Research Exchange: April 2022

Selected Outside Research

Crisis Liquidity Facilities with Nonbank Counterparties: Lessons from the Term Asset-Backed Securities Loan Facility

The Federal Reserve and U.S. Treasury twice launched the Term Asset-Backed Securities Loan Facility (TALF), in 2008 and again in 2020, to provide loans to nonbank financial institutions in response to extreme stress in the asset-backed securities market. Using detailed loan-level data this study examines the types of nonbank borrowers that made most effective use of the program, particularly in relation to (1) participating in the program right at its onset, and thereby helping to stabilize ABS markets quickly; (2) repaying TALF loans when market conditions normalized, (3) investing in a broad range of assets; and (4) internalizing credit risk rather than trying to shift it to the government. The study finds that institutional constraints were a key determinant of whether borrower behavior supported program goals. For instance, “investors with flexible investment guidelines, such as hedge funds, insurance companies and pension funds, were active early participants. In contrast, some types of private capital funds needed time to recruit investors and draw up governing documents.” Read More ⇨

Intermediation Frictions in Debt Relief: Evidence from CARES Act Forbearance

This paper examines the role of mortgage servicers in implementing the CARES Act mortgage forbearance program during the COVID-19 pandemic and finds significant differences in forbearance activity by type of servicer. Although all nonperforming, federally backed loans in the study sample were eligible for the program, one-third of them failed to enter forbearance. The analysis indicates that small servicers and nonbanks, and especially nonbanks with small liquidity buffers, had a lower propensity to provide forbearance, and had a higher frequency of forbearance-related complaints by borrowers. Read More ⇨

How Do Banks Respond to Capital Regulation? The Impact of the Basel III Reforms in the United States

This study examines the response of U.S. banks to changes to the way capital ratios are measured, that were introduced as part of the adoption of Basel III. The analysis finds significant effects among banks with total assets between $10 billion and $50 billion. Specifically, “if a bank’s capital ratio when measured under the new rules was lower than under the old rules, then the bank took steps to increase its capital ratio.” The latter response took place prior to the publication of the specific language applicable to U.S. banks, suggesting that the changes were largely expected by that time. Drilling down to the specific changes affecting mortgage servicing rights, the study finds a significant effect among banks of all sizes, whereby banks with greater exposure to MSRs increased their capital ratios relative to those less exposed. These adjustments took place in the periods following the release of the proposed rules by U.S. regulators, which suggests that banks may not have anticipated the changes regarding MSRs that ended up in the U.S. implementation of Basel III. Read More ⇨

Climate Regulatory Risks and Corporate Bonds

This paper examines the effect of climate and other environmental regulatory risks on corporate bond risk assessment and pricing. The study finds that “firms with poor environmental profiles or high carbon footprints tend to have lower credit ratings and higher yield spreads, particularly when their facilities are in states with stricter regulatory enforcement.” Further, empirical tests based on treating the Paris Agreement as an exogenous shock to climate risk regulation suggest that climate regulatory risks causally affect bond credit ratings and yield spreads. Read More ⇨

Bank Technology and the COVID-19 Pandemic

This study constructs a measure of banks’ investment in financial technology, which reflects “a bank’s coverage of products installed at nonbank fintech firms,” and applies it to assess the effect of such investments on lending during the COVID-19 pandemic period. The analysis indicates that greater investment in financial technology is associated with a larger volume of lending in Paycheck Protection Program (PPP) in the second quarter of 2020. The analysis further indicates that advanced technology “enabled banks to supply PPP loans outside of their branch market area, though this more geographically dispersed lending does not crowd out in-market lending.” Read More ⇨

Collateral versus Lending Relationships: Shocks to Small Business Credit in the Great Recession

This paper examines how the availability of credit to small businesses responds to two kinds of adverse developments: a decline in real estate values at the business owner’s location, and disruption in existing credit relationships due to bank failures. Using transaction-level data from a major online accounting software provider in the U.S., the study finds that bank failures reduce the supply of small business credit. The decline is specific to relationship-dependent firms, however, whereas little effect is observed for firms that rely on collateral-based credit. In contrast, declines in real-estate values lead to reduced credit availability for firms reliant on collateral-based credit, with little observed effect on relationship-dependent firms. Read More ⇨

Syndicated Lending, Competition, and Relative Performance Evaluation

The authors look at the competitive effects of relative performance evaluation (RPE) based compensation among banks’ senior management. A senior manager with a typical RPE contract gets a higher bonus when achieving higher profits relative tof rival banks (the RPE peer group). The study analyzes the syndicated lending market and shows that bank managers with RPE contracts are less likely to invest in loans arranged by banks named in their contract and more likely to invest in loans arranged by banks outside their RPE peer group. As a result, banks more frequently named in the RPE peer group end up holding larger shares of the loans they syndicate, and their borrowers face higher loan spreads. These banks, in turn, lose market share to banks less likely to be named in RPE contracts. Read More ⇨

The Blockchain Revolution: Decoding Digital Currencies

This essay provides an overview of cryptocurrencies and blockchain technologies and how they compare with traditional money and banking structures. Four key areas are explored: (1) Money, digital money and payments; (2) Cryptocurrencies, blockchain and the double-spend problem of digital money; (3) Understanding decentralized finance; and (4) The makeup of a central bank digital currency. The essay concludes by noting that traditional forms of transactional and financial record-keeping “are likely to be challenged by blockchain technology, which provides a very different model of information management and communication.” Organizations and institutional arrangements are likely to evolve in response to this changing informational environment, in ways that are difficult to predict. Read More ⇨

Chart of the Month

The USD 1-year/1-year forward swap rate reflects market expectations for interest rates one year ahead with one year term. The graph below illustrates how the monetary policy path has rotated sharply over the last 4 months as the 1-year/1-year swap rates has surpassed 3 percent for the first time since 2018.

Featured BPI Research

On the Overcapitalization for Market Risk Under the U.S. Regulatory Framework

The Basel Committee’s revisions to the market risk capital framework, known as the Fundamental Review of the Trading Book (or FRTB), are aimed at improving the current market risk framework by better capturing tail risk and placing more stringent guardrails on banks’ use of their own internal models. However, the note points out that the global market shock (GMS) component of the Dodd Frank stress tests already captures market risk losses under stress conditions and, in fact, results in capital requirements for market risk that are more than double those of the current Basel Framework. Implementing FRTB would further increase U.S. banks’ capital requirements for market risk. To avoid such a double counting of capital requirements, the authors suggest several adjustments to both the FRTB and GMS frameworks. Read More ⇨

When Will Banks Start Raising Deposit Rates? Here’s What History Shows

This blog post examines how deposit rates have behaved in relation to the fed funds rate, by estimating an empirical model that accounts for the effect of the zero lower bound on rates. The authors use the fitted model to project the path of deposit rates in response to the FOMC continuing to increase the fed funds rate. The findings suggest that deposit rates will start rising when the funds rate exceeds 1.33 basis points. Increases above that level pass are projected to pass through to deposit rates, but about half of the pass-through occurs gradually. Read More ⇨

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.