximately twice their regulatory capital over the period 1977 through 1987.s

3. The Heterogeneous

Creditor hypothesis

In this section, I discuss three reasons why the value of LDC loans might vary among commercial banks. These reasons are: (1) differences in the ability of banks to avoid additional lending and free ride on a restructuring, (2) differences in bargaining power and investment opportunities among creditor banks, (3) differences in access to implicit loan or deposit guarantees. As I discuss, these explanations differ in their predictions concerning cross-sectional differences in the value of LDC loans. 3.1. Forced lending and the free rider problem Recent studies by Krugman (198.5) and Herring (1989) examine the economics of debt restructurings and the role of commercial banks in the restructuring process. These studies conclude that the conditions for profitable lending to a borrower, with loans outstanding to a group of creditors, differ from the conditions for profitable lending without a debt overhang. In particular, with a debt overhang, the expected return associated with new ‘Regulatory capital is defined as the sum of the book value preferred stock, and reserves for loan losses. ‘Exposure outstanding

of equity,

subordinated

debt,

to certain country groups is also high. For example, money center banks had loans to the 15 Baker plan countries equal to 106 percent of their capital in 1987.

C. James, Heterogeneous creditors and LDC lending

329

lending will include the effect of new loans on the probability of default on existing loans. Krugman (1985) shows that it is always in the interest of creditors as a group to lend enough to avert default if there is some positive probability of repayment in subsequent periods. Krugman defines a forced lending situation as one in which lending is unprofitable in absence of existing loans. As a result, in a forced lending situation, lenders individually have an incentive to free ride and rely on others to lend enough to avert a default.” The U.S. government and multinational agencies have attempted to enforce sharing rules that reduce the free rider problem. For example, Sachs (1987) argues that the Federal Reserve System and the IMF require concerted lending as a condition for their participation in a restructuring. Concerted lending requires individual banks to contribute new loans in proportion to their existing claims. The Federal Reserve has also used moral suasion to pressure banks to continue to refinance loans to troubled LDCs.“’ As table 1 indicates, smaller banks have failed to maintain their proportional shares. The decline in the lending of smaller banks has been explained, in part, by differences in the ability of the Fed to enforce sharing rules. In particular, the regulator’s threat to require banks to mark heavily discounted loans to market is more effective in compelling the participation of banks with high levels of exposure than banks with modest LDC loan exposure [see Sachs (1987)l. The free rider problem and the declining shares of smaller banks has led to distinction between two groups of lenders: (1) members of the core group of creditors (who are compelled by the size of their exposure to participate in a restructuring) and (2) members of the fringe group of creditors (who free ride on restructurings by reducing their exposure). The two groups are distinguished either by the size of their exposure or by changes in their exposure (with fringe members reducing their exposure more rapidly during a restructuring). The model of forced lending suggests that the value of LDC loans will differ between the two groups of banks. In particular, the value of LDC loans held by fringe members who are able to avoid proportionality rules will exceed the value of loans held by core members who must continue to lend. This follows from the fact that in a restructuring the expected return on new lending is decreasing in the amount of new lending.” This argument predicts

‘One explanation of the widespread use of bank loans as a source of external debt financing for LDCs is that a smaller group of lenders is better able to control the free rider problem than a large dispersed group of creditors. “‘See, for example, Wall Street Journal, July 28, 1988. Sachs (1987) refers problem as the ‘exploitation of the large by the small’. “See

Krugman

(1985).

to the free rider

330

C. James, Heterogeneous creditors and LDC lending

that the value of LDC loans to fringe banks will exceed core lenders.

the value of loans to

3.2. Differences in sanctions, bargaining power, and incestment opporturzities The above discussion ignores differences in the sanctions banks can impose on deadbeat LDC borrowers as well as the differences in the investment opportunities lenders may have. These differences can result in the value of LDC loans held by heavily exposed banks (so called core lenders) exceeding the value of loans held by fringe banks (even though fringe banks can free ride). Bulow and Rogoff (1988) argue that creditors can impose significant costs on LDCs in the event of default. These costs include the seizure of collateral and disruptions of international goods markets and capital market transactions. Moreover, Folkerts-Landau (1985) and Edwards (1986) argue that one reason most external debt to LDCs is financed through banks is that banks are in a better position to seize assets and impose sanctions than are individual investors. The existence of enforceable sanctions has two important implications for the value of LDC debt held by commercial banks. First, as in domestic lending, the value of LDC loans will vary with the type of collateral backing of the loan and with the ability of the lender to seize the collateral.‘2 Moreover, money center banks, by virtue of their involvement in international capital markets, may be better able to track down bank accounts or other assets that can be seized. These banks may therefore expect to receive more in the event of default than smaller lenders.‘” A second implication of sanctions is that banks with large foreign loan exposure may have, by virtue of their ability to impose sanctions, superior bargaining power. Differences in bargaining power can create differences in the ability of banks to negotiate concessions. Concessions may take the form of access to exit bonds that provide senior claims to certain assets of the borrower or access to preferential exchange rates in debt for equity swaps.14 Differences in creditor banks’ abilities to obtain concessions from borrowing “For lending

example, the power to appropriate collateral to avoid any debt restructurings. See Struber

has enabled (1985).

