Essays on the Measurement and Detection of Risk in Banks
Creators: name: Flanagan, Thomas
Publisher: name: My University
Year: 2024
Subjects: subject: Banking
subject: Finance
subject: Business and Economics

description: This dissertation explores different aspects of risk measurement in banks, including the risk-adjusted returns of bank lending activities, the financial returns earned by taxpayers on bailouts, and the economic drivers behind banks’ risk-hiding behavior. In Chapter 1, I study the value of bank lending. Although a vast theoretical literature suggests that banks’ screening and monitoring skill makes them special, there is limited direct evidence on the level and sources of value creation from bank lending activities. Using a novel dataset of realized syndicated loan cash-flows and a risk-adjustment methodology adapted from the private equity literature, I provide a loan-level measure of the value of bank lending activities. I show that banks, on average, earn 190 bps in risk-adjusted returns on each loan they make. Cross-sectionally, banks earn higher risk-adjusted returns when they lend to financially constrained borrowers and when they retain a higher stake in the deal. In addition to banks earning risk-adjusted income, I show that borrowers are also better off and capture some of the surplus through higher stock market valuations. Overall, my results show direct evidence of banks’ critical role in mitigating borrowers’ financing frictions and provide a useful input for policies that encourage prudent lending. In Chapter 2, I study the financial returns earned by taxpayers on the Troubled Asset Relief Program (TARP). Financial institutions received investments under TARP in a bad state of the world but repaid them in a relatively good state. I show that the recipients paid considerably lower returns to the taxpayers compared to private market securities with similar risk over the same investment horizon, resulting in a subsidy of over $50 billion. Ex-post renegotiation of contract terms contributed to the subsidy and limited the upside gains received by the taxpayers in good times. While I do not evaluate the net social benefit of TARP, the results challenge the oft-cited narrative that taxpayers made “profits” on TARP from a purely financial perspective. These findings have important implications for the design of future bailouts and theoretical models in the area. In Chapter 3, I study why banks hide losses. Despite plenty of anecdotal evidence of hidden losses in banks, there is no systematic study analyzing its economic drivers: we simply do not get to observe what banks are hiding. Using a regulatory change in India that forced banks to reveal their hidden losses, I show that banks with higher shareholding by passive foreign investors hide more. These effects are stronger for banks where CEOs get highly compensated for reported profits. The findings caution against using high-powered compensation contracts as a substitute for active shareholder monitoring. Instead of solving the agency problem, it can result in perverse misreporting incentives. Overall, my dissertation demonstrates that banks can create value net of the risk they take when lending. However, government interventions and shareholder-manager conflicts can also destroy value, resulting in negative financial returns to taxpayers and hidden losses in the system.