NPLs, Moral Hazards, and Bond Markets

Abstract

This paper uses the FDIC time series data to examine the interrelationship between nonperforming loans (NPLs), loan growth, and high yield bond spread. We find that loan growth leads to higher NPL ratio (moral hazard hypothesis) when the economy is in recessions, banks have more liquidity, banks are less capitalized, or banks have more risk-weighted assets. An increase in high yield bond spread is spontaneously coupled with a temporary increase in commercial and industrial loans initially (bond-loan substitution effect), and then followed by decreases in loan growth subsequently for general loans (default information effect). The major implication is that high yield bond spread contains very important information for future NPLs, and aggregate loan loss provisions have not incorporated this important information enough possibly due to the GAAP guidelines. This suggests a risk-shifting from shareholders to insurers for the US financial institutions, and highlights the importance of expected loan loss approach to loan loss provisioning.