U of L researcher to examine effects of banking networks

People rely on networks to learn about job prospects, good restaurants and local news. Similarly, banking institutions go to their networks when they need information like determining a borrower’s creditworthiness.

While banks are increasingly connected through their involvement in lending networks, no one has analyzed these networks in any depth. Dr. Yutao Li, a University of Lethbridge Management professor at its Calgary campus, wants to remedy that situation. Thanks to an Insight Development Grant worth approximately $39,000 from the Social Sciences and Humanities Research Council (SSHRC), Li will examine the costs and benefits of banks’ connectivity.

“There’s a trend that we’re now living in a more connected world,” says Li. “We are connected with each other through social networks, but I’m looking at the effect of connection among banks. This has been a hot issue since the financial crisis in 2007,” says Li. “There are good things about being connected and it can be helpful.”

Greater connectivity can have benefits. For example, banks that are more connected can get more information to better evaluate borrowers’ credit risk. Alternatively, connectivity can have a downside, like it did in the financial crisis of 2007-2008 when risk entered the financial system and spread throughout the network. Many banks were affected by the subprime mortgage crisis, which illustrated a trend toward lowered lending standards and mortgage products with a higher risk.

As in social network theory, a bank that is more centrally located in a network should have better access to information, because, as Li predicts, that bank can monitor borrowers more efficiently and produce higher quality financial reporting.

“If they are better connected, are they able to make a better decision in their lending because they are able to collect more information? Will this connection help them weather a financial crisis?” says Li. “I’m not sure what I’m going to find but there are arguments on both sides.”

Using the Dealscan database, which contains extensive and reliable information on the global commercial loan market, Li will first identify North American banks’ lending networks. Then she’ll examine their performance during the 2007-2008 financial crisis and in normal times to gauge how their position in a network affected their performance.

As the first study to investigate banks’ lending networks, Li’s research will provide evidence of banks’ connectivity in the syndicated loan market and build understanding about how that affects a bank’s information acquisition, its lending practices and financial reporting quality. For example, Li will examine banks’ loan-loss provisions, which is an estimate of the uncollectible loans.

“This is a very important item in banks’ financial statements,” she says. “Most people think accounting is just numbers, but there’s a lot of discretion and judgement. Some of the banks have a better ability to predict their future loss. It would be interesting to see whether a bank’s connectivity affects its judgement and ability in making such estimates.”

The study will also look at whether banks in the centre of a network are exposed to greater systematic risk. The results will be valuable to regulators and build their understanding of the effect of a bank’s centrality in a lending network on the financial system and the economy.

“The implication for regulators is to understand whether these connected networks are beneficial or detrimental for the financial system,” says Li.

Dr. Gerald Lobo, an accounting professor at the University of Houston, is a co-investigator on the project.