WASHINGTON–The FDIC has released a white paper it calls the first of its kind that has found that monitoring of construction loans by lenders “ultimately improves loan outcomes and adds value to banks.”
The study was conducted using a proprietary transaction-level dataset of nearly 30,000 construction loans that spans 10 years from a large bank, according to the FDIC.
The researchers behind the study focused on what the FDIC described as a “novel” measure of monitoring, by examining the timing and frequency of such inspections along with the text contained in the inspection reports for each construction loan in the sample.
“This allows us to quantify the frequency at which banks obtain information on the project’s progress and how banks use the information contained within these reports,” according to the paper.
The Findings
According to the FDIC, the researchers found that their measure of on-site inspections revealed:
- Lenders are more likely to trade-off monitoring with more favorable loan terms; and riskier borrowers and projects, as indicated by harder and softer information measures, have inspections that are more frequent and initiated sooner.
- Bank lending relationships, either with the borrower or project contractor, have a negative relationship with on-site inspections, potentially due to banks transferring information between projects.
Textual Analysis
The researchers said that by using textual analysis they found that on-site inspection reports that are more negative or less positive are associated with a greater likelihood of borrowers being denied draws, showing that banks use the information they acquire from monitoring in real time.
“In subsequent analysis, we provide a comprehensive analysis of the determinants of construction default, the first study of its kind, as a preamble to analyzing the incremental effect of monitoring,” the FDIC researchers said. “After implementing an instrumental variable framework and controlling for relevant determinants, we find that loans with more on-site inspections are less likely to default, suggesting that, in line with theoretical predictions, monitoring ultimately improves loan outcomes and adds value to banks.”