Finance: Research, Policy and Anecdotes

Interesting papers - May 2022

One nice benefit of being able to travel again to conferences and seminars is that one meets interesting people with interesting papers.  Here a small selection

 

Oliver Rehbein and Simon Rother make an important contribution to the literature on the role of social connections and distance in lending in The Role of Social Networks in Bank Lending. The authors use data from Facebook to construct indicators of social ties within the U.S. population across counties. Controlling for physical and cultural distances, social connectedness increases cross-county lending. On average, a standard-deviation increase in social connectedness increases cross-county lending by 24.5%, which offsets the lending barrier posed by 600 miles between borrower and lender. This effect is stronger for SME lending (where screening and monitoring is more difficult) than for mortgage lending, in line with theory. And social connectedness between counties is not associated with riskier cross-county lending. Further, borrowers’ counties tend to profit from their social proximity to bank lending, as GDP growth and employment increase with social proximity.  Overall, social networks can thus help to overcome information frictions and improve bank lending, effects that are orthogonal to other measures of distance and can partly offset physical distance between borrowers and lenders.

 

Sebastian Doerr , Thomas Drechsel and Donggyu Lee show that rising income inequality can reduce job creation at small firms in Income Inequality, Financial Intermediation, and Small Firms. A lot has been written about the determinants of increasing income inequality in the U.S. and its consequences. Sebastian and co-authors focus on one specific negative effect of this rise in income inequality: as high-income households save relatively less in the form of bank deposits, a higher share of income accruing to top earners therefore undermines banks’ deposits base and their lending capacity for small businesses, thus reducing job creation. Exploiting variation in top incomes across US states and over time, they find that a 10 percentage point increase in the income share of the top 10% reduces the net job creation rate of small firms by 1.5–2 percentage points, relative to large firms. The effects are stronger at smaller firms and in bank-dependent industries, thus providing evidence on the mechanism mentioned above. Rising top incomes also reduce bank deposits and increase deposit rates, in line with a reduction in the supply of household deposits. While the political debate on income inequality often focuses on fairness and the rise of populism, this paper shows the important economic costs of rising income inequality.

 

Rainer Haselmann, Christian Leuz and Sebastian Schreiber provide evidence that German banks use knowledge acquired in lending relationships for trading purposes in Know Your Customer: Relationship Lending and Bank Trading. Universal banks combine lending business with investment banking and brokerage services, which might raise conflict of interests.  However, it is difficult to find a smoking gun for information exchange between different parts of an universal banks. The authors do so, by combining detailed German data on banks’ proprietary trading and market making with lending information from the credit register. They then examine how banks trade stocks of their borrowers around important corporate events and find that banks trade more frequently and also profitably ahead of events when they are the main lender (or relationship bank) for the borrower. Specifically, relationship banks are more likely to build up positive (negative) trading positions in the two weeks before positive (negative) news events, and they unwind these positions shortly after the event. This trading pattern is more pronounced for unscheduled earnings events, M&A transactions, and after borrower obtain new bank loans. A back of the envelope calculation shows that on average, relationship banks earn an additional trading profit of €3,890 per event. These results suggest that lending relationships endow banks with important information, highlighting the potential for conflicts of interest in banking, which has been a prominent concern in the regulatory debate.