How do credit ratings affect bank lending under capital constraints?

Summary

Focus

We assess how a bank's capitalisation influences the conditions on its corporate loans, including the volume and spread. We use a supervisory data set that includes almost all individual corporate loans for the United States.

Contribution

A bank's lending conditions are influenced by the state of its balance sheet. The challenge is to correctly identify how this link works, and how strongly. This paper's contribution is to study the link between the characteristics of a bank's balance sheet and its lending conditions by using a natural experiment and applying various statistical techniques.

Specifically, we look at how unexpected adjustments to banks' internal rating systems are mapped to a uniform external rating scale. Such adjustments do not change the riskiness of the borrower nor do they alter the pool of existing borrowers. The adjustments only change how outsiders, including bank regulators, assess the riskiness of borrowers. Studying how the effects of adjustments vary across banks lets us then establish how the state of the balance sheet actually influences loan conditions.

Findings

We find that rating adjustments trigger changes in loan terms that are asymmetrical: downward adjustments increase spreads by some 40 bps and reduce committed loan sizes and maturities. By contrast, upward adjustments lead to much weaker (yet opposite) effects. Importantly, we find these effects to be stronger for smaller, riskier, and banks with less capital strength, as well as for borrowers with poorer credit quality and for non-guaranteed loans. Other tests confirm that the risk weighting under the capital adequacy requirements, which are in part based on ratings, helps to explain these effects. Results remain valid after controlling for bank characteristics, other shocks, and various changes in samples, among other tests. Overall, our evidence suggests that regulatory capital affects loan terms, but in an asymmetrical manner.

Abstract

Through the lens of credit risk ratings, we investigate how banks determine loan terms under capital constraints. Using a unique and comprehensive supervisory dataset of individual corporate loans in the US, we show that unexpected adjustments to banks' internal rating systems, which only alter how outsiders assess the riskiness of borrowers, trigger changes in loan terms. The effects are asymmetric: downward adjustments to ratings increase spreads by some 40 bps and decrease committed loan sizes and maturities, but upward adjustments lead to much weaker (yet opposite) effects. Importantly, we find effects to be strong for smaller, riskier, and capital constrained banks as well as for borrowers with poorer credit quality and for non-guaranteed loans. Our findings, robust in several ways, highlight the important role of regulatory capital in loan terms.

JEL classification: G21, G28

Keywords: ratings, bank capital, regulation, loan conditions