creditors

that provide

aircraft

13A substantial portion of the loans held by Citibank and other money center banks are not syndicated. See Wall Street Journal, September 26, 1988. In the case of nonsyndicated loans, the individual bank will enjoy all of the benefits associated with its ability to seize assets. 14Sachs and Huizinaa (1987) point out that debt conversions and exit bonds violate these proportionality rules. T-he debt-for-equity swap market for Brazilian debt is discussed in a recent Wall Street Journal article (September 9. 1988, p. 18). See also New York Times, ‘US Banks SWAP Latin Debt’, September 11, 1986, p. 33. Some banks appear to receive a higher price for their loans in ‘informal’ swaps, that is swaps that are not conducted through the Brazilian central bank.

C. James, Heterogeneous creditors and LDC lending

countries Citibank’s

is suggested in a recent Wall Street Journal article reduction in LDC loans:

331

concerning

the

In exchange for the $2 billion of developing nation loans it shed, Citibank said it got cash and investments valued at $1.63 billion, resulting in a loan loss provision charge of $360 million - or just over 18% - of the total amount. The effective discount compares favorably with the much larger discounts taken by Citibank’s competitors, such as First Chicago Corp. which reported a discount of 36 percent on the $505 million reduction in its Third World loans in the six months ended June 30.15 Finally, the value of LDC loans can vary because of differences in the investment opportunities available to creditors. Differences in investment opportunities can affect the value of LDC loans that are used in debt-forequity swaps. Although debt-for-equity swaps programs differ in their requirements and procedures, these transactions generally involve the exchange of dollar-denominated external debt (extended to either sovereign entities or to private sector companies) into equity in government-approved investment projects. The value of LDC debt in these conversions will depend on the investment opportunities available to the creditor or the purchaser of the debt. For differences in value to persist, trade in LDC loans must be constrained. While banks with large LDC loan exposures have purchased some LDC debt in the secondary market, regulatory pressure to limit their LDC loan exposure has limited trade among commercial banks, particularly since 1984.ih In addition, the importance of collateral suggests that the value of LDC loans may be affected by the same factors that affect the value of domestic loans.” In this case, the agency problems arising from private information that limit the market for domestic bank loan sales also constrain the sale of foreign loans [see Pennacchi (1988)]. ‘“Wall Street Journal, July 28, 1988, p. 26. The average price of bank loans trading in the secondary market in the first quarter of 1988 was $43 implying a discount of 57 percent. The smallest discount was 35 percent for loans to Colombia. The article states that Citibank is reluctant to disclose how it has reduced its exposure because it fears losing an advantage over its competitors. “The supervision and regulation of bank foreign lending was strengthened under the International Lending and Supervision Act of 1983. The general objectives of the Act are to encourage diversification of risk and to limit exposure to heavily indebted LDC countries. See Young (1985). 17Differences in value attributable to differences in the types of loans held can create differences in the apparent value of LDC loan portfolios among commercial banks that will not diminish with trade in LDC loans. Moreover, since a bank’s willingness to lend in a restructuring is positively related to the probability of default, more secured loans are likely to remain in bank portfolios. Therefore, the poorest quality loans will be sold and the highest quality loans maintained in the bank’s portfolio.

332

C. James, Heterogeneous

creditors and LDC lending

3.3. Implicit insurance A final reason the value of LDC loans may vary among banks is differences in access to implicit government guarantees. Penati and Protopapadakis (1988) argue that the exposure of large U.S. banks to LDCs and the systemic risk associated with LDC loans make the provision of implicit government guarantees more likely. While there have been no public pronouncements that provide unequivocal evidence of the existence of LDC loan guarantees, Sachs (1987) and Guttentag and Herring (1985) and others argue that the extensive government involvement in restructuring (either directly through the Federal Reserve System or the Treasury or indirectly through the IMF) has resulted in the expectation by bank depositors that LDC loans will be guaranteed. Moreover, regulatory accounting treatment of troubled LDC debt, it is argued, has resulted in capital forbearance by bank regulators (i.e., the failure to close banks that do not meet minimum capital requirements). In particular, for purposes of capital requirements banks have not been required to record losses on LDC loans even though these loans trade at a substantial discount in the secondary market. Access to implicit deposit guarantees may vary among banks depending on their LDC loan exposure. For banks with substantial exposure relative to their capital, regulatory forbearance is more likely. In addition, banks with access to implicit guarantees will be less likely to reduce their exposure than banks without access to implicit guarantees. In this paper I examine whether the rate on large CDs (i.e., deposits in excess of $100,000) reflect an implicit guarantee that differs across banks. In addition, as in the case of differences in sanctions or investment opportunities, the existence of implicit guarantees together with regulatory constraints on the volume of loans held, implies that the value of LDC loans to core banks will exceed the value of LDC loans to less heavily exposed fringe banks.

