Banco de España – Blog,Better safe than sorry: how prudent lending standards lead to fewer corporate defaults

Better safe than sorry: how prudent lending standards lead to fewer corporate defaults

Banco de España – Blog

Abstract:

This paper studies the impact of prudent lending standards on corporate defaults. We use a unique dataset of syndicated loans in the euro area to measure the stringency of lending standards and find that stricter standards are associated with lower default rates. This relationship is robust to a battery of sensitivity checks and alternative specifications. We also find that the effect of lending standards is stronger for riskier borrowers and in periods of economic stress. Our results suggest that prudent lending standards can help to reduce the incidence of corporate defaults and promote financial stability.

Introduction:

Corporate defaults are a major source of financial instability. They can lead to losses for investors, disrupt economic activity, and damage the reputation of the financial system. As a result, there is a great deal of interest in understanding the factors that contribute to corporate defaults.

One factor that has been shown to influence corporate defaults is the stringency of lending standards. Lending standards refer to the criteria that banks use to assess the creditworthiness of potential borrowers. When lending standards are tight, banks are more selective in who they lend to and the terms of those loans. This can make it more difficult for risky borrowers to obtain financing, which can in turn lead to a lower incidence of corporate defaults.

Data and methodology:

We use a unique dataset of syndicated loans in the euro area to measure the stringency of lending standards. Syndicated loans are loans that are made by a group of banks to a single borrower. They are typically used to finance large-scale projects, such as mergers and acquisitions or capital expenditures.

We measure the stringency of lending standards using a variety of variables, including the loan-to-value ratio, the debt-to-equity ratio, and the interest rate spread. We also use a qualitative measure of lending standards that is based on the subjective assessments of loan officers.

We use a logistic regression model to estimate the relationship between lending standards and corporate defaults. The dependent variable in our model is a dummy variable that indicates whether or not a borrower defaulted on its loan. The independent variables include our measures of lending standards, as well as a number of control variables, such as the borrower’s industry, size, and profitability.

Results:

Our results show that stricter lending standards are associated with lower default rates. This relationship is robust to a battery of sensitivity checks and alternative specifications. We also find that the effect of lending standards is stronger for riskier borrowers and in periods of economic stress.

Conclusion:

Our results suggest that prudent lending standards can help to reduce the incidence of corporate defaults and promote financial stability. This is an important finding, given the recent increase in corporate debt levels. By ensuring that banks are lending to creditworthy borrowers on reasonable terms, we can help to reduce the risk of a future financial crisis.

Policy implications:

Our findings have a number of policy implications. First, they suggest that regulators should encourage banks to adopt prudent lending standards. This could be done through a variety of measures, such as requiring banks to hold more capital or to conduct more rigorous stress tests.

Second, our findings suggest that policymakers should be cautious about measures that could lead to a loosening of lending standards. For example, policymakers should avoid putting pressure on banks to lend to risky borrowers or to relax their underwriting criteria.

By taking these steps, policymakers can help to reduce the risk of a future financial crisis and promote financial stability.


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