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FINANCIAL INDUSTRY
August 1994

STUDIES
Federal Reserve Bank of Dallas

Financial Derivatives:
Are New Regulations

Warranted?

Thomas F. Siems
Senior Economist

What Determines B u s i n e s s e s '
B o r r o w i n g f r o m Banks?
Linda Hooks
Professor of Economics
Washington and Lee University
Tim Opler
Professor of Finance
Southern Methodist University

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Financial Industry Studies
Federal Reserve Bank of Dallas
August 1994

President and Chief Executive Officer
Robert D. McTeer, Jr.
First Vice President and Chief Operating Officer
Tony J. Salvaggio
Senior Vice President
Robert D. Hankins
Vice President
Genie D. Short

Financial

Industry' Studies is published by the Federal Reserve Bank
of Dallas. The views expressed are those of the authors and
do not necessarily reflect the positions of the Federal Reserve Bank
of Dallas or the Federal Reserve System.

Subscriptions are available free of charge. Please send requests for
single-copy and multiple-copy subscriptions, back issues, and address changes
to the Public Affairs Department, Federal Reserve Bank of Dallas,
P.O. Box 655906, Dallas, TX 75265-5906, (214) 922-5254.
Articles may be reprinted on the condition that the source
is credited and the Financial Industry Studies Department is provided
a copy of the publication containing the reprinted material.

Contents
Page 1

Financial Derivatives:
Are New Regulations
Warranted?
Thomas F. Siems

The development, evolution, and growth of financial
derivatives constitute one of the most dramatic stories
in modern economic history. In less than twenty-five
years, financial derivatives have sprung from conception to global prominence, spanning the world's financial markets and institutions and integrating the global
financial system.
Are bankers and corporations rolling the dice and
gambling away their future by using derivatives? Or,
do derivatives offer new ways for banks to better
manage risk exposures and assist customers in managing their risks?
Thomas F. Siems concludes that financial derivatives are complex tools that banks and corporations
can use—indeed, should use—to better manage risk
exposures. Any regulation of financial derivatives
markets should emphasize the use of market-oriented
incentives to manage risk as opposed to governmentmandated rules designed to eliminate the use of
derivatives because of their potential riskiness. Laws
that restrict derivatives' usage could undermine market
efficiency in transferring financial risks and destroy the
economic benefits provided by derivatives.

Page 15

What Determines
Businesses' Borrowing
from Banks?
Linda Hooks and
Tim Opler

Traditionally, banks have served as an important
source of financing for businesses. Recently, however,
their role as credit providers to business has diminished. Medium and large businesses are increasingly
satisfying their credit needs through nonbank sources,
such as the commercial paper market and other types
of securities. Even smaller businesses, which cannot
access the securities markets, have relied increasingly
on nonbank sources of financing.
Linda Hooks and Tim Opler examine the characteristics of a sample of small- to medium-sized businesses
(Continued

on the next page)

Contents
(Continued from the previous

What Determines
Businesses' Borrowing
from Banks?
Linda Hooks and
Tim Opler

page)

to determine the factors associated with a reliance on
bank financing among such borrowers. They find that
the relative amount of bank debt a firm holds depends
on firm size, with smaller firms using less bank debt
than the medium-sized and larger firms. Also, smaller
firms, without well-established reputations, are more
likely than larger firms to need to pledge collateral to
obtain bank loans. Hooks and Opler point out that
awareness of which segments of the credit market are
served by banks may help in evaluating policies
designed to address concerns about a credit crunch.

Financial Derivatives:

Dealing with Volatility

Are New Regulations Warranted?

In general terms, a derivatives transaction is a contract whose value depends on,
or derives from, the value of an underlying
security, commodity, reference rate, or
index. The most common derivatives
include swaps, futures, and options based
upon interest rates, currencies, equities,
and commodities. 1
The tremendous growth of financial
derivatives products was brought about by
three primary forces: increasingly volatile
markets, deregulation, and new technologies.
The turning point seems to have occurred
in the early 1970s with the breakdown of
the Bretton Woods agreement, after which
currencies floated freely, and the gradual
removal of interest rate ceilings w h e n
Regulation Q interest rate restrictions were
phased out. Not long afterward came inflationary oil price shocks and wild fluctuations in interest rates. Thus, as shown in
Charts 1, 2, and 3, financial markets became far more volatile.
Chart 1 shows the quarterly change in
yield for the ten-year U.S. Treasury bond.
Interest rate volatility increased during the
late 1960S and again in the late 1970s and
early 1980s. Exchange rate volatility is
shown in Chart 2. As shown, the breakd o w n of the Bretton Woods agreement in
1971-72 led to increased volatility of the
U.S. dollar against the currencies of the
other G - 1 0 countries. 2 Chart 3 presents

Thomas F. Siems
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

he development, evolution, and growth
of financial derivatives constitute one
of the most dramatic stories in modern
economic history. In less than twenty-five
years, financial derivatives have sprung from
conception to global prominence, spanning
the world's financial markets and institutions
and integrating the global financial system.
Are bankers and corporations rolling the
dice and gambling away their future by
using derivatives? Or, do derivatives offer
new ways for banks to better manage risk
exposures and assist customers in managing their risks?
What follows is a brief history of financial
derivatives activities, an overview of financial derivatives products, and a demonstration of why (and how) a bank might use
simple financial derivatives. I will then discuss
current regulatory issues and proposed legislative changes involving financial derivatives.
The article concludes with the view that
financial derivatives are complex tools that
banks and corporations can use—indeed,
should use—to better manage risk exposures. Any regulation of financial derivatives markets should emphasize the use of
market-oriented incentives to manage risk
as opposed to government-mandated rules
designed to eliminate the use of derivatives
because of their potential riskiness. Laws
that restrict derivatives' usage could undermine market efficiency in transferring
financial risks and destroy the economic
benefits provided by derivatives.

I wish to thank Robert Hankins, Kenneth Robinson,
Jeffery Gunther, and Robert Moore for helpful comments on earlier drafts. Any remaining errors are
solely my responsibility.
1

See Kapner and Marshall (1990) for an excellent
reference work for understanding financial derivatives
products and Federal Reserve Bank of Atlanta (1993)
for a collection of articles about financial derivative
instruments and markets.
2

The countries in the G-10 group are the United
States, United Kingdom, Germany, Japan, France,
Canada, Italy, Netherlands, Belgium, Sweden, and
Switzerland.
1

efficient and effective methods for reducing
certain risks and enhancing returns through
hedging. From a market-oriented perspective, derivatives allow for the free trading
of financial risks.

