Credit Scoring and Loan Default
Rajdeep Sengupta(Banking Research, Federal Reserve Bank of Kansas City)
Geetesh Bhardwaj(Research, SummerHaven Investment Management)

A metric of credit score performance is developed to study the usage and performance of credit scoring in the loan origination process. We examine the performance of origination FICO scores as measures of ex ante borrower creditworthiness using loan-level data on ex post performance of subprime mortgages. Parametric and nonparametric estimates of credit score performance reveal different trends, especially on originations with low credit scores. The data suggest a trend of increased emphasis on higher credit scores accompanying a trend of increased riskiness in other origination attributes. Over time, this increased emphasis on credit scoring coincided with deterioration in FICO performance largely because of the fact that higher credit score originations of later cohorts were more likely to have riskier attributes. However, controlling for other attributes on originations and changes in economic conditions, we find that, as measures of borrower ranking, FICO performance on subprime loans over the years remains fairly stable.

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Dissipative Competition: Evidence from a Quasi-Natural Experiment
Yuk Ying Chang(School of Economics and Finance, Massey University)
Martin Young(School of Economics and Finance, Massey University)

We document that contrary to the conventional view, the costs of domestic firms in terms of selling, general and administrative expenses and cost of goods sold increase significantly following exogenous shocks that increase competition, namely material import tariff cuts affecting US manufacturing industries over the period 1974–2005. Incompatible with an agency explanation, the cost increase is more pronounced among firms with higher CEO/insider/board ownership. We further find that the cost increase is more evident among firms with smaller market share and among focused firms. Generally, our results are consistent with the notion of ‘dissipative competition’ discussed in the seminal papers by Tullock.

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The Effectiveness of Regulatory Capital Requirements Prior to the Onset of the Financial Crisis*
José Filipe Abreu(Banco de Portugal and European Central Bank)
Mohamed Azzim Gulamhussen(ISCTE Business School, Instituto Universit?rio de Lisboa)

We extend the literature on the role of capital requirements as a regulatory tool by developing a continuous measure of the degree of regulatory pressure and by examining data on US commercial banks during the economic upturn that preceded the 2007–2009 financial crisis. Our findings indicate the inability of regulatory pressure to force banks to build capital buffers during the economic upturn that preceded the crisis. These findings are consistent with the view that banks entered the crisis with inadequate levels of capital. Our findings support the endeavors of regulators in explicitly demanding capital buffers in their new regulatory framework.

*We thank Carlos Branco, José Carlos Dias, Patrick Van Roy, Tiago Nunes and the seminar participants at the Central Bank of Portugal, the European Financial Management Association Annual Conference and the ECPR European Consortium for Political Research Standing Group on Regulatory Governance Third Biennial Conference for their comments and suggestions. We acknowledge the financial support provided by ‘Fundação para a Ciência e Tecnologia’ (PTDC/EGE-ECO/114977/2009). The views and opinions expressed in this paper belong to the authors and do not necessarily represent the views of the institutions with which the authors are affiliated. Any errors are our own responsibility.

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Call Auction Transparency and Market Liquidity: Evidence from China*
Dionigi Gerace(School of Accounting, Economics and Finance, University of Wollongong)
Qigui LiuSchool of Accounting, Economics and Finance, University of Wollongong)
Gary Gang Tian(School of Accounting, Economics and Finance, University of Wollongong)
Willa Zheng(School of Accounting, Economics and Finance, University of Wollongong)

This paper uses the natural experiment offered by the Shanghai Stock Exchange to investigate the impact of opening call auction transparency on market liquidity. We find that the dissemination of indicative trade information during the pre-open call auction session leads to an overall improvement in stock liquidity in the continuous trading session. Bid-ask spreads narrow in the first trading hour because adverse selection risk fell significantly and there is less price volatility in the continuous market. This effect is greater for actively traded securities than illiquid securities. Our findings are robust for different lengths of sample period, different lengths of trading hours after market open, and stocks that had (and had not) reformed the share split structure during our research period.

*We are grateful to the comments of Dr. Kang Wenjin on the early version of the paper, and to Prof. Alex Frino and the SIRCA Inst. for providing us the valuable data to do this study. We are also grateful to the participants of FMA-Reno (2009), China International Finance Conference (2009), Asian Finance Association conference in Brisbane (2009). However, the authors are responsible for all of the errors.

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Parametric Portfolio Policies in the Surplus Consumption Ratio*
Joachim Inkmann(Department of Finance, The University of Melbourne)
Zhen Shi(Department of Finance, The University of Melbourne)

The surplus consumption ratio plays a central role as a state variable in successful attempts to explain the time series properties of stock and bond prices with consumption-based asset pricing models. In this paper, optimal portfolio policies for a strategic investor who maximizes the conditionally expected utility of terminal wealth are parameterized as a polynomial in the surplus consumption ratio. Optimal portfolio policies are estimated using a method of moments estimator based on Euler equations. Unconditional portfolio policies are rejected in favor of conditional policies. Lower order polynomials are rejected in favor of higher order polynomials. Optimal stock and bond allocations are clearly countercyclical.

*We thank an associate editor, an anonymous referee, Ralph Koijen, Arjen Siegman, and participants at a Netspar seminar at Tilburg University and a Netspar International Pension Workshop in Amsterdam for helpful comments.

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