4. Methodology

and data

I perform two tests of the Heterogeneous Creditor hypothesis. First, I examine the relation between changes in the market value of a bank’s equity and the return on its LDC loan portfolio calculated using secondary market prices. l8 The secondary market p rice for LDC loans is assumed to reflect the value of LDC loans to fringe banks. ‘sLaney (1987) finds a significant relation between secondary market prices and traditional measures of country risk (e.g., the debt to export ratio or the ratio of foreign debt to GNP). For the 15 countries with price quotes available from Salomon Brothers, I find a negative and statistically significant relation between the Institutional Imestor ‘Country Credit’ risk ratings and the discount on LDC in the secondary market, Using year-end prices for 1985 and 1986 the Spearman’s rank correlation between credit ratings and loan discounts is 0.843.

C. James, Heterogeneous creditors and LDC lending

333

The return on a bank’s LDC loan portfolio is constructed as follows: First, information on public or publicly guaranteed LDC loans outstanding (at book value) was obtained for each bank from the Federal Reserve’s Country Lending Exposure Survey (CELS). I9 This information is available on a quarterly basis beginning with the first quarter of 1985 through the second quarter of 1987. Secondary market price quotes for developing country bank debt were obtained from Salomon Brothers’ quote sheets. Secondary market prices are available for bank loans to 15 countries.20 The banks in my sample reported exposure in each quarter to only seven of these countries. Therefore, the analysis is based on the seven countries for which exposure was reported. The seven countries are: Argentina, Brazil, Chile, Colombia, Mexico, Philippines, and Venezuela. The return on the debt of country i in quarter t, denoted as R,,, is calculated as

where Pi, is the average of the bid and offer prices on the debt of country i at the end of quarter t, and Pi,_, is the average of the bid and offer prices on the debt of country i at the end of quarter t - 1. Quarterly returns rather than monthly returns were used for two reasons. First, balance sheet measures of exposure by country are available only on a quarterly basis. Second, use of quarterly returns reduces any bias induced by infrequent trading in the debt of LDCS.~’ The return on LDC loans ignores interest flows, if any, associated with the loan. However, since the interest rate on LDC bank loans is tied to LIBOR [see Edwards (198.511, I assume that the primary reason for changes in secondary prices is changes in default risk. The return on each bank’s LDC loan portfolio was calculated to account for differences in the composition of each bank’s LDC loan portfolio. The return on the LDC loan portfolio of bank j is defined as

where

eijr is the market

value of loans by bank j to country

‘“Banks are required to report country exposure that Federal Reserve’s Statistical Release El6 for a description “‘See Laney (1987) for a description

of the secondary

i

at the beginning

exceeds 0.74 percent of capital. See of the CELS reporting requirements. market

for LDC loans.

“See Dimson (1983) for a discussion of the problems associated with infrequent trading. Salomon Brothers (1987) estimates that the secondary market for LDC bank loans has expanded from $1.5 billion in 1983 to $19 billion in 1987.

334

C. James, Heterogeneous creditors and LDC lending

of quarter t divided by the market value of all LDC loans held by bank j, and Ri, is the return on loans to country i for quarter t. Next, since the effect of LDC loan returns on the market value of bank equity will vary with the size of the LDC loan portfolio relative to the market value of equity, the return on each bank’s LDC loan portfolio was multiplied by the ratio of the market value of its LDC loan portfolio to the market value of the bank’s common stock at the beginning of the quarter. The market value of equity was calculated by multiplying the price of the bank’s stock at the beginning of each quarter by the number of shares outstanding. Finally, to examine the relation between changes in the market value of equity and changes in the value of LDC loans, I estimated the following pooled cross-section time series regression: N

T

mT,t=P,

+ C P,W,+ I=2

C ‘jZ,

+al

II

;=2

TBLMQ

TBLMb$ +‘yIYI

Assets,,

TBLMV + ~z~,~R,;Xjt

TBLMI/,, MV, Rs

RT; +

a2

+ &,

MI/;,

RT;‘yI

(1)

where

TBLMY, wjt

Asset ;,

= return on the jth bank’s common stock over quarter t, = 1 for quarter t (t = 2,. . . , T), 0 otherwise, = 1 for bank j (j = 2,. . . , N), 0 otherwise, = 1 if bank j is a member of the core group of lenders, 0 otherwise, = market value of bank j’s LDC loans at the start of quarter t, = market value of bank j’s common stock at the start of quarter t, = book value of the assets of bank j at the start of quarter t.