Chart 1
Interest Rate Volatility
Ten-year Treasury bond
Quarterly change, basis points

200 -|

Financial Derivative Products:
Forwards, Futures, and Beyond

100 -

-100

-200

- 3 0 0 -I

,
1960s

1
1970s

1
1980s

,
1990s

DATA SOURCE: CITIBASE, Citibank Economic Database.

energy market volatility by showing the
quarterly change in the spot price of crude
oil. The chart highlights the periods of
major disruptions in the supply of oil.
A host of new competitors accompanied
the deregulation of financial markets in the
early 1980s, and the arrival of powerful
computing machines ushered in new ways
to analyze information and break down
risk into component parts. Banks, which
are in the business of managing financial
risks, quickly learned that it was far more
difficult to control risk in this new environment. They responded by developing new
risk management products designed to
better control financial risks.
Few markets have grown or evolved as
rapidly as the financial derivatives markets.
But what makes derivatives important is
not so much the size of the activity as the
role they play in fostering new ways to
understand, measure, and manage financial
risks. Through derivatives, risks can be
efficiently unbundled and managed independently. Users can keep the risks they
are most comfortable managing and transfer
those they do not want to others more
willing to accept those risks. From a risk
management perspective, derivatives offer
2

When the financial derivatives boom
began in the early 1970s, the first products
were simple foreign exchange forwards
that obligated one counterparty to buy, and
the other to sell, a fixed amount of currency
at an agreed date in the future. Next came
futures contracts. Futures are similar to
forwards, except that futures are standardized on exchange clearinghouses, which
facilitates anonymous trading in an active
and liquid market.
Around 1980, the first swaps were developed. A swap transaction is another
forward-based derivative that obligates two
counterparties to exchange a series of cash
flows at specified settlement dates. Swaps,
like forwards, are entered into through
private negotiations to meet the specific

Chart 2
E x c h a n g e Rate Volatility
Index of Weighted-Average
of U.S. Dollar Against
G-10

Exchange

Currencies

Value
Other

Countries

Quarterly change, percent

DATA SOURCE: CITIBASE, Citibank Economic Database.

Chart 3
Energy Market Volatility
Quarterly change, percent
C r u d e oil s p o t p r i c e ( d o l l a r s p e r b a r r e l )

area olive presses by placing small deposits
with each of them to guarantee him first
claim on the use of their presses when fall
arrived. Thales successfully negotiated low
prices because the harvest was in the distant
future and no one knew whether or not
the next harvest would be plentiful.
Nine months later, Thales became a
wealthy man. "When the harvest-time came,
and many [presses] were wanted all at
once and of a sudden, he let them out at
any rate which he pleased, and made a
quantity of money," Aristotle wrote.
Using Derivatives Today

DATA S O U R C E : CITIBASE, Citibank Economic Database.

risk management objectives of each counterparty. The other basic derivatives product
is the options contract. In exchange for a
premium, an option contract gives the
option holder the right, but not the obligation, to buy or sell the underlying asset for
a specified time for a specified price.
From these basic derivatives—forwards,
futures, options, and swaps—a plethora
of complex new risk management instruments has taken financial markets by storm.
These include caps, floors, collars, swaptions, and a host of others (see the box
entitled "A Brief Derivatives Lexicon" on
page 12). But modern-day financial derivatives are not fundamentally different from
those used throughout history. The basic
principle remains the same: to spread risk
and reward so that uncertainty does not
inhibit commerce.
Aristotle described the first known
options contract. In Book I of Politics, he
tells the story of the philosopher Thales
who developed a "financial device which
involves a principle of universal application." Thales had great skill in forecasting
and predicted that the next autumn olive
harvest would be exceptionally good. So
Thales made agreements with owners of

Today, bankers and corporations use
financial derivatives in similar ways. Like
the olive press owners, bankers and corporations can use derivatives to hedge
against future uncertainties. Or, like Thales,
they can use derivatives to speculate, by
taking positions in anticipation of expected
market movements.
To understand how (and why) a bank
might use derivatives today, consider the
following example. 3 Small Regional Bank
(SRB) has total assets of $5 million. The
assets of the bank include a $3 million loan
portfolio primarily composed of fixed-rate
mortgages and $1 million in government
securities. SRB's liabilities include $3 million
in interest-bearing deposits that are often
repriced {Chart 4).

Chart 4
Small Regional Bank (SRB) Balance Sheet
Liabilities

Assets
Loans

$3 million

Securities

$1 million

Interest-bearing

$3 million

Cash and Premises

$1 million

Noninterest-bearing

$1 million

Total Assets

$5 million

Deposits

Equity

$1 million

Total Liabilities
and Equity

$5 million

This example is based on Wilson (1993).
3

Chart 5
Effect of Interest Rates on SRB's
Securities Earnings
Earnings

After derivatives

Before derivatives

Decrease

Current
(Interest rates)

If SRB were concerned that a rise in
interest rates would negatively affect prices
in its securities portfolio, it could hedge
against this interest rate risk by selling
short a $1 million Treasury bond futures
contract. Or, it could buy a put option that,
in effect, would manage this same risk.
If rates rose, SRB would be hurt by a
drop in value in its securities portfolio, but
this loss would be offset by a gain in its
derivative contract. Similarly, if rates fell,
the bank would gain from the increase in
value from its securities portfolio, but
would record a loss from its derivative
contract {Chart'5).4
Additionally, because of the bank's mismatch in repricing its assets and liabilities,
SRB may also wish to enter into a $3 million swap contract to guard against rising
interest rates. Chart 6 shows SRB's interest
flows before a swap transaction. Obviously,
rising interest rates will harm SRB because
it receives fixed cash flows and pays variable cash flows. But SRB can hedge against
this interest rate risk by entering into a

The hedge in Chart 5 is shown using a futures contract. If an option contract were used as a hedge, the
"after derivatives" line would have a different shape.
The "loss" in the case of the option contract comes
from the premium paid for the option, which is never
exercised.
4

swap contract with a dealer to make fixed
payments and to receive floating payments.
Assume that SRB currently receives 7
percent fixed from its loan portfolio and
pays a variable rate for its deposits that
proxies the three-month Treasury-bill rate.
The bank negotiates with a swaps dealer
to pay 4.5 percent fixed in exchange for
receiving T-bill minus 0.5 percent (Chart 7).
Now the bank knows more precisely what
its interest flows will be. With the swap,
the bank effectively receives 7 percent
fixed and pays 5 percent fixed, a guaranteed 200 basis point spread, no matter
what happens to interest rates.
Table 1 shows an interest rate sensitivity
analysis on the net interest margin before
and after this swap transaction under three
different interest rate scenarios: rates fall
300 basis points, rates are unchanged, and
rates rise 300 basis points. Without the
swap, the spread, or net interest margin,
would be 300 basis points, assuming that
T-bill rates are currently at 4 percent. But if
T-bill rates rose, the spread would become
progressively more narrow (Chart 8). At
T-bill rates above 5 percent, the 200 basis
point spread guaranteed by the swap will
always exceed the spread in the absence of
a swap. In fact, without a swap, SRB could
record a substantial loss from rising interest
rates. Note that through the swap transaction, the bank has taken on other risks,
such as counterparty credit risk and basis
risk (that is, the risk that the T-bill repricings
might not occur simultaneously). However,
with the swap, SRB has considerably reduced its interest rate sensitivity.
Financial derivatives are useful risk
management tools that allow for the efficient
unbundling of risks into component pieces
that can be sold and managed indepen-

Chart 6
SRB's Interest Flows Before Swap

Loans

Floating

Deposits

dently. The financial derivatives market has
grown rapidly because of the economic
benefits that derivatives provide institutions
in effectively controlling risk exposures.

