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FRBSF

WEEKLY lETTEA

July 24, 1987

Are Bank Loans Special?
Recent innovations in financial markets, such as
the growth of asst'it securitization and the
deregulation of depository institutions, have
raised new questions concerning the role of
commercial banks in the economy. Much of the
present system of bank regulation is based on
the premise that banks are special, i.e., that they
provide a unique service or set of services for
which no close substitutes are provided by other
financial institutions. If banks indeed were special, then the way in which they are special
would have important implications for bank regulation as well as the conduct of monetary
policy.
This Letter examines the arguments as to why
banks might be special and discusses the evidence on whether bank loans are special. The
public policy implications associated with
whether banks are special are also discussed.
Traditional view
The traditional view of the role of banks in the
economy focuses on their role in the payments
system. Banks are special, the argument goes,
because, unlike other financial institutions, they
provide transactions services by taking in
demand deposits. This involvement in the
money supply process has been the basis for
regulations, such as reserve requirements,
designed to facilitate monetary control and for
regulations directed at bank safety and soundness. The latter set of regulations is intended to
prevent bank failures and runs, which, if they
were to become widespread, could threaten the
payments system.

This focus on the role of banks in the payments
system is reflected in a recent proposal calling
for the separation of bank lending activities from
the provision of transaction services. The proposal would require the establishment of a bank
subsidiary or an entirely separate entity to offer
checking accounts. In addition, checking
accounts would be subject to a 100 percent
reserve requirement (which could be met with

marketable, interest-bearing securities). Commercialloans could be made only by banks or
their subsidiaries not offering demand deposits.
The intent of this proposal is to provide a completely safe payments system (a system without
the possibility of bank failure) without the need
for deposit insurance. This so-called "safe
depository" proposal is based on the premise
that, while there is something special about
deposit-taking, there is nothing special about
bank loans.
Unique features of bank assets
An alternative view is that banks are special at
least in part because of their lending activity.
The uniqueness of their role lies in the information gathering and monitoring process associated with commercial lending. Specifically,
banks have a comparative cost advantage in
information gathering and monitoring relative to
other financial institutions. This comparative
advantage arises, in part, from banks' ongoing
deposit history with the borrower. The inside
information provided by this ongoing relationship with a depositor/borrower is especially useful in the short-term repeat lending activity in
which banks specialize. Moreover, an ongoing
relationship is particularly valuable for small
business borrowers that would find it
uneconomical to generate the type of information needed for public securities offerings.

Two facts tend to support this view. First, banks
often require that borrowers maintain compensating balances (i.e., have a deposit account at
the lending institution). This suggests that the
bank and its borrower view a deposit account as
an integral part of the lending relation. Second,
commercial banks are the dominant supplier of
short-term debt, particularly to smaller corporate
borrowers. At year-end 1986, commercial banks
held $541 billion in commercial and industrial
loans, most of which have a maturity of one year
or less. The next largest source of short-term
financing is the commercial paper market with

FRBSF
$79 billion in paper issued by industrial firms
outstanding. The commercial paper market is
limited however to relatively large, well-known
borrowers.
The important role of banks in the information
gathering process has led to a distinction
between "inside" and "outside" debt. Inside
debt is defined as a loan for which the lender
has access to information about an organization
not otherwise publicly available. Outside debt,
in contrast, is defined as a publicly traded claim,
for which the security holder relies on publicly
available information generated, for example, by
security analysts and auditors. Publ icly traded
bonds, equities (stocks), and commercial paper
are examples of outside securities. Bank loans
are an example of inside debt.
Implications

If bank loans were special, then several important public policy implications would follow.
First, regulatory policy motivated solely by a
concern over the role of banks in the payments
system may impose serious costs on the economy. For example, the proposal discussed earlier for separating bank lending and checking
account services may disrupt the supply of bank
loans. If there were important synergies in
deposit-taking and lending, then cost savings
could be lost, increasing the cost of commercial
bank loans. This increase in the cost of intermediation services could result in a decrease in
investment activity.
A second implication of the view that bank
loans are special is that widespread bank failures
may have serious macroeconomic consequences beyond their effect on the money
supply or the payments system. Specifically, if
banks were an important part of the financial
infrastructure because of their lending activities,
then widespread failures could close an important conduit of funds to borrowers and result in a
decline in the amount of investment.
Finally, the proposal to separate bank lending
from deposit-taking activities would not provide
financial stability if bank loans were unique.
Protection of the payments system, which the
proposal affords, only addresses a part of the
problem presented by bank failures. Ensuring
financial stability also involves avoiding disruptions in the credit intermediation process, in
which banks playa critical role. As long as
banks invest primarily in nonmarketable and

illiquid commercial loans while funding themselves with more liquid deposits, the potential
for bank runs will continue to exist.
A recent study of the banking failures of
1930-1933 by Ben Bernanke suggests that banks
playa unique role in credit markets. He finds
that bank failures during the period raised the
real cost of borrowing, particularly to small, less
creditworthy firms that did not have access to
"outside" sources of debt. His analysis suggests
that the disruption to the intermediation process
caused by the bank failures of the 1930s contributed significantly to the decline in economic
activity during the period.
Evidence from the stock market

