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Banks Monitor Their Borrowers, But Who Is Monitoring Them?

Banks Monitor Their Borrowers, But Who Is Monitoring Them?Banks Monitor Their Borrowers, But Who Is Monitoring Them?Simon Business School

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As the jobs picture brightens and housing begins its slow recovery, banks will be playing an increasingly important role in screening and monitoring borrowers. But, banks can sometimes fail to perform the due diligence necessary to enhance the likelihood of repayment from their borrowers. This leads to the question: Who monitors the monitor?

The banking business thrives on financial intermediation abilities that allow the lending of money at relatively high interest rates, while receiving money on deposit at relatively low interest rates. This model of a bank’s capital structure plays an important role in encouraging banks to monitor their borrowers’, and their own, financial health.

Now, new research from Simon Business School at the University of Rochester reveals the dynamics that influence how bank capital structure affects credit monitoring. The study titled, Who Monitors the Monitor: Bank Capital Structure and Borrower Monitoring, details how researchers measure the effects of a bank’s capital structure on its credit monitoring, and delivers new evidence explaining how government safety nets that enhance banking protections, affect bank capital structure, and, in turn, influence bank monitoring and risk-taking behavior.

“Our approach examines how banks modify their capital structure in response to changes in the regulation of creditor rights or strengthening the banks legal protection,” said Sudarshan Jayaraman, associate professor of accounting at Simon Business School and co-author of the study. “We believe that the greater the extent of legal protection offered to banks during borrower bankruptcy or renegotiation, the lower the incentives to monitor borrowers before a renegotiation or bankruptcy event becomes necessary.”

The research highlights four main findings:

  • Banks take on less equity and more debt when creditor rights increase and the reverse when creditor rights decrease.
  • This indicates that bank equity appears to provide stronger monitoring incentives to banks and that they need less of this mechanism when there is a lower need for monitoring.
  • These effects are not driven by the supply side (i.e., bank creditors are more willing to lend to the bank when creditor rights increase).
  • The increase in bank leverage increases the bank’s risk-taking appetite, especially when government guarantees are in place.

Jayaraman and his co-author Anjan Thakor, of the ECGI and Olin Business School at Washington University, studied legal reforms in 14 countries across Europe and Asia during the 1990s and early 2000s.

The researchers conclude that stronger creditor rights tend to increase the bank’s cost of debt, particularly when governments offer a strong guarantee to banks. These results indicate that bank creditors are more willing to lend to banks when creditor rights become stronger. Their conclusion: Bank equity is a stronger source of discipline on banks than bank debt.

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