Chart 8
Effect of Interest Rates
on SRB's Net Interest Margin

The Evolving Market:
The Changing Roles of Derivatives Players
Financial derivatives participants can be
divided into two groups: end-users and
dealers. End-users typically are corporations, government entities, institutional
investors, and financial institutions. Dealers
are mainly banks and securities firms.
Financial derivatives are utilized by endusers to lower funding costs, enhance
yields, diversify sources of funding, hedge,
and speculate by taking positions in anticipation of expected market movements.
In the early years of financial derivatives,
dealers, for the most part, acted as brokers,
finding counterparties with offsetting requirements. Then, dealers themselves began
to act as counterparties to intermediate
customers' requirements. Once a position was
taken, a dealer immediately either matched
(hedged) it by entering into an opposing
transaction, or "warehoused" it until a match
could be found by temporarily using the
futures market to hedge unwanted risks.
Today, dealers manage a portfolio of
derivatives and oversee the net, or residual,
risk of their overall position. This development has changed the focus of risk manage-

- -

Fixed
(4.5%)

Loans

Fixed
(7%)

ment from individual transactions to total
portfolio exposures and has substantially
improved dealers' ability to accommodate
a broader spectrum of customer transactions. It has also provided a new way for
banks to serve in their roles as financial
intermediaries.
Players in the financial derivatives market
do not have to join one particular group:
they can act as both end-users and dealers.
For example, a bank acts as an end-user
when it uses derivatives to take positions
as part of its proprietary trading, or for
hedging as part of its asset/liability management. A bank acts as a dealer when it
quotes bids and offers and commits capital
to satisfy customers' needs for derivatives.
The Main Derivatives Players

Chart 7
Effect of Interest Rate Swap on SRB

DEALER
"H

(Interest rates)

The biggest players in the U.S. financial
derivatives market are mostly large money
center banks {Chart 9).5 In fact, more than

]
5

Floating
(T-bill - . 5 % )

Floating __
(T-bill)

Deposits

All data were taken from the December 31, 1993, Consolidated Financial Statements for Bank Holding Companies With Total Consolidated Assets of $150 Million
or More or With More Than One Subsidiary Bank
(FR Y-9C). Total derivatives activity include interest rate
contracts; foreign exchange rate transactions; and futures,
forwards, and option contracts on other commodities.

Chart 9
Top Ten Derivatives Players
N o t i o n a l v a l u e (billions of d o l l a r s )

Chemical

$2,479

Citicorp
Bankers Trust
J. P. Morgan
Chase Manhattan
BankAmerica
First Chicago
NationsBank
Republic New York •

$156

Continental Bank I

$138

N O T E : D a t a a s of D e c e m b e r 31, 1 9 9 3 .
D A T A S O U R C E : FR Y-9C Reports.

90 percent of the derivatives usage among
bank holding companies is done by ten
institutions.
Few other bank holding companies are
derivatives players. At year-end 1993, only
19 percent of bank holding companies
reported any derivatives activity. But because they are much larger than average,
they account for 87 percent of all bank
holding company assets. 6

These figures include eight bank holding companies
in the Eleventh Federal Reserve District (Texas, southern New Mexico, and northern Louisiana).

Derivatives players such as securities firms and
insurance companies that do not file regulatory reports
with the banking agencies make the financial derivatives market even larger.
8

Bank participation in financial derivatives markets
is examined in Board of Governors of the Federal
Reserve System and others (1993) and Remolona
(1992-93).

In May 1994, the General Accounting Office (1994)
released their two-year study of financial derivatives,
sounding a call for stiffer government regulation of
financial derivatives markets.
6

According to quarterly regulatory reports
filed by bank holding companies, the
financial derivatives market is at least $11
trillion." The amounts shown in Chart 9
are in billions of dollars, and they are correct:
the notional value of Chemical Banking
Corporation's derivatives holdings are nearly
$2.5 trillion. A word of caution about notional amounts: for derivatives, notional
principal is the amount upon which interest
and other payments in a transaction are
based. Notional principal typically does not
change hands; it is simply a quantity that
is used to calculate payments and does not
give any indication of the underlying risk
of the positions.
Derivatives' Credit Exposures
Although notional principal is the most
frequently used volume measure in financial
derivatives markets, it is not a measure of
credit exposure. A useful proxy for credit
exposure is the replacement cost credit
exposure. This is the cost to replace the
contract at current market values should
the counterparty default prior to the settlement date. 8
For the ten largest financial derivatives
players among United States bank holding
companies, derivative credit exposures
average 12 percent of total assets. This compares with an average exposure of 51 percent of assets for the banks' loan portfolios.
In other words, if these ten banks were to
lose 100 percent of their loans, it would be
more than four times as great than if they
had to replace all of their derivative contracts (Chart 10).
Are New Regulations Warranted?
Fears of the unknown and recent market
volatility have raised new concerns among
lawmakers regarding the use of financial
derivatives products. From January to May
1994, three House bills and one Senate bill
regarding financial derivatives have been
introduced, and many more are expected. 9
The first bill, introduced in January 1994 by

Table 1
Effect of Interest Rates on SRB's Net Interest Margin
Rates drop
300 basis points
(Percent)

No change
in rates*
(Percent)

Rates rise
300 basis points
(Percent)

7.00
-1.00

7.00
-4.00

7.00
-7.00

6.00

3.00

Fixed swap outflow
Floating swap outflow

-4.50
.50

-4.50
3.50

-4.50
6.50

Net swap outflow

-4.00

-1.00

2.00

Asset yield (loans)
Liability yield (deposits)
Net margin (without swap)

Net margin ( with swap)

* Assumes the current Treasury-bill rate is 4 percent.

Congressman James A. Leach of Iowa, calls
for the establishment of a Federal Derivatives Commission. This commission would
be headed by the chairman of the Federal
Reserve Board of Governors and would
focus on preventing unexpected large losses
by firms that trade in derivatives. The bill
calls for the establishment of guidelines for

Chart 10
Credit Exposure: The Top Ten
Billions of dollars

•-:
|

•.

.... ^
S:/..::r

fssaiiiis'&m*IMwM'

: :

Loan
exposure

Derivatives
exposure

NOTE: Data as of December 31, 1993.
DATA SOURCE: FR Y-9C Reports.