In appendix A, I derive eq. (1). Individual bank and time period dummy variables are included to account for other factors that might effect bank stock returns that vary cross-sectionally and through time (for example, general stock market movements or changes in the level of interest rates). In addition, the model is estimated including individual bank dummy variables multiplied by the holding period return on 90-day T-bills and the return of the NYSE composite index. As shown in appendix A, (Y, and a2 measure the responsiveness of fringe banks’ and core banks’ stock returns to the return on their LDC loan portfolio (controlling for asset composition). In the previous section, fringe

C. James, Heterogeneous creditors and LDC lending

335

and core banks were distinguished by changes in their LDC loan exposure and the size of their exposure. I define members of the core on the basis of both the size of a bank’s LDC loan portfolio and changes in the holdings of LDC loans.** I assume that there is a critical level of loan exposure or change in loan exposure that determines group membership. Since there is no way to know this level of exposure a priori, I employ Quandt’s switching regression methodology to determine the critical level. Defining core group membership on the basis of the book value of LDC loan exposure, the critical value for exposure is $2.0 billion. When membership is defined on the basis of the percentage change in exposure the critical level is - 1.1 percent.*’ The average book value of troubled LDC loans held by the core group and fringe group (defined on the basis of total loans outstanding) is $6.4 billion and $212 million, respectively. The average ratio of troubled LDC loans to total capital for the core and fringe group is 1.7 and 0.25, respectively. Appendix B contains a list of banks in the core group. If secondary loan prices serve as a reasonable measure of the value of loans held by fringe banks, then &, is expected to be positive. By construction, 6, measures the change in the value of equity associated with a change in the value of the bank’s LDC loan portfolio. Under the forced lending hypothesis the estimated value of &* is expected to be greater than zero, while differences in bargaining power and differential access to implicit insurance imply the estimated value of I_?~will be less than zero. The sensitivity of bank stock returns to the return on LDC loans will also vary with leverage. In particular, Galai and Masulis (1976) and Brickley and James (1986) show that the sensitivity (or elasticity) of stock returns with respect to the return on the underlying assets varies inversely with the ratio of equity to total assets. As shown in appendix A, the parameter y captures the effects of leverage on stock return sensitivity. Therefore, the expected sign of 9 is negative.24 The second test of the Heterogeneous Creditor hypothesis involves examining the relation between the interest cost of large CDs, financial leverage and the composition of a bank’s loan portfolio. Lenders may value their LDC loans differently because of differential access to implicit deposit guarantees on foreign loan exposure. The interest cost of large CDs is estimated from

‘“The banks in my sample are the largest money center and regional banks. As table 1 suggests, the share of LDC loans held by these banks did not decrease during the 1980’s. A better indicator of fringe group membership would be banks in the smallest size category (i.e., banks in the ‘other banks’ category in table 1). Unfortunately these banks did not report exposure on a consistent basis during the 1986 through 1987 period. aa1 also estimated the model using the ratio of LDC loans to equity capital to define core group membership. The switch point using this definition is 1.93. The results under all three definitions of core group membership are virtually identical. 241 thank

the referee

for pointing

this out to me.

336

C. James, Heterogeneous creditors and LDC lending

information contained in the Consolidated Report of Condition and Income. The average rate paid on CDs is estimated by dividing the total interest paid on domestic CDs of $100,000 or more by the average volume of large CDs outstanding during the quarter (only the interest cost on domestic CDs is reported). A problem with using the average interest paid on CDs as a proxy for the offer rate on new CD issues is that it fails to account for differences in the maturity of CDs outstanding. However, the large bank supplement to the Report of Condition contains information on the maturity structure of CDs outstanding. From this information a weighted average maturity of a bank’s CDs can be computed.25 The interest cost on large CDs is assumed to be a function of several factors: (1) the average maturity of the CDs outstanding, (2) the general level of interest rates as measured by the average yield on 90-day Treasury bills over the quarter, (3) the default or credit risk of the bank’s asset portfolio, (4) the ratio of domestic loans to capital, and (5) the ratio of troubled LDC loans to bank capital. Month-end yields on 90-day Treasury bills in the secondary market are used to calculate the average yield on Treasury bills during each quarter. To measure the risk of a bank’s asset portfolio, I calculated the variance of the bank’s monthly common stock returns for the twelve months prior to the end of each quarter. I then multiplied the variance in stock returns by the square of the ratio of assets to the market value of equity. This adjusted variance measure provides an estimate of the variance of the bank’s asset returns2” The volume of loans to troubled LDCs represents the book value of loans to countries whose bank loans are trading at a discount in the secondary market. LDC loan exposure is divided by the market value of total bank capital. Total bank capital equals the sum of the book value of subordinated debt and preferred stock and the market value of common stock outstanding (preferred stock and subordinated debt are included in capital because they represent claims junior to those of depositors). Finally, the volume of domestic loans outstanding is calculated from the Call Report. If deposits are implicitly insured against all losses, then no significant relation is expected between CD rates and either asset risk or financial leverage. If deposits are implicitly insured against losses arising from only

‘“The dollar volume of time deposits of $100,000 or more is reported for five maturity categories; 1 day to 3 months, 3 months to 6 months, over 6 months to 12 months, over 1 year to 5 years, and over 5 years. The weighted average maturity is calculated in months, with deposits of from 1 day to 3 months assigned a value of one month. For the remaining categories, the maturity of CDs is assumed to be the longest maturity in that category. For deposits over 5 years a maturity of 60 months was assigned. *(‘This calculation is based on a simplifying assumption uninsured deposits is zero. See Brealey and Myers (1986).

that

the variance

of the return

on

C. James, Heterogeneous creditors and LDC lending

337

LDC loans, a significant relation is expected between CD rates and the volume of domestic loans relative to total capital. However, no significant relation is expected between CD rates and the volume of foreign loans to total capital.

