Financial Innovations, Idiosyncratic Risk,
and the Joint Evolution of Real and
Financial Volatilities by Christina Wang
Conference on Financial Innovations
and the Real Economy
November 2006
Discussion by:
Richard Rosen
FRB Chicago
1
Big issues
The volatility of financial variables has increased at the same
time as the volatility of real variables has decreased.
How can we explain this?
• Jermann and Quadrini point out that new financial
markets give firms more flexibility in financing.
• This paper focuses more tightly on bank lending.
Changes in information and communication technology
have made financial markets more complete and have
lowered the cost of analyzing risk.
 How has this affected bank lending?
2
How might technological change
affect bank lending?
• Risks can now be disaggregated (securitization).
• The role of public markets has increased.
• This may affect intertemporal smoothing (Allen & Gale).
• Entry barriers are lower (for new banks and for geographic
expansion).
• Local banking market structure affects industry
concentration and growth (Cetorelli & Gambera, 2001).
3
Where firms get financing
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
2005
1997
0.00%
Syn loan
Bond
1987
Equity
ABS
Source: Chase, Paine Webber as reported in the Economist (1987, 1997) and Thomson Financial (2005)
4
Where firms get financing
(“all ABS” version)
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
2005
1997
0.00%
Syn loan
Bond
1987
Equity
ABS
Source: Chase, Paine Webber as reported in the Economist (1987, 1997) and Thomson Financial (2005)
5
The (first) model
Christina’s model examines an alternative impact of
technological change on the pattern of bank lending.
• Banks screen borrowers at a cost.
• Technological change reduces the cost.
• Banks have a required return that depends on their overall
systematic and idiosyncratic risk.
 The premium on idiosyncratic risk declines with
monitoring costs. This allows banks of a given scale to
make more small loans.
6
The evidence, part I
An interesting possibility drawn from the model is that:
the degree of diversification at banks of a given size
may have fallen as the efficient scale has increased
over time.
At the same time:
idiosyncratic risk should have increased at banks (in
contrast to decreases observed at non-financial firms).
 The regressions in the paper find support for these.
7
The evidence, part II
Page 15: “More importantly, most of the additions to the loan
pool [from bank mergers] are small loans.” Is this true?
• It may depend on which loans we are talking about.
• We can test this for commercial loans.
8
The evidence, part II
To test using commercial loans:
The Survey of Terms of Bank Lending (STBL) is a
quarterly survey of about 300 banks. The banks report
every commercial loan they make during a short window
(one week each quarter). Since many banks are in the
sample for a repeated period, we can look at how the size
distribution of loans changes over time.
9
Results from the STBL
• The sample period is 1982Q3 – 2006Q1.
• I examine changes at banks which are in the survey for at
least 10 years.
• Divide loans into 3 categories: small (<$100K), medium
($100K-$1MM), and large (>$1MM).
• Divide banks into 3 categories based on final period size:
small (<$1B), mid-size ($1B-$10B), and large (>$10B).
[All values are 2006 dollars]
10
Results from the STBL
B
a
n
k
B
a
n
k
s
i
z
e
s
i
z
e
First period in the sample.
Loan size
Small Medium Large
79.7% 17.3%
3.0%
Small
Mid-size 58.0% 22.5% 19.5%
45.3% 21.5% 33.1%
Large
Last period in the sample.
Loan size
Small Medium
59.3% 30.7%
Small
Mid-size 30.9% 30.5%
16.9% 28.3%
Large
Large
10.0%
38.6%
54.8%
11
Results from the STBL:
fast growing banks
B
a
n
k
B
a
n
k
s
i
z
e
s
i
z
e
First period in the sample.
Loan size
Small Medium Large
89.8% 10.2%
0.0%
Small
Mid-size 68.3% 18.6% 13.1%
48.9% 24.1% 26.9%
Large
Last period in the sample.
Loan size
Small Medium Large
64.8% 27.7%
7.6%
Small
Mid-size 42.0% 28.3% 29.8%
23.7% 31.5% 44.8%
Large
12
Results from the STBL:
number of loans
B
a
n
k
B
a
n
k
s
i
z
e
s
i
z
e
First period in the sample.
Loan size
Small Medium Large
14
4
1
Small
39
15
13
Mid-size
80
31
43
Large
Last period in the sample.
Loan size
Small Medium Large
8
6
3
Small
32
51
71
Mid-size
148
258
403
Large
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What this means for the paper
Lower monitoring costs mean that banks can take more
idiosyncratic risk.
How this affects this affects lending is model specific.
• By changing the screening cost function, but still
consistent with the spirit of the model, I suspect that you
can get a result that lower screening costs increase the share
of large loans.
 The distribution of loan sizes at a bank changes over
time. What can we learn from this?
14
Final thoughts
Are banks (still) special?
Financial innovation (and deregulation) have changed the
structure of banks and financial markets.
This paper points out that this matters for lending:
Lower screening costs allow banks to lend to borrowers
with more idiosyncratic risk.
 This adds to our understanding of how banks have reacted to
their changed environment.
15