Equity
capital

Notional
value of
derivatives

using financial derivatives and limiting
active participation in derivatives markets
only to those institutions with solid capital
and sound management.
The second House bill, introduced in
April 1994 by Congressman Henry B. Gonzalez of Texas, is directed at the regulation
of bank derivatives activities. His bill calls
for banks to disclose more information
about their financial derivatives holdings
and would boost regulatory oversight of
banks' involvement in the derivatives
market. Gonzalez' bill also would make
"improper management" of derivatives
illegal and would mandate a study by the
General Accounting Office to examine the
feasibility of a transaction tax on "excess
speculation."
Congressman Gonzalez also introduced
a third House bill in May 1994 that blends
provisions of his previous bill and the Leach
bill. This latest bill calls for increased oversight of financial derivatives markets to
protect the federal deposit insurance system
and control financial market risk. According to the bill, this would be accomplished
by directing regulators to establish appropriate standards for supervising derivatives
trading and increasing regulators' ability in
gathering information regarding derivatives
activities at financial institutions.

Also in May 1994, Senator Byron L.
Dorgan of North Dakota introduced a bill
that would require proprietary trading of
derivatives to be placed in separately capitalized subsidiaries. The proposal, if enacted, could severely limit banks' use of
financial derivatives products because so
many banks use the portfolio management
method of trading.10
Lawmakers' concerns over banks' activity
in financial derivatives stems from the potential to speculate in the derivatives market,
which allows banks to bet with federally
insured deposits and, ultimately, with taxpayers' funds. Although financial derivatives
are fairly new, their risks are not. They reflect
essentially the same basic risks that banks
have always faced: credit risk, settlement
risk, operating risk, market risk, and so on.
New laws that curtail derivatives activities
could prove harmful to market efficiency
because of the economic benefits that derivatives provide in efficiently transferring
market risks. Financial derivatives have
become a new, sophisticated tool banks
can use to accomplish more successfully
their risk management objectives. It is important that financial innovation not be discouraged. After all, banking is not intended
to be a risk-free activity.
Even so, the elimination of risk in banking seems to be the goal of many regulatory policymakers. It is certainly important
that problems arising in financial markets
are quickly contained, and that they do not

Using this trading scheme, an institution manages
the net, or residual, risk, thereby changing the focus
of risk management from individual transactions to
portfolio exposures.
11
See Short (1991) for a discussion of the role deposit
insurance has played in bank risk-taking. An empirical
investigation of the impact of moral hazard on bank
risk-taking during the 1980s can be found in Gunther
and Robinson (1990).
12

See Short (1987) and Short and O'Driscoll (1983).

See Short (1991).

develop into major crises. But regulatory
proposals that discourage the use of prudent risk management strategies, create an
unlevel playing field for market participants,
or that eliminate the discipline provided by
the market mechanism should be avoided.
Are Derivatives or Deposit
Guarantees the Problem?
In the 1930s, deposit insurance and
other banking reforms were introduced to
address some of the instabilities associated
with systemic risk. The primary objectives
of deposit insurance were the protection of
small depositors and protection of the circulating medium of exchange. By addressing
depositor confidence, the U.S. government
hoped to avoid the experience of deposit
runs that were characteristic of many earlier
banking crises.
The current deposit guarantee structure
does, indeed, reduce the probability of
large-scale bank panics but has also created
new problems. Deposit insurance effectively
eliminates the discipline provided by the
market mechanism in encouraging banks
to maintain appropriate capital levels and
restrict unnecessary risk-taking.11 This decline
in market discipline provided through an
incentive for depositors to monitor banks
may encourage banks to pursue higher risk
strategies.12
Because of the federal deposit guarantee,
some government lawmakers now propose
to restrict insured banks' activities in financial derivatives markets. But are derivatives the problem, or is the current federal
deposit guarantee structure the problem?
Without federal deposit guarantees, banks'
activities would be disciplined by depositors and the banks would take only calculated risks because uninsured depositors,
concerned about the safety of their deposits,
would provide the discipline necessary
to guide financial institutions in maintaining adequate capital and limiting risky
strategies.13
Further, the presence of federal deposit
guarantees may encourage banks to use

derivatives to pursue higher risk strategies,
such as speculating on the direction of
interest rates or exchange rate differentials,
instead of using derivatives for hedging to
improve their management of financial
risks. Federal deposit insurance discourages
market discipline, so regulators are forced
to exert pressure on banks to ensure that
they are managed in a safe and sound
manner.
If the current federal deposit guarantee
structure is to remain intact, regulatory
proposals involving financial derivatives
should focus on market-oriented reforms as
opposed to laws that eliminate the usefulness of derivatives in managing risk. Such
reform proposals include emphasizing
more disclosure of derivative holdings and
their accompanying risks, appropriate
capital adequacy standards, and guidelines
that foster sound risk management practices.
This does not imply that derivatives
activities should be forced into separately
capitalized subsidiaries of bank holding
companies. The risks associated with proprietary trading are not inherently greater
than those associated with other banking
activities. As Federal Reserve Chairman
Alan Greenspan (1994) said in recent testimony to a House Subcommittee:
Some derivative contracts, notably
options products, are quite complex,
but a complex, difficult-to-manage
option is imbedded in every fixedrate home mortgage. As is the case
for home mortgage lending or any
other banking activity, whether proprietary trading places the deposit
insurance fund at risk depends on the
bank's capital, the degree of concentration in its risk exposures, the
strength of its risk management systems and internal controls, and the
expertise of its personnel, including senior management and risk
managers as well as traders.
Indeed, implementing and monitoring a
segregated proprietary trading function
would be extremely difficult because such

functions are difficult to define in principle
and difficult in practice to distinguish from
market-making and other customer accommodation activities of banks.
Systemic Risk: The Domino Effect
For banking supervisors, probably the
most important question they face concerning financial derivatives is, What could go
wrong to engender systemic risk, the danger
that disruptions or difficulties at one institution could have a significant impact on
other financial institutions and through them
on the overall economy? In other words,
what safeguards exist to prevent a domino
effect, precipitating a banking crisis?
Individual financial derivative contracts,
by their nature, allow risk to be distributed
throughout the entire financial system.
Derivatives allow different components of
risk to be segregated, isolated, and passed
around the financial system to those who
are willing and able to bear each risk component at least cost. This activity reduces
the overall cost of risk-bearing and enhances
economic efficiency.
Thus, a major shock that would jolt
financial markets in the absence of derivatives would also have an impact on financial markets in which the use of derivatives
was widespread. But because the holders
of various risks would be different, the
impact would be different and presumably
not as great because the holders of the risks
should be better able to absorb potential
losses. Note that this presumption holds
only in a market where bank risk-taking is
disciplined by depositors. In a market with
deposit guarantees, banks may be more
willing to adopt risky strategies and speculate with derivatives.14

14
The link between deposit insurance and risk-taking
behavior is not unique to derivatives. The point is,
the present deposit guarantee structure could create
incentives for banks to take on higher risk strategies,
whether using derivatives or through a bank's loan
portfolio.

