FDIC researchers find construction loans with more on-site inspections less likely to default

A white paper called the first of its kind by the researchers behind it finds that monitoring of construction loans “ultimately improves loan outcomes and adds value to banks.”

The study, released Monday by the Federal Deposit Insurance Corp. (FDIC), was conducted using a proprietary transaction-level dataset of nearly 30,000 construction loans that spans 10 years from a large bank. Focusing on a “novel” measure of monitoring, on-site inspections, researchers observed 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,” the paper states.

Researchers found that, using their measure of on-site inspections:

  • 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.
  • Although a large group of relationship banking studies focus on the relationships between banks and borrowers, this study’s result suggests that contractor relationships can also be valuable in construction lending.

Using textual analysis, the researchers 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,” they wrote. “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.”

FDIC Working Paper Series: Bank Monitoring in Construction Lending