4.1. Data The empirical analysis is based on a sample of 23 banks. Banks were included in the sample if they met the following criteria: (1) information on the bank or bank holding company was contained in the Compustat Quarterly Bank File, (2) a lead bank was identifiable in the case of a multibank holding company, and (3) the bank reported loans outstanding to an LDC with bank loans trading in the secondary market during the entire period from the first quarter of 1986 through the second quarter 1987. Only banks contained in the Compustat Quarterly Bank File were included because Compustat was used to obtain monthly stock returns and balance sheet information for bank holding companies. Only bank holding companies with an identifiable lead bank were included in the sample so that balance sheet items obtained from the lead bank’s Call Report will adequately reflect the holding company’s balance sheet.” Finally, information on bank exposure to troubled LDCs was obtained on a quarterly basis from the CELS. Secondary market prices are available beginning in December 1985. Therefore, the analysis covers the period 1986 through second quarter 1987.

5. Empirical

results

5.1. Stock return analysis Table 2 provides summary statistics for the 23 banks reporting exposure to LDCs with bank loans trading in the secondary market. Table 3 provides the quarterly bid and ask prices for LDC loans over the 1986 through 1987 period. As the data in table 2 indicates, the average ratio of the market value of troubled LDC loans to market value of equity is 0.597 and the average ratio based on the book value of loans is 0.834. Loans to troubled LDCs are *‘Only bank holding companies with the lead bank constituting 75 percent or more holding company’s assets in 1986 are included in the sample. For holding companies sample, assets of the lead bank average 90 percent of the holding company’s assets.

of the in the

C. James, Heterogeneous creditors and LDC lending

338

Table 2 Descriptive

statistics

for a sample

of 23 commercial banks with exposure through second quarter 1987.

Assets of the holding company (in thousands) Book value of loans to troubled LDCs/market value of capital Market value of loans to troubled LDCs/book value of bank capital Book value of troubled LDC (in thousands) Ratio of domestic loans to market value of bank capital Average maturity of CDs (in months) Interest cost on CDs Yield on T-bills

to troubled

LDCs,

Mean

Maximum

Minimum

$41,482,831

$196,124,000

$3,948,208

0.887

5.169

0.537

1.37

0.099

$231,153

$9,709,400

$24,420

10.33

52.46

1.998

10.74

30.50

1.25

0.074 0.059

0.105 0.069

0.041 0.053

1986

0.0269

Table 3 Indicative 1986

prices for LDC bank loans.”

:1

1986:2

1986 : 4

1986:3

Country

Bid

Offer

Bid

Offer

Bid

Offer

Bid

Offer

Argentina Brazil Chile Colombia Mexico Philippines Venezuela

64.0 74.0 67.0 84.0 60.0 57.0 78.0

66.0 77.0 69.0 85.0 63.0 62.0 81.0

66.0 74.0 67.0 84.0 58.0 64.0 76.0

67.0 75.5 69.0 86.0 60.0 65.0 78.0

66.5 75.0 66.0 84.0 56.0 56.0 75.0

67.5 76.0 69.0 86.0 58.0 58.0 76.0

65.0 75.0 65.0 82.0 55.0 56.0 73.0

66.0 77.0 68.0 84.0 57.0 57.0 74.0

Country

Bid

Offer

Bid

Offer

Bid

Offer

Argentina Brazil Chile Colombia Mexico Philippines Venezuela

59.5 63.0 69.5 86.0 59.0 59.0 73.0

61.5 65.0 70.5 87.0 59.75 59.75 74.5

47.0 61.0 69.0 84.5 56.0 69.0 70.0

49.0 62.0 70.5 86.0 56.75 70.0 71.0

34.0 38.0 52.0 73.5 47.25 55.0 49.0

35.0 39.0 53.0 75.0 48.0 57.0 51.0

1987 : 2

1987: 1

“Source:

Salomon

Brothers.

1987:3

339

C. James, Heterogeneous creditors and LDC lending Table 4

Pooled cross-section time series estimates of the relation between bank stock returns, the return on bank LDC loan portfolios, and leverage, using quarterly data for 23 commercial banks, 1986 through second quarter 1987.

Estimated Equation: N

T

RE7;,-/?,-I

c&W,+ i=2

TBLW;, +a,-R.;X,, IWK

TBLMV;,

~A,Z,+a,~ js?