What Should Regulators Do?
Banking regulators should emphasize
more disclosure of derivatives positions in
financial statements and also require that
institutions trading huge derivatives portfolios have adequate capital. Additionally,
because derivatives could have implications
for the stability of the financial system as a
whole, it is important that users maintain
sound risk management practices. To this
end, regulators have issued guidelines that
banks with substantial trading or derivatives activity should follow. These include
(1) active board and senior management
oversight of trading activities,
(2) the establishment of an internal risk
management audit function that is
independent of the trading function,
(3) thorough and timely audits to identify
internal control weaknesses, and
(4) risk measurement and management
information systems that include
stress testing, simulations, and contingency planning for adverse market
movements.
It is the responsibility of a bank's senior
management to ensure that risks are effectively controlled and limited to levels that
do not pose a significant threat to its capital
position. In addition to the guidelines mentioned above, the Group of Thirty (1993)15
recently published a set of sound risk management principles for users and dealers of
financial derivatives products in the form

The Group of Thirty is an international financial
policy organization made up of representatives of
central banks, international banks, securities firms,
and academia.
16
See McDonough (1993) for additional comments
regarding the Group of Thirty (1993) study.
17

Becketti (1993) concludes with a similar view that
banks can safely manage and regulators can effectively supeivise bank participation in financial derivatives markets.
10

of twenty recommendations (see the box
entitled "Summary of Recommendations: The
Group of Thirty Global Derivatives Study").
These recommendations address issues
associated with the measurement, control,
accounting, and disclosure of derivatives
activities.16 This is a step in the right direction for practitioners and responds to many
public policy concerns surrounding the
management of financial derivatives products. Sound risk management practices
at the individual firm level are the most
important factor in preventing systemic
disturbances. 17
Derivatives are here to stay. Both financial institutions and regulators have made
substantial progress in meeting the challenges posed by financial derivatives. But
greater challenges remain. Like it or not,
we are well on our way toward truly global
financial markets that will continue to develop new financial innovations designed
to improve risk management practices.
Conclusion
In conclusion, financial derivatives products are useful risk management tools for
breaking risk into components that can be
managed independently. The viability of
financial derivatives rests on the principle
of comparative advantage. Whenever comparative advantages exist, there can be
benefits to all parties from trade. And financial derivatives allow for the free trading of
individual risk components.
In addition, regulation is an ineffective
substitute for sound risk management at
the individual firm level. Increased disclosure requirements, capital adequacy standards, and guidelines that foster sound risk
management practices are prudent regulatory strategies. The overall health of the
financial system depends on the adoption
of sound risk management practices at the
individual firm level.
Furthermore, the safety and soundness
of financial markets depends more on the
effective monitoring and molding of bank
risk-taking through market forces than

through continued regulatory oversight.
Laws that destroy derivatives' economic
benefits could prove harmful to individual
firms and global financial markets. Successful regulations need to emphasize the incentives and self-correcting features found

in free-enterprise systems. Efforts should be
made to improve the role depositors play
in controlling bank risk-taking instead of
eliminating the role financial derivatives
play in controlling bank risk-taking.

Summary of Recommendations
The Group of Thirty Global Derivatives Study
For end-users and dealers of derivative
products:
• Use derivatives in a manner consistent with the firm's overall risk
management and capital policies
approved by its board of directors.
Management at all levels should enforce these policies.
• Mark-to-market derivatives positions,
at least on a daily basis, for risk
management purposes.

• Ensure that only well-trained, responsible professionals are involved in
derivatives activities.
• Establish computerized risk management information systems that measure, manage, and report risks in a
timely manner.
• Adopt accounting and disclosure
practices for international harmonization and greater transparency.
For Regulators:

• Quantify market risk under adverse
market conditions against limits, perform stress simulations, and forecast
cash investment and funding needs.
• Assess credit risk based on frequent
measures of current and potential exposure against counterparty limits.
• Reduce credit risk by broadening the
use of multiproduct master agreements with close-out netting provisions.
• Establish independent and authoritative credit risk management functions responsible for reviewing and
monitoring risk exposures.

• Recognize close-out netting arrangements and encourage their use by
reflecting them in capital adequacy
standards.
• Remove remaining legal and regulatory uncertainties.
• Amend tax laws to remove impediments to the use of derivatives in risk
management strategies.
• Provide comprehensive and consistent guidance on accounting and reporting of derivative instruments.

A Brief Derivatives Lexicon
Cap:

An option-like contract that protects the holder against a rise in
interest rates or some other underlying beyond a certain level.

Collar:

The simultaneous purchase of a cap and sale of a floor with the
objective of maintaining interest rates, or some other underlying,
within a defined range.

Dealer:

A counterparty who enters into a swap in order to earn fees or trading
profits, serving customers as an intermediary.

Derivative:

A contract whose value depends on (or derives from) the value of an
underlying asset, typically a security, commodity, reference rate,
or index.

End-user:

A counterparty who engages in a swap to manage its interest rate or
currency exposure.

Floor:

An option-like contract that protects the holder against a decline in
interest rates or some other underlying beyond a certain level.

j®

is : [

Forward:

A contract obligating one counterparty to buy and the other to sell
a specific asset for a fixed price at a future date.

Future:

A forward contract traded on an exchange.

Notional Value:

The principal value upon which interest and other payments in a
transaction are based.

Option:

A contract giving the holder the right, but not the obligation, to buy
(or sell) a specific quantity of an asset for a fixed price during a
specified period.

Swap:

An agreement by two parties to exchange a series of cash flows in
the future.

Swaption:

An option giving the holder the right to enter (or cancel) a swap
transaction.

Underlying:

The asset, reference rate, or index whose price movement determines the value of the derivative.

References
Aristotle, Politics, Book I, Chapter 11.
Becketti, Sean (1993), "Are Derivatives Too
Risky for Banks?" Federal Reserve Bank
of Kansas City Economic Review, Third
Quarter, 27-42.
Board of Governors of the Federal Reserve
System, Federal Deposit Insurance Corporation, and Office of Comptroller of the
Currency (1993), "Derivative Product Activities of Commercial Banks, Joint Study Conducted in Response to Questions Posed by
Senator Riegle on Derivative Products,
January 27.
Federal Reserve Bank of Atlanta (1993),
Financial Derivatives: New Instruments
and Their Uses, December.
General Accounting Office (1994), Financial
Derivatives: Actions Needed to Protect the
Financial System, Report to Congressional
Requestors, GAO/GGD-94-133, May 18.
Greenspan, Alan (1994), Testimony Before
the Subcommittee on Telecommunications
and Finance of the Committee on Energy
and Commerce, U.S. House of Representatives, May 25.
Group of Thirty Global Derivatives Study
Group (1993), Derivatives: Practices and
Principles, Washington, D.C., July.
Gunther, Jeffery W., and Kenneth J. Robinson (1990), "Moral Hazard and Texas Banking in the 1980s: Was There a Connection?"

