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Transmission Channels

posted by Sarah Woo

The BIS folks have just released a literature review about the transmission channels between the financial and real sectors of the economy. This is a pretty comprehensive literature review (which also means that it is a tad dry), but there are interesting bits in their identification of gaps in the literature.

One of the observations in the paper led me to consider a question: is cash-flow based lending or collateral-based lending more susceptible to systemic risk? Which of them serves as a stronger transmission channel for risk between the financial and real sectors? The answer might point the way to better regulation of the financial industry.

As the BIS working group observed, “[b]orrower balance sheet positions (even without defaults and delinquencies) are relevant to the perceived creditworthiness of borrowers, which in turn influences borrowers’ access to credit and their terms on credit, which in turn affects their borrowing and ultimately economic activity.”

Creditworthiness, of course, is not simply influenced by the balance sheet. Let’s think for a bit about how banks think about their borrowers. Lending can be divided into two types: cash-flow based and collateral-based, or asset-based. In the former, a loan is made based on whether the lender believes that the borrower’s assets can generate enough cash to pay off the loan. In the latter, the lender is more concerned with the assets as collateral, and makes the loan at a level of over-collateralization such that the cost of realizing the collateral as well as accrued interest and principal, should the borrower default, can be collected.

The existence of cash flow lending can be proved by the prevalence of unsecured credit such as corporate bonds, just as lenders’ over-reliance on collateral (housing) prices prior to the crisis is also well-known. Nonetheless, some might argue that collateral is the foundation of credit, and point to studies showing that the price of credit is directly proportional to the level of collateral and that asset value is based on cash flows (think DCF model). The proper monitoring of the quality of collateral is thus the key to financial stability in the financial and thus real sectors.

Others might point out that excessive focus on market prices of collateral ignores (or even encourages) bubble effects and that a constant evaluation of the income-producing potential of assets, e.g. focusing on the rental income of real estate rather than its market price, would have led to less of a bubble. On a related note, in 2009, financial regulators issued a policy statement exhorting banks to renew or restructure loans with commercial real estate borrowers which are still generating cash flows and have the ability to repay their debts, even if the market value of the underlying collateral has declined to an amount less than the loan balance.

Of course, what we need is more empirical research. But it’s important to understand that these different kinds of lending (and different borrower profiles) can have different implications for risk transmission. For example, in the collateralized world, the real sector transmits risk to the financial sector when collateral values fall suddenly in a market correction, causing the values of loans (defaulted and performing both) to fall and causing undercapitalization of banks. In the cash flow world, it is when incomes and economic activity start falling that cash flow starts to dry up and defaults increase. Reflexively, banks start to discount cash flows more heavily and the risk premium goes up across the market, causing mark-to-market losses for bank’s assets and thus undercapitalization. It may seem like a fine distinction but these are just examples of the kinds of hypothetical mechanisms which we should be investigating (perhaps with data on loans in bankruptcy).


Same question in the equity markets-- are we better off favoring income investors or speculators? Domination by income investors may produce a stabler world, but it's the speculator who drives innovation and growth. Is it worth minimizing systemic risk if the price is a stratified and stagnant economy?

One of the problems with analyzing this issue is that neither secured nor unsecured debt lines up very neatly. On the unsecured side, bonds are completely different animals from lines of credit and revolving accounts, but they are all based on projections of debtor's ability to make cash payments. Secured debt, while traditionally based on hard assets, has increasingly become cash-flow based, not just through DCF but by directly encumbering liquid assets such as rent streams and A/R (A review of cash collateral orders should give you an idea of how prevalent this practice is. It should also give you some idea of why DIP financing comes at such a seemingly steep price and why debtors so frequently obtain it from existing creditors.).

In either case, the real task is correctly setting a value on borrower's promise to repay. The problem that came home with a vengeance in 2007 was that too much of the analysis of these promises had been junk. Cash flows were bogus, repos and swaps had no basis in reality, discount rates were from Mars. If a lender can not be bothered to obtain the correct inputs for its analysis, the loan will not be valued correctly. As with anything, garbage in --> garbage out.

Good post and comments, thanks to you and the commenters. My only comment would be this: I agree with your bubble effets sentence. One of the problems is that market values really are unstable and depend on what assumptions you make about the orderliness of the market so that there is a feedback effect and momentum swings get built in to collateral valuations making for instability. At the same time, fire sale value means a lot of good loans don't get made. Ultimately, you can ameliorate this problem by valuing collateral partly on an orderly market basis and partly on a disorderly mareket basis, and arguably the regulators should be shifting the proportions back and forth in anticyclical fashion. But that is probably too much to hope for. Or you can just have variable and higher margin requirements, that do the same thing more or less. But mostly you need political consensus that allows regulators to tampen down credit expansion cycles regardless of the impact of short term indicia of economic growth and thus elected officials' re-electability..

Asset Backed Securities (ABS) are much more prevalent than securities based on "cash flow lending" such as revolving credit, for example. In large part this is because ABS have a longer life.

But I think it may be an error to promote a "tastes great/less filling" binary debate on this topic because the two are intertwined, viz. the HELOC. Many people consolidated revolving credit into HELOCs in the run up to the bubble peak and the distortions caused by the RE asset bubble created a sense of excessive liquidity -- AKA your home as ATM.

Additionally, how do you classify the leveraged positions of financial institutions going as high as what, 30:1 or 40:1? Cash-flow or secured, let's just call it a colossally bad idea.

As Stalin famously said, "Quantity has a quality all its own." Once notional values of credit-based derivatives ballooned to an order of magnitude or two over underlying, you had a phenomenon in which lending standards became so corrupted/degraded by the insatiable demand of the secondary market that earnest academic technical analysis seems, frankly, a bit naive.

But in the end it's all about speculative asset bubbles, so asset-backed lending has always been and will always be the greater source of systemic risk. But you really can't tease the two apart, nor should you, for good understanding.

To paraphrase "mt" above, it would be awfully nice to see government practice the austerity portion of the Keynesian cycle, wouldn't it?

If you are interested in the effect of asset value bubbles on the financial system, you might find this short paper from the Philadephia Fed interesting. I found it in a folder by coincidence after I read your post and I read it again and it still has a lot to offer, especially the prescient discussion of the black swan risk to VAR models at the end.


In my opinion, you need to make a clear distinction about the type of asset-based lending you are talking about. In traditional asset-based lending, loan advances are formula based on a company's most liquid assets: for example 85% of eligible A/R, 50% on eligible inventory, 40% on the forced liquidation value of machinery, etc. Collateral eligibility requirements effectively reduce those advance rates below the stated level. Liens are perfected. In this case, asset-based lending in not as susceptible to systemic risk. Liquidation is an acceptable means of repayment. Due to the inherent collateral cushion, historical losses have been quite small. On the other hand, there is an entire class of "asset-based" lending that is really a cash-flow loan in drag. Blanket liens really only provide a cover of asset coverage. The over-collateralization is illusory when limited analysis of the collateral is performed or collateral values are uncertain: for example lending on intangible assets. In this instance, "asset-based" lending is as susceptible to systemic risk as a cash-flow loan because that is really what it is.

@John H
Yes, massive cross-collateralization is nothing but a fraud. It allows banks to say, "Oh yes, we're secured," when in fact they hold third and fourth position liens and are secured by hot air. On top of that, those pseudo-liens mean they get to hold Chapter 11 debtors' reorganizations hostage by insisting on protection on protection at every turn, when in reality they should be sitting on an unsecured creditors' committee.

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