TBLMV,, R; + a,~-------R; Assets,,

TBLM;’ RJ;‘X), f ciii, +n,y 2 W,l

(11

where RET;,

equals the return on the jth banks stock in quarter t, W, and Z, are trend and bank dummy variables, TBLMV,, is the market value of LDC loans, 3, is the market value of the bank’s stock, Rz is the return on the bank’s LDC loan portfolio, Assets,, equals total assets of the bank, and X,, is a dummy variable for core group membership. Estimate”

Coefficient” “I a2 Y

1.716 - 1.413 -11.435

R* = 0.603 “Individual hEstimates iterations. ‘t-statistics

f-statistic’ 4.144 - 3.023 -2.155

SSR = 0.227

bank and trend dummy variables are omitted. are based on a linear ~ipproximation to eq. it). are based

Convergence

occurs

at four

on the last iteration.

therefore an important part of the ioan portfolios of the banks in my sample. Finally, it is interesting to note that the average market discount from book value of LDC loans during this period is 35 percent. The first test of the Heterogeneous Creditor hypothesis involves an analysis of the relation between bank stock returns and the return on LDC loans trading in the secondary market.‘s Because eq. (1) is inherently nonIinear, it is estimated by an iterative process which involves successive estimates of a linear approximation of eq. (1) using OLS techniques.” The coefficient estimates obtained from this procedure and the t-statistics from the final iteration are contained in table 4.

*‘This test of the Heterogeneous Creditor hypothesis is based on an assumption that the returns on LDC loans are uncorrelated with other factors affecting bank stock returns. To determine whether this assumption is consistent with the data, I calculated the correlation between LDC loan returns and the NASD bank stock index (an index that consists primarily of smaller banks with little LDC exposure). None of the correlation coefficients are statistically significant at the 0.10 level. ‘“In estimating terms of eq. (1).

eq. (1). ai, cyz, and y are constrained

to have the same value in the different

340

C. James, Heterogeneous creditors and LDC lending

The results indicate a statistically significant relation between bank stock returns and changes in the market value of bank LDC loan portfolios as measured by changes in secondary market prices. Similar results are obtained when an interest rate factor (90-day T-bill returns) and the return on the NYSE composite index are included in the model. The negative coefficient on the core group dummy variable (a,) is consistent with the Heterogeneous Creditor hypothesis. Banks with the largest book value of LDC loans outstanding are significantly less sensitive to changes in the value of LDC loans as measured by changes in secondary market prices than are banks with smaller LDC loan portfolios. This result suggests that for members of the core group, changes in the value of LDC loans trading in the secondary market provide a poor indication of changes in the market value of their LDC loan portfolios. Moreover, since the average return on LDC loans is negative, the results are consistent with the hypothesis that the value of LDC loans held by core lenders exceeds their secondary market prices. This is evidence consistent with either differences in bargaining power or differences in access to implicit deposit guarantees among commercial banks. In addition, when I estimate the model using only data for the core group, I fail to find any significant relation between core bank stock returns and the return on LDC loans. Finally, ? is negative and statistically significant. This result is consistent with the work of Galai and Masulis (1975) which predicts that the sensitivity of common stock returns with respect to the return on the underlying assets of the firm varies inversely with the firm’s capital to asset ratio.

5.2. CD rate analysis The value of LDC loans may differ among banks due to differential access to implicit deposit guarantees. To determine whether investors expect implicit guarantees on large deposits, I examined the relation between the rate paid on bank CDs and measures of default risk and bank exposure to troubled LDC loans. The result of the analysis of CD rates is presented in table 5. The results are consistent with previous studies that find a risk premium in the rates paid on large CDs [see, for example, Baer and Brewer (19861, Hannan and Hanweck (1987), and James (1987,1988)]. I find a positive and statistically significant relation between CD rates and bank asset risk. Moreover, I find a positive and statistically significant relation between CD rates and the ratio of domestic loans to total capital. This result is inconsistent with the hypothesis that large CDs are priced as if they are fully insured. The negative coefficient on the ratio of LDC loans to total capital is consistent with the hypothesis that implicit insurance extends to losses arising

C. James, H&rogeneous

creditors and LDC lending

341

Table 5 Pooled cross-section time series regression relating interest cost on large CDs to loan portfolio composition for a sample of 23 banks with LDC loan exposure (t-statistics are in parentheses). Independent

variable

Intercept

(1) 0.0040 (0.364)

1.0723

T-bill rate

(2) 0.0056 (0.67X)

(5.935)

1.0013 (7.X64)

of CD

0.0004 (2.700)

O.OOOh (4.573)

Domestic market

loans/ value of capital

0.0053 (1.03X)

0.0074 (2.280)

Troubled market

LDC loans/ value of capital

- 0.0086 (-2.612)

(~ 1.623)

0.0002 (2.263)

0.0001 (157.1)

Average

maturity

Adjusted variance in monthly stock returns Asset size R2 Number

of observations

- 0.0085

1.23D(0.527) 0.277 13X

”