Federal Reserve Bank of Dallas Financial
Industry Studies, December, 1-8.
Kapner, Kenneth R., and John F. Marshall
(1990), The Swaps Handbook: Swaps and
Related Risk Management
Instruments
(New York: New York Institute of Finance).
McDonough, William J. (1993), "The Global
Derivatives Market," Federal Reserve Bank
of New York Quarterly Review, Autumn,
1-5.
Remolona, Eli M. (1992-93), "The Recent
Growth of Financial Derivative Markets,"
Federal Reserve Bank of New York Quarterly Review, Winter, 28-43.
Short, Genie D. (1991), "Banking in the
Southwest and the Rest of the Nation:
Where We Are and Where We Are Going,"
Federal Reserve Bank of Dallas Financial
Industry Studies, December, 1-14.
(1987), "Bank Problems and Financial Safety Nets," Federal Reserve Bank of
Dallas Economic Review, March, 17-28.
, and Gerald P. O'Driscoll, Jr. (1983),
"Deregulation and Deposit Insurance,"
Federal Reserve Bank of Dallas Economic
Review, September, 11-23.
Wilson, Gregory P. (1993), "BAI/McKinsey
Survey on the Usage of Derivative Products," Presentation at the BAI Conference
on Derivative Products, December.

What Determines
Businesses' Borrowing
from Banks?
Linda Hooks
Professor of Economics
Washington and Lee University
and formerly
Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas
and
Tim Opler
Professor of Finance
Southern Methodist University

anks have long served as an important
source of credit for businesses. Their
role as credit providers to businesses has
diminished in recent years, however. It is
widely recognized that medium to large
businesses have been increasingly satisfying their credit needs through nonbank
sources, including markets for commercial
paper and other types of securities. But even
among the small businesses that cannot
turn to the securities market, there is a
growing reliance on nonbank credit sources.
Firms that use banks as a source of
financing do so because bank credit is the
most attractive alternative. Banks may hold
a comparative advantage in business financing because they possess informational
advantages over other types of lenders.
For instance, a bank may find it easier than
some other types of outside lenders to
evaluate and monitor a firm because the bank
may have expertise in lending to certain
types of firms or an ongoing relationship
with the firm seeking credit. This relationship
provides the bank with borrower-specific
information not readily available to other
participants in the financial markets. The

bank's greater information on the firm means
that it might find a loan to the firm profitable even though other lenders would not.
This article examines the characteristics of
a sample of small- to medium-sized businesses to determine what factors are associated with reliance upon bank credit among
such borrowers. Awareness of what parts
of the credit market are served by banks
may help in evaluating policies designed to
address concerns about a credit crunch.
Empirical evidence suggests that the
relative amount of bank debt a firm holds
depends on firm size. The smallest firms in
the sample use less bank debt than the
medium-sized and large firms. In addition,
smaller firms that are not well-known, or
that are without well-established reputations,
are more likely than larger firms to need
to pledge collateral to obtain bank loans.
These differences in borrower characteristics suggest that firms face a changing array
of borrowing opportunities as they grow
and become more established.
Recent Growth in Business Financing Choices
Banks today face increasing competition
for extending credit to businesses. Alternatives to bank loans, such as the commercial
paper market, loans from finance companies, and private placements, have made
inroads into a territory once dominated by
banks. Chart 1 shows the growth in the
shares of commercial paper and finance
company loans in total short-term business
liabilities over the period 1977-93- By the
end of 1993, these two sources of financing
combined accounted for almost 16 percent
of short-term credit in the economy. 1
Potentially lower costs attract many businesses to these alternative sources of credit.
Chart 2 shows that the spread between the
banks' prime rate and the commercial paper

The data presented in this section are national
amounts and are not from the sample analyzed later
in the article.
15

Chart 1
Nonbank Financing as a Percentage
of Total Short-Term Liabilities
Percent

'77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93

DATA SOURCE: FAME Database, Flow of Funds.

rate widened in the late 1970s and early
1980s and increased again in the early
1990s.2 The higher cost of credit from banks
reflects a number of factors in the financial
markets, including regulatory capital requirements and the erosion of a base of
core deposits, a traditional source of lowcost funds for banks. Another factor affecting banks' competitiveness is the cost of
regulations imposed on the banking industry
but not on its competition. A recent study
by the Federal Financial Institutions Examination Council (FFIEC) concludes that
banks' annual total costs stemming from
the array of regulations they operate under
equal between 6 and 14 percent of banks'
noninterest expenses.
Alternative sources of credit are important for many large firms but often are only
a secondary source of credit for smaller
firms. Data from the 1989 National Survey
of Small Business Financing provide some
insight into the importance of bank credit

for small businesses, defined as those with
fewer than 100 employees. The data show
that banks are the source of credit for 81
percent of the small firms that obtain credit.
In contrast, only 41 percent of the firms
use any nonbank source of credit.3
The sources of credit available to small
firms may be a factor influencing their growth
opportunities. Small firms with easier access
to outside credit may be better positioned
for growth than firms that must rely solely
on internal financing. As Table 1 illustrates,
growth through small businesses is important to overall economic growth. Small
firms—defined here as those with fewer
than 100 employees—were responsible for
44 percent of the net jobs generated in the
United States over the 1976-86 period.
Similarly, small businesses in Texas generated 43 percent of the new jobs in the state.
Concerns about credit availability, especially for small firms, have led policymakers
to consider a number of initiatives to address
the issue. On March 10, 1993, the four
federal banking agencies announced a
number of regulatory changes to enhance
the availability of credit, especially to small
businesses. One component of the new
policy allows banks more freedom in making
"character" loans. This initiative recognizes

Chart 2
Prime Rate and Commercial Paper Rate
Percent

Although banks sometimes offer a discount on their
prime rates, the prime rate is useful as a rough indicator of the cost of bank financing.
3

See Elliehausen and Wolken (1990).

DATA SOURCE: CITIBASE.

Table 1
Net Jobs Generated by Small Businesses, 1976-86
Percentage of jobs generated by firms
with fewer than 100 employees
Industry
Total
Agriculture
Construction
Finance
Manufacuturing
Mining
Retail trade
Services
Transportation
Wholesale trade

United States

Texas

44
75
102
37
106
52
25
37
30
65

43
59
83
48
30
35
34
44

28
53

NOTE: Percentages may exceed 100 because the industry experienced a loss of jobs in total, even
though small businesses showed a net gain of jobs.
SOURCE: U.S. Small Business Administration, Office of Advocacy, Handbook of Small
Data 1988.

that banks often form special relationships
with certain businesses that may enhance
credit availability for these enterprises.
Because small businesses contribute
significantly to economic growth in the
United States, and because banks are their
primary source of credit, it is important to
understand the factors that influence the
relative amount of bank debt held by small
businesses. The next section discusses an
economic theory of businesses' use of
bank loans versus nonbank sources of
credit. This theory stresses that banks may
have a comparative advantage in providing
funds to certain types of businesses and
that this advantage allows banks to fulfill
credit needs more efficiently than can
alternative providers of financing.

