Don’t Put All Your Eggs in One Basket? Diversification and Specialization in Lending

Should lenders diversify, as suggested by the financial intermediation literature, or specialize, as suggested by the corporate finance literature? I model a financial institution's ("bank's") choice between these two strategies in a setting where bank failure is costly and loan monitoring adds value. All else equal, diversification across loan sectors helps most when loans have moderate exposure to sector downturns ("downside") and the bank's monitoring incentives are weak; when loans have low downside, diversification has little benefit, and when loans have sufficiently high downside, diversification may actually increase the bank's chance of failure. Also, it is likely that the bank's monitoring effectiveness is lower in new sectors; in this case, diversification lowers average returns on monitored loans, is less likely to improve monitoring incentives, and is more likely to increase the bank's chance of failure. Diversified banks may sometimes need more equity capital than specialized banks, and increased competition can make diversification either more or less attractive. These results motivate actual institutions' behavior and performance in a number of cases. Key implications for regulators are that an institution's credit risk depends on its monitoring incentives as much as on its diversification, and that diversification per se is no guarantee of reduced risk of failure.

Financial Intermediation

The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years' of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Risk overhang and loan portfolio decisions

Despite operating under substantial regulatory constraints, we find that commercial banks manage their investments largely consistent with the predictions of portfolio choice models with capital market imperfections. Based on 1990-2002 data for small (assets less than $1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer sectors increased with expected sector profitability, tended to decrease with the illiquidity of existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns. Small banks are most appropriate for this study, because they make illiquid loans and manage risk via on-balance sheet (non-hedged) diversification strategies.Portfolio management ; Investment banking

Booms, Busts, and Fraud

We examine firm managers' incentives to commit fraud in a model where firms seek funding from investors and investors can monitor firms at a cost in order to get more precise information about firm prospects. We show that fraud incentives are highest when business conditions are good, but not too good: in exceptionally good times, even weaker firms can get funded without committing fraud, whereas in bad times investors are more vigilant and it is harder to commit fraud successfully. As investors' monitoring costs decrease, the region in which fraud occurs shifts towards better business conditions. It follows that if business conditions are sufficiently strong, a decrease in monitoring costs actually increases the prevalence of fraud. If investors can only observe current business conditions with noise, then the incidence of fraud will be highest when investors begin with positive expectations that are disappointed ex post. Finally, increased disclosure requirements can exacerbate fraud. Our results shed light on the incidence of fraud across the business cycle and across different sectors.Boom, Credit Cycle, Fraud, Monitoring

Monitored finance, liquidity, and institutional investment choice

A presentation of a model predicting that debt or similar claims will dominate the portfolios of institutions that specialize in providing monitored finance. Among these institutions, those with greater liquidity needs should hold fewer monitored equity positions, make less risky loans, and monitor less intensively.Financial institutions ; Liquidity (Economics)

Bank Capital Regulation in General Equilibrium

We study whether the socially optimal level of stability of the banking system can be implemented with regulatory capital requirements in a multi-period general equilibrium model of banking. We show that: (i) bank capital is costly because of the unique liquidity services provided by demand deposits, so a bank regulator may optimally choose to have a risky banking system; (ii) even if the regulator prefers more capital in the system, the regulator is constrained by the private cost of bank capital, which determines whether bank shareholders will agree to meet capital requirements rather than exit the industry.

Bank capital, borrower power, and loan rates

We examine how bank capital and borrower bargaining power affect loan spreads. Consistent with previous studies, higher bank capital has a negative impact on loan rates, but borrower cash flow has a significant effect on this impact: Compared with high-capital banks, low-capital banks charge more for borrowers with low cash flow, but offer greater marginal discounts as these borrowers' cash flow rises. These effects are largely focused on more bank-dependent borrowers. We find some evidence that low-capital banks charge a higher premium for bank-dependent borrowers' systematic risk, but not for their total equity risk or default risk. Received January 27, 2015; editorial decision July 7, 2018 by Editor Philip Strahan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.authorsversionpublishe

Secession in Bougainville and the Australian government response

Bougainville is part of the North Solomons Province of Papua New Guinea and is located nearly 1,000 kilometres from Port Moresby (refer to maps on pages 3 and 4). In November 1988, a dispute at the Panguna copper mine on the island between landowner s and the owners of the mine, Bougainville Copper Limited (BCL), erupted into violence. The subsequent formation of the Bougainville Revolutionary Army and demands for secession led to the most serious political and economic problems facing Papua New Guinea (PNG) since independence was granted in 1975. In the four years since the initial trouble began, more than 1,500 people have been killed - in military conflict on the islands of Bougainville and Buka, and the mine, which until 1989 provided employment for 3,500 people, has closed.1 A blockade of Bougainville by Guinea Defence Force (PNGDF) resulted in shortages of food, fuel and the Papua New medical supplies to the island, the latter resulting in the deaths of 3,000 innocent civilians.2 Terence Wesley-Sm ith of the University of Hawaii writes, " Except for the independence struggle in Irian Jaya, no other conflict in the Pacific Islands region has produced this level of human suffering since World War 11.3 The Namaliu Government and the country's image abroad were weakened by allegations of human rights abuses and indiscipline amongst the security forces. The role of the Australian Government, largely through its training of military personnel and the supply of military hardware to the PNGDF, has also been placed under scrutiny by a Commonwealth parliamentary committee and human rights activists. The dispute has had a significant impact on the economy of the mainland. Closure of the mine resulted in the loss of approximately 40 per cent of export earnings for the country and 17 per cent of the Government's budget revenue. The blockade of Bougainville led to the loss of export earnings from cocoa (45 per cent of PNG's total cocoa production), copra (the province was the second highest producers of copra) and timber. The loss of national income from the mine and other cash crops forced the Government to announce in January 1990 a 10 per cent devaluation of the kina, cuts in government recurrent spending and a firmer line on wage increases

The Flip Side of Financial Synergies: Coinsurance Versus Risk Contamination

This paper characterizes when joint financing of two projects through debt increases expected default costs, contrary to conventional wisdom. Separate financing dominates joint financing when risk-contamination losses—that are associated with the contagious default of a well-performing project that is dragged down by the other project's poor performance—outweigh standard coinsurance gains. Separate financing becomes more attractive than joint financing when the fraction of returns lost under default increases and when projects have lower mean returns, higher variability, more positive correlation, and more negative skewness. These predictions are broadly consistent with evidence on conglomerate mergers, spinoffs, project finance, and securitization

Potential drivers of virulence evolution in aquaculture

Infectious diseases are economically detrimental to aquaculture, and with continued expansion and intensification of aquaculture, the importance of managing infectious diseases will likely increase in the future. Here, we use evolution of virulence theory, along with examples, to identify aquaculture practices that might lead to the evolution of increased pathogen virulence. We identify eight practices common in aquaculture that theory predicts may favor evolution toward higher pathogen virulence. Four are related to intensive aquaculture operations, and four others are related specifically to infectious disease control. Our intention is to make aquaculture managers aware of these risks, such that with increased vigilance, they might be able to detect and prevent the emergence and spread of increasingly troublesome pathogen strains in the future