0.3x I 1.18

from LDC loans. Finally, the difference between the coefficient on domestic and LDC loans is statistically significant at the 0.05 level. While the results reported in table 5 are consistent with the hypothesis of implicit insurance extending to LDC loans, an alternative interpretation of these results is that LDC loan exposure serves as a proxy for bank size. It might be argued that larger banks are perceived by investors as ‘too big’ to be permitted to fail. This argument implies that implicit insurance is provided because of bank size and not as a result of LDC loan exposure. To test whether LDC loan exposure simply serves as a proxy for bank size, I re-estimated the CD interest rate model including bank size (as measured by total assets) as an independent variable. These results are reported in the second column of table 5.“” As the results reported in table 5 indicate, I find no significant relation between CD rates and bank size. Moreover, when bank size is included in the regression, the coefficient on LDC loans continues to be negative. Finally, to determine whether banks that are members of the core group are afforded implicit deposit insurance while smaller fringe banks are not, I included in the CD rate model a dummy variable that takes on the value of a”The model was also estimated using a dummy variable that takes on the value of one, if a bank is one of the nine money center banks, zero otherwise. The estimated coefficient on the dummy variable is positive although not statistically different from zero.

C. James, Heterogeneous creditors and LDC lending

342

one if the growth in a bank’s LDC loan portfolio or the level of exposure is above the critical value determined in section 4. The estimated coefficient for this variable (using the volume of LDC loans to determine group membership) is negative although not statistically different from zero at the 0.30 level. Therefore, while bank CDs appear to be implicitly insured against losses arising from LDC loan defaults, access to implicit guarantees does not appear to differ for core and fringe group members.

6. Summary

and conclusion

In this paper 1 cxaminc whether the identity of the lender affects the market value of LDC loans. I test this hypothesis using bank securities’ prices and prices for LDC loans trading in the secondary market. I find significant cross-sectional differences in the sensitivity of bank stocks to changes in the price of LDC loans trading in the secondary market. Differences in sensitivity appear to be related to whether the bank is a member of the core group or a member of the fringe group. In particular, I find that the stock returns of banks who arc members of the core group are less sensitive to changes in LDC loan prices than are the stocks of smaller banks. This evidence is consistent with the hypothesis that LDC loans of banks that have continued to lend to LDCs have a value that exceeds the price of these loans trading in the secondary market. In addition, I examine whether banks are afforded implicit deposit insurance for losses associated with LDC loans and whether differences in access to insurance can explain differences in the value of LDC loans among banks. I find evidence consistent with the hypothesis that CDs are implicitly insured. However, I cannot reject the hypothesis that all banks in my sample are afforded access to implicit insurance.

Appendix

A

Derirztiorl of the relation between bank stock returns to returns on bank LDC loan por[folios In this appendix, I derive an expression for the relation between bank stock returns and the return on bank LDC loan portfolios that accounts for differences in leverage among banks. This appendix is based on comments provided to me by the referee. Define the market value of equity as MV, and the market value of bank assets as ,4,. Assume that the return on bank assets are lognormally distributcd with a constant instantaneous variance of a,‘. In addition, assume that the bank stocks pay no dividend and that bank deposits have promised are consistent with the payments of X, due in r periods. These assumptions

C. James, Heterogenrous creditors and LDC kwditq

343

valuation of equity as a European call option using the Black-Scholes option pricing formula. The call option is written on the assets of the bank and has a strike price of X,. Given these assumptions, Ito’s lemma can be used to derive an expression for the change in the market value of equity tdMI/;) given a change in the bank’s asset values. In particular:

dM1/;=

aMy aA I

dAi +I”-

iPMV -&,‘A; 3A;

fiMr/; dt + ~ dt. ijt

Assuming the last two terms (which are nonstochastic) can be captured constant hi, the return on equity (dMb$/MI/;) can be written as

RE7;=Aj+--p

aMy

A,

dAi

c?A; My

A,

by a

(A.11

’

with RE7; = return on bank stock j, i.e., the return on the stock is a function of the return on bank assets and the elasticity of the stock with respect to the underlying assets. Assume that bank assets can be divided into two groups: LDC loans and ‘other assets’. Let A, = TBLMV, + v,, where TBLMI( is the market value of the bank’s LDC loan portfolio the market value of the bank’s other assets. Dividing the bank’s assets in this way, the return on bank equity expressed as

REl+,+-

aMv, aA,

aMl( V TBLMV ‘-R; Mv. ’ R:” + ~ ilA, My i

where R,” is the return on the bank’s LDC on the bank’s ‘other assets’. In the empirical analysis, I assume that are uncorrelated with the return on LDC index and the return on 90-day Treasury return on other bank assets.

loan portfolio

and r/: can be

(A-2)

and RI the return

the returns on other bank assets loans. The return on the NYSE bills are used as proxies for the

C. Jumes, Heterogeneous creditors and LDC lending

344

Ignoring

for the moment

the return

dMVj TBLMV ~ -R1” dAi MV

RE7;=hit

on ‘other

assets’, we have

+ .$I,.

