Household Delinquency, Bank Capital Reserves, and Risk-Taking Spillover

Abstract

In the traditional banking system, growth-seeking private firms and households sit separately on the asset and liability sides of a bank’s balance sheet. Fire sales of nonperforming loans are justified to address risk-taking failures and protect household depositors. After households join the borrower clientele, household defaults pose a challenge. That households absorb most of the foreclosure discounts is difficult to justify because households are much less than firms in risk taking. High household delinquency rates could escalate the problem as household wealth losses on a large scale could impact long-term economic growth. Therefore, the central bank offers a liquidity guarantee when all market lenders back out so the lending bank can hold nonperforming loans to negotiate fair value sales. However, the capital buffer has to service financing costs, and cash outflows compromise its priority role to satisfy the Basel capital ratio. A lending bank develops capital constraints if financing costs wear down its capital buffer before completing fair value sales. Once subject to capital constraints, lending banks must downsize and issue new equity. Downsizing affects all borrowers, and the spillover is on corporate borrowers. Empirically, we document the risk-taking spillover to corporate borrowers when large banks collectively hold nonperforming household debt. The risk-taking spillover has three unique features. Of all non-financial firms, those without a prior borrowing relationship enjoy isolation benefits during the subprime crisis. We document spillover channels of revenue priority and collective operations among corporate borrowers affected.

Keywords: Household default, capital reserves, risk-taking crisis, nonperforming debt, systemic risk

JEL Classification: E58; G21, G23, G24, G28, G51