Some evidence (albeit indirect) on whether bank
loans are special can be found by examining the
stock price response of borrowing firms around
the announcement date of new bank loan agreements and public securities offerings. Several
studies have found a significant decrease in the
value of a firm's common stock around
announcements of public offerings of debt and
equity.
One explanation for this finding is that a corporation's managers have information about the
firm's future prospects that outside investors do
not. Therefore, firms tend to issue new securities
when they perceive they are overvalued by the
market. In contrast, firms with new investment
opportunities of which outsiders are unaware, or
firms with opportunities that are costly to convey
to outsiders in an accurate or reliable fashion
(since all firms have an incentive to overstate the
profitability of new projects), will find themselves undervalued in the market. These firms
will be reluctant to issue new public securities
because these securities would be underpriced.
Therefore, they may pass up valuable investment
opportunities.
Bank loans as a form of inside debt provide a
possible solution to the problem of information
asymmetries associated with public securities
offerings. Banks, having better information about
the firm's prospects than outsiders, presumably
would price their loans to reflect the true prospects of the firm. If this conjecture were correct,
one would expect to observe a rise in the stock
price of the borrowing firm in reaction to the
announcement of new bank loans.
A related reason an appreciation of a firm's stock
may result in response to the announcement of
new bank loans is that the loan approval process
itself may convey information to market partici-

Stock Price Reaction to New Financing
Percentage
Abnormal
Return

* 1.98%

2.5

n = 80

2.0

1 5
1.0
Public
Straight
Debt

0.5
00

-0 5

Private
Placements

-j----

Bank
Loans

-0.11%
n = 90

-1.0

* -0.91%
n = 37

* Statistically Different From Zero

pants about the financial strength of the firm.
Loan renewals or new extensions provide a
credible "seal of approval" concerning the
firm's future prospects. This seal of approval
implies that other claimants of the firm need not
undertake similar costly evaluations of the firm's
financial condition.
To examine the stock price reaction to the
announcement of new bank loans as well as
other debt offerings, a sample was constructed
of all announcements of public straight debt
offerings, private placements of debt with nonbank institutions (primarily insurance companies), and new commercial bank loans for
300 randomly selected firms. The sample consisted of all announcements of new debt offerings and bank loan agreements by these firms
over the period 1973 through 1983. For each
financing event, the percentage change in the
borrowing firm's stock price was computed
around the announcement date. The price
change was adjusted for the stock's expected
price behavior based on general movements in
the market to provide an estimate of the abnormal return attributable to the financing
announcement.
As the chart indicates, there is a positive (1.98
percent) stock price reaction to the announcement of new bank loan agreements. Incontrast,
there is a small negative price reaction for public
straight debt offerings. This finding is consistent
with the hypothesis that bank loans are special
because they are a form of inside debt.

Of particular interest is the difference between
the stock price reaction to bank loans and private placements of debt. If a positive stock price
response to bank loan announcements were
representative of some benefit associated with
borrowing through a financial intermediary, we
would expect to see a similar price reaction for
private placements made through insurance
companies. However, as the chart indicates, the
price reaction to announcements of private
placements is negative (and the difference in
price response between bank loans and private
placements is statistically significant). This result
suggests that bank loans are special relative to
loans made by other financial institutions, such
as insurance companies, possibly because of the
information generated from a deposit relation a
bank has with a borrower.

Additional evidence
An additional piece of evidence on the question
of whether bank loans are special, comes from
the market for bank-issued large certificates of
deposits (CDs). These deposits are currently subject to a 3 percent reserve requirement, which
acts like a tax to raise the cost of these funds to
banks. A recent study found that bank CD
holders do not appear to "pay" the tax in the
form of lower yields. In particular, when reserve
requirements were increased in the late 1970s,
CD yields did not fall relative to yields on other
money market instruments, as would be the case
if CD holders shared the burden of increased
reserve requirements. The lack of change in CD
yields suggests that the reserve tax is shifted to
bank borrowers in the form of higher loan rates.
This could occur, however, only if bank loans
had no close substitutes, i.e., if they were
unique.

Conclusion
A critical question in the debate over how bank
regulation should be structured is whether there
is anything special or unique about commercial
banks. Evidence from the stock market and the
market for bank CDs suggests that bank loans
are unique. Thus, when making regulatory
chcmges, policymakers should consider the consequences for the cost and availability of bank
credit as well as for the payments system.

Christopher James

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments' 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency securities 2
Other secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
lotal Non-Transaction Balances 6
Money Market Deposit
Accounts -Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed (-)

Change from 7/2/86
Dollar
Percent!

Amount
Outstanding

Change
from

7/1/87
206,975
184,016
53,147
69,516
36,685
5,405
16,034
6,924
214,619
60,073
39,896
19,859
134,687

6/24/87
1,583
1,727
474
259
8
9
168
311
11,148
9,875
4,795
949
325

44,604

211

-

537
147

-

31,726
23,995

-

4,002
2,236
1,241
2,675
- 4,446
116
5,331
444
3,610
4,137
- 11,549
3,397
3,923

Period ended

22.4

-

20.6
2.8

2,506

-

5.3

4,590
383

-

-

12.6
1.5

6/15/87

217
18
199

51
8
44

, Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATs, NOW, Super NOW and savings accounts with telephone transfers
5 Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annual ized p'ercent change
2

..

-

-

Period ended

6/29/87

-

2.0
1.1
2.3
3.7
10.8
2.1
49.8
6.0
1.7
7.3