(A.3)

Estimating (A.3) requires a measure of dM1/;/dA,, the responsiveness of the market value of equity to a change in the value of bank assets. This sensitivity will vary with the leverage of the bank. In particular, in the context of the Black-Scholes call option pricing formula it can be shown that dMV __ =N(d,), dA i where N(d,) is the standard normal evaluated at d, [0 I N(d,) I 11 and ,J7,with rf= risk-free rate of interest. d, = [ln( A,/X,) + (rf + q2/2hl/ (T Galai and Masulis (1976) show that N(d,) varies inversely with leverage. In the empirical analysis I use a linear approximation for N(d,), that is

(A.4)

Substituting

(A.41 into (A.3) and simplifying

yields

TBLMV,, TBLMV RET,, = A, + a, ~ RI”,+ (YIYI Assets, R,Y. M’/;I 11

(A.3

To determine whether the value of LDC loans differ for the core group, estimate the following model [eq. (1) in the text]: N

7’

RET,,=P,+

CPtY+

t-2

TBLMI/;,

C’jZ,+a,

j=2

012

R;X,r MY,

TBLMI/;[ R; + ff IYI Assets, Ri”; If

TBLMq*

TBLMI/,, +

M1/,,

+ ~ZY 1

Assets,

I

RT;‘Xjr

+ Sj,.

(A.61

Since the sensitivity of stock returns with respect to the return on the underlying assets of the bank varies inversely with leverage, the expected sign of 9 is negative. The estimate of y, reported in table 4, is - 11.43. Given the average ratio of market value of equity to total assets is 0.056, the estimate of y implies that N(d,) = 0.36.

C. James, Heterogeneous creditors and LDC lending

Appendix

345

B

Banks in the core group of lenders

.“The

Defined by volume of LDC loans

Defined by percentage change in exposure”’

Bank of America NA Citibank NA Chase Manhattan Bank NA Morgan Guaranty Chemical Bank NA Bankers Trust Company

Bank of America NA Citibank NA Chase Manhattan Bank NA Chemical Bank NA Bankers Trust Company First National of Chicago Continental Illinois NA

last two banks

are defined

as part of the core for two quarters

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346

C. James, Heterogeneous creditors and LDC lending

Guttentag, J. and R. Herring, 1985, Commercial bank lending to developing countries: From overlending to underlending to structural reform, in: G. Smith and J. Cuddington, eds., International debt and the developing countries (World Bank, Washington, DC). Hannan, T. and G. Hanweck, forthcoming, Bank insolvency risk and the market for large certificates of deposits, Journal of Money Credit and Banking 20. Helpman, E., 1987, The simple analytics of debt-equity swaps, IMF working paper, Aug. Herring, R.J., 1989, The economics of workout lending, Journal of Money Credit and Banking 21. James, C., 1988, The use of loan sales and standby letters of credit by commercial banks, Journal of Monetary Economics 18. James, C., 1989, Empirical evidence on implicit government guarantees of bank foreign loan exposure, Carnegie-Rochester Public Policy Conference Series 30. Krugman, P., 1985, International debt strategies in an uncertain world, in: Gorton Smith and John Cuddington, eds., International debt and the developing countries (World Bank, Washington, DC). Laney, L., 1987, The secondary market in developing country debt: Some observations and policy implications, Economic Review, July, Federal Reserve Bank of Dallas, Mills, R., 1986, Foreign lending by banks: A guide to international and U.S. statistics, Federal Reserve Bulletin, Oct. Penati, A. and A. Protopapadakis, 1988, The effect of implicit deposit insurance on bank portfolio choices with an application to international ‘overexposure’, Journal of Monetary Economics 21. Pennacchi, G., 1988, Loan sales and the cost of bank capital, Journal of Finance 43. Quandt, R.E., 1958, Estimation of parameters of a linear regression system obeying separate regimes, Journal of the American Statistical Association 53. Sachs, J., 1984, Theoretical issues in international borrowing, Princeton Studies in International Finance 54. Sachs, J., 1987, International polic. coordination: The case of the developing country debt crisis, NBER working paper, June. Sachs, J. and H. Huizinga, 1987, II Z ,mmercial banks and the developing country debt crisis, NBER working paper 2455, Dei Salomon Brothers, 1987, Debt for equ. y swaps: Market characteristics and regulatory initiatives, Stock research reports, Aug. 14. Saunders, A., 1986, The determinants of country risk: A selective survey of the literature, Studies in Banking and Finance 3. Smirlock, M. and H. Kaufold, 1987, Bank foreign lending, mandatory disclosure rules, and the reaction of bank stock prices to the Mexican debt crisis, Journal of Business 60. Struber, W.D., 1985, How foreign banks can finance aircraft in Brazil, International Financial Law Review 5. Terrell, H., 1984, Bank lending to developing countries: Recent developments and some considerations for the future, Federal Reserve Bulletin, Oct. Young, J., 1985, Supervision of bank foreign lending, Economic Review, May, Federal Reserve Bank of Kansas City.