Business

notion that banks are better positioned
than alternative lenders to gather information on businesses. 4 This view emphasizes
the effect of information asymmetry on the
supply of bank loans.
Banks have an informational advantage
relative to other providers of capital because they can better observe firms' cash
flows and investment decisions. A bank
establishes a relationship with a borrower,
and this gives the bank additional access
to information on the firm's performance
and the ability to monitor the investments
the bank finances.
For example, as a bank develops a relationship with a business, it gains access to
the managers of the business, w h o can
provide the bank with information not
readily available to the general public. This

The Role of Bank Loans
in Business Financing
Information Asymmetry, Reputation,
and Bank Lending. The information
asymmetry view of banks' comparative
advantage in business lending relies on the

Diamond (1984), Ramakrishnan and Thakor (1984),
Fama (1985), and Seward (1990) show that hanks
can bring welfare improvements in an economy with
informational asymmetries between borrowers and
lenders.
17

information may range from additional
accounting data to a manager's hunch
about a new product. Any such information available to the bank, but not to the
public, gives the bank a comparative advantage in evaluating the business. In addition,
a bank's experience in lending to smaller
borrowers may give the bank an advantage
in processing the information it does obtain.
For example, a bank's experience in evaluating business plans may enable the bank
to more accurately evaluate a firm's prospects than an alternative lender could by
studying the same business plan. Through
this ongoing process, banks may be able to
derive more insight from a given piece of
information than a nonbank lender could.
The information asymmetry view of
banks' role in the credit process implies
that a firm with investments that are more
difficult to observe will be the most likely
user of bank debt. A bank may be able to
monitor the investment efficiently, while
other lenders would find equivalent monitoring too costly. Similarly, a firm with performance that is difficult to observe will
likely use bank debt because banks are
probably more efficient monitors of performance.
A more complex version of the informationasymmetry story explains how a firm's
choice between bank debt and other debt
is affected by its reputation. 5 The reputa-

Diamond (1991) has shown that information asymmetry may lead to a more complex equilibrium when
firms build reputations in the credit market.
6

Other theories that are important in explaining the
role of banks in business financing include the costly
monitoring view, developed by Rajan (1992). This
view emphasizes that the monitoring services a bank
provides will involve not only benefits, but also costs.
Boot, Thakor, and Udell (1991) develop a collateral
view of bank lending, which shows that firms that are
relatively easy to observe would use more bank debt,
not less, because the observable assets serve as collateral on the loans. A more complete discussion of
each of these views can be found in Hooks and Opler
(1993).

tion view illustrates how bank loans can
help a firm build and establish a reputation
that would enable the firm to earn higher
credit ratings in the financial markets. Both
supply and demand effects are incorporated in this view.
The reputation view holds that a firm
that has not yet established a reputation,
and therefore has a low credit rating, may
be rejected for a bank loan. By contrast, a
firm with a more established reputation
and an intermediate credit rating is usually
accepted for a loan. The bank loans are
made because banks have a comparative
advantage in gathering information on these
firms relative to other lenders. The more
established firm wants to obtain the monitoring services over firm investments and
performance that a bank provides because
the bank's monitoring will signal other
lenders that the firm is a good credit risk.
This helps the firm to further establish and
enhance its reputation. Finally, a firm with
a high credit rating and a well-established
reputation chooses to borrow directly from
financial markets, issuing publicly traded
bonds or commercial paper, because its
reputation provides it with low-cost access
to these markets. 6
Empirical implications. The perspectives
outlined above offer several reasons why
banks might have a comparative advantage
in making loans. This section identifies
variables that would proxy for the predictions identified in the preceding section.
Further examination of these variables would,
therefore, lead to some insights into the
factors that might lie behind a firm's use
of bank versus nonbank sources of credit.
Tangible assets. In the information asymmetry view, the observability of a project
is an important determinant of whether a
firm borrows from a bank. Empirically,
observability of firms' investments can be
measured as the fraction of tangible, or
fixed, assets to total assets. Firms with more
tangible assets will tend to make investments that are more easily observable by
outsiders. For example, it would be much
easier to verify whether a firm builds a new

factory with a loan than to verify whether it
provides appropriate training to its workers
(an intangible asset) with the same loan.
Because the information asymmetry
view predicts that more observability is
associated with fewer bank loans, it suggests
that tangible assets, the empirical measure
of observability, will be negatively associated
with the concentration of bank debt. So,
the greater a firm's proportion of tangible
assets, the less it would rely on bank debt.
Firm size. Another measure of the observability of a firm's investment choices is
firm size." Small firms are typically more
difficult for outsiders to observe than larger
ones because little public information is
produced about these firms. A bank, however, usually will have access to the management and premises of a firm that borrows
from it, regardless of the firm's size.8 According to the information asymmetry view,
this implies that small firms would be more
likely to use bank debt than larger firms.
The related reputation view, though,
suggests that the amount of a firm's bank
borrowing depends on firm size in a more
complex way than the simple informationasymmetry view suggests. At the high end
of the market, large firms build strong
reputations that allow them to tap cheap
credit in external credit markets. Therefore,
they tend to have little bank debt. At the
other end of the market, many small firms
are screened out of the financial markets.
These firms instead use internal financing,
financing from suppliers, or similar credit
sources and, therefore, will have little bank
debt. In the middle part of the market,
firms that lack sufficient reputation to tap
the external credit market, but may pose
demonstrably low credit risk for a bank,
will use banks as a source of capital.
Thus, the reputation view has the empirical implication that bank borrowing
depends on both observability and on firm
size. Firms that have investments that are
difficult to monitor (have fewer tangible
assets) will more likely be denied credit
when they are small. However, as they
grow sufficiently in size to be able to access

external credit markets, they will be more
likely to borrow from banks when outsiders
can't easily observe their quality. Therefore,
firms with low concentrations of tangible
assets will have low bank loan intensity
when they are small but high bank loan
intensity as they grow in size. Ultimately,
when they become very large and wellknown in the external credit market, they
will have little bank debt at all.
Leverage. The information asymmetry
view may be interpreted to suggest that a
relationship exists between a firm's leverage
ratio, or total debt to asset ratio, and its use
of bank debt. According to this view, firms
with low observability have difficulty obtaining financing and, therefore, may have
low leverage ratios. But because banks have
a comparative advantage in producing information about these difficult-to-observe
firms, they do obtain bank loans. Thus,
firms with low observability might be expected to have low leverage, but high concentrations of bank debt.
Evidence on Businesses' Use of Bank Loans
This section turns to some empirical
evidence to determine the relative importance of the information asymmetry view
in practice. 9 The data, obtained from Dun
and Bradstreet, provide aggregate information on the borrowing behavior of a sample
of small- and medium-sized businesses

Observability might also be measured by the age of
a firm. Unfortunately, this variable is not available for
the data analyzed in the next section.

Fama (1985) and Slovin, Johnson, and Glascock
(1992) discuss these ideas further.

Previous empirical studies of the determinants of
bank borrowing include Easterwood and Kadapakkam
(1991), Calem and Rizzo (1992), and Hoshi, Kashyap,
and Scharfstein (1993). Related literature finds that
announcements of bank loans can have positive effects
on a firm's market value. See James (1987), Lummer
and McConnell (1989), and Slovin, Johnson, and
Glascock (1992).
19

each year between 1982 and 1987.10 Because all firms in the sample have less than
$5 million in assets, this analysis will, of
course, provide only suggestive evidence
on the questions posed.
The analysis measures reliance on bank
debt by calculating the ratio of industryconsolidated bank debt to total industryconsolidated liabilities. It is important to
note that the analysis distinguishes between
two decisions: reliance on debt and reliance on bank debt. The theories discussed
earlier in this article address only the second
decision, reliance on bank debt. Thus, the
principal question may be restated as follows: Given the amount of debt that a firm
chooses, how much of that debt will be
bank debt? 11
The concentration of bank loans in
total firm debt. The recent trend away
from bank financing for many firms is
apparent in Chart 3- Between 1982 and
1987, the large firms in the sample—those
with assets between $1 million and $5
million—decreased their average proportion of bank debt to total liabilities from 22
percent to 12 percent. Small firms, with
assets up to $100,000, and medium-sized
firms, with assets between $100,000 and $1
million, also held a reduced share of bank
debt by 1987. For all firms combined, the
relative amount of bank debt held over the
period fell by about one-half.
While the share of bank debt for firms
of all sizes has decreased over time, Chart

The analysis that follows is based on Hooks and
Opler (1993). The data are at the 4-digit SIC level.
Firms need not have outstanding debt to be included
in the sample. Other sources of credit for these firms
include finance companies, venture capitalists, mezzanine financiers, and Small Business Administration
loans. Using data up through 1987 avoids possible
distortions that may have arisen in light of the credit
crunch episode that began several years later.
11

A measure of reliance on total debt, like the ratio of
debt to assets or the leverage ratio, is not appropriate
for testing the predictions of the views described
above because it does not focus on the relative use of
bank debt.
20

Chart 3
Firms' Average Concentrations
of Bank Debt by Firm Size
Percent of total debt

All firms
in sample

Small firms,
less than
$100,000

Medium firms,
$100,000$1 million

Large firms,
$ 1 - 5 million

NOTE: Firm size by asset value.
DATA SOURCE: The INSIGHT database from Dunn &
Bradstreet.

3 also indicates that small firms use less
bank debt than larger firms in each time
period. In 1982, the smallest firms in the
sample held an average of 16 percent of
their liabilities as bank debt, but the largest
firms held a higher share—22 percent of
their liabilities—as bank debt. A similar
pattern holds for 1987. The simple information asymmetry view predicts that small
firms will use relatively more bank debt
than large firms, but this is not reflected in
the data.
Although the reputation view can be
only partially examined with the data at
hand, the evidence in Chart 3 does support
a number of its predictions. The finding
that small firms use less bank debt is consistent with the reputation view because it
predicts that small firms without wellestablished reputations will often find it
difficult to obtain bank loans. The reputation view also predicts that medium-sized
firms will hold more bank debt, and this
prediction, too, is consistent with the evidence in Chart 3- Unfortunately, the prediction that large firms with good reputations

will use little bank debt cannot be tested
with this sample because the sample does
not include very large firms.
The relationship of bank loans and
firms' observability. Chart 4 shows the
pattern between one measure of businesses'
observability, tangible assets relative to
total assets, and the concentration of bank
debt in 1987. The chart groups the firms in
each size category into five classes that
depend on firms' concentrations of bank
debt. The firms with the least bank debt
are in group 1, and those with the most
bank debt are in group 5.
As shown in Chart 4, firms with more
bank debt tend to have relatively fewer
tangible assets than firms with little bank
debt. This trend is especially apparent for
the medium- and large-sized firms in the
sample. The pattern displayed in Chart 4 is
consistent with the information asymmetry
view of bank lending, which holds that
firms that are more difficult to observe are
more likely to use bank financing than are
other firms.
The pattern in Chart 4 is also consistent
with the reputation view. Among those

Chart 4
Firms' Average Share of Tangible Assets,
Ranked by Concentration of Bank Debt, 1987
Percent of total assets

Charts
Firms' Average Leverage,
Ranked by Concentration of Bank Debt, 1987
Percent of total assets

NOTE: Rank based on ratio of bank debt to total debt.
DATA SOURCE: The INSIGHT database from Dunn &
Bradstreet.

banks with the largest concentration of
bank debt (group 5), small firms hold more
tangible assets (or collateral) than do larger
firms. One interpretation of this is that
small firms do not have established reputations, so to obtain bank loans they must
pledge part of their tangible assets as collateral. Larger firms that have established
stronger reputations are less likely to need
collateral to obtain bank loans. 12
Bank loans and firms' leverage. Chart 5
shows the relationship in 1987 between the
relative amount of total debt held by firms,
or the leverage ratio, and the concentration
of bank loans for firms. As before, the
firms have been classified into five groups
based on their bank loan concentrations.
The pattern in Chart 5 suggests that firms
with relatively higher concentrations of
bank debt (groups 4 and 5) have relatively

NOTE: Rank based on ratio of bank debt to total debt.
DATA SOURCE: The INSIGHT database from Dunn &
Bradstreet.

A formal test that controls for other factors affecting
firms' bank loan concentration shows that the relationship between fixed assets and loan concentration
is positive for small firms but negative for large firms.
This evidence, which supports the conclusions drawn
here, is described in Hooks and Opler (1993).

smaller amounts of total debt. That is, bank
debt concentration is highest in those firms
whose leverage ratios are low. The relationship is most pronounced in the largefirm category, for which the average leverage
ratio falls from 51 percent to 24 percent
across the bank loan-concentration groups.
The negative relationship between leverage and bank loan concentration is consistent with the information asymmetry view.
As discussed earlier, a firm that is difficult
to observe may encounter difficulties obtaining financing in general, so it would
have low leverage. However, such a firm
is well-suited to bank financing, so it may
have a relatively high concentration of
bank debt even though it has low leverage.
Conclusions
Current economic theory suggests that
banks play an important role in lending to
businesses because of information asymmetries. Empirical evidence exists that is

consistent with the simple information asymmetry view, which says that banks may
have a competitive advantage in obtaining
and processing information on firms. This
evidence sheds light on bank loan patterns
observed for larger firms but is less compelling as an explanation for the patterns
associated with smaller firms. The reputation view of bank lending, which implies
that bank financing depends on firm size
as well as an informational advantage,
better fits the patterns observed among
different sizes of firms.
The ongoing relationship between borrower and lender can allow banks to cultivate informational advantages and reduce
monitoring costs in lending to businesses.
The importance of these types of relationships between banks and their business
customers and the implications for banking
and economic activity have been the motivating factor behind recent policy actions
that attempt to ensure the smooth flow of
credit to businesses.

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Full text of Financial Industry Studies : August 1994

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