Research Exchange: April 2024

Selected Outside Research

Book Value Risk Management of Banks: Limited Hedging, HTM Accounting and Rising Interest Rates

This paper examines how banks responded to rising interest rates in 2022. The analysis indicates that banks focused on managing “the interest rate exposure of the accounting value of their assets” but left long-duration assets significantly exposed to interest rate risk. In particular, banks, and especially banks more vulnerable to interest rate and solvency risk, reclassified $1 trillion in securities as held-to-maturity, which left the book values of these assets unaffected by interest rate changes. The analysis includes an examination of data from call reports and SEC filings which finds “that only 6% of U.S. banking assets used derivatives to hedge their interest rate risk, and even heavy users of derivatives left most assets unhedged.” Additionally, the paper argues that “capital regulation could address run risk by encouraging capital raising, but its effectiveness depends on the regulatory capital definitions and can by eroded by the use of HTM accounting.” Book Value Risk Management of Banks: Limited Hedging, HTM Accounting, and Rising Interest Rates | BFI (uchicago.edu)

A Framework for Evaluating Banks’ Resilience in a Rising Interest Rate Environment

The recent failure of Silicon Valley Bank highlighted how financial institutions may be vulnerable to runs on their deposits. This paper develops a framework for evaluating a bank’s risk of a run in relation to bank and market conditions and compares it to alternative measures of bank fragility. The proposed approach is shown to be able to identify weak banks “earlier and as accurately as any of the alternatives, and at much lower cost in terms of falsely identifying banks as weak.” The authors conclude that “this metric could be used to help banks effectively manage their balance sheets to avoid creating conditions where depositors have an incentive to run.” A Framework for Evaluating Banks’ Resilience in a Rising Interest Rate Environment by Filippo Curti, Jeffrey R. Gerlach :: SSRN

Internal Liquidity’s Value in a Financial Crisis

Broker-dealers that are part of a bank holding company have access to internal liquidity from other affiliated entities, which can provide resilience during times of market stress. This article provides evidence that broker-dealers affiliated with a bank holding company benefitted in this way during the 2007-2009 Global Financial Crisis. The analysis relies on confidential balance sheet and income data for the population of U.S. broker-dealers from 2004-2011, including both BHC-affiliated and non-affiliated firms. The data show that non-BHC-affiliated broker-dealers increased their shares of repo and reverse repo activity involving Treasuries during the crisis, as well as the share of Treasury securities in their long inventory holdings, which indicates a “flight to quality” toward more liquid and safer assets. In contrast, BHC-affiliated broker-dealers decreased their repo/reverse repo shares and Treasury security holdings during the same period. Their access to internal liquidity sources meant they did not face the same pressures to shift toward the most liquid assets, allowing them “to provide more intermediation services in a range of financial markets that were under stress, likely reducing the extent of the disruptions.” The authors conclude that the benefits of access to central bank liquidity are likely even greater “since that liquidity should be more reliable than access to internal liquidity.” Internal Liquidity’s Value in a Financial Crisis – Liberty Street Economics (newyorkfed.org)

From Competitors to Partners: Banks’ Venture Investments in Fintech

This paper documents banks’ increasing venture investments in fintech startups and considers whether these investments represent a strategic approach to fintech competition. Consistent with that notion, the paper finds that banks facing greater fintech competition are more likely to make such investments. Moreover, the study finds that banks “target fintech firms that exhibit higher levels of asset complementarities with their own business” and that “venture investments increase the likelihood of operational collaborations and knowledge transfer” between the bank and its fintech associate. From Competitors to Partners: Banks’ Venture Investments in Fintech by Manju Puri, Yiming Qian, Xiang Zheng :: SSRN

Revenge of the S&Ls: How Banks Lost a Half Trillion Dollars during 2022

This paper draws parallels between the unrealized securities losses suffered by U.S. commercial banks during 2022 as a result of the Federal Reserve’s rapid interest rate hikes, estimated at over $500 billion, and the S&L crisis of the late 1970s and early 1980s. The paper analyzes the role of different types of securities (Treasuries, municipal bonds, residential mortgage-backed securities), and commercial mortgage-backed securities and mortgages (residential and commercial) in explaining these losses. Through regression analysis, the authors demonstrate that unrealized securities losses were positively associated with banks’ holdings of Treasuries, municipal bonds, RMBS and CMBS, but the losses were much more strongly associated with municipal bonds and RMBS due to their longer durations. The paper also investigates whether markets priced these losses and whether better regulatory oversight of interest rate risk and uninsured deposits is needed. The authors find mixed evidence on the market pricing of these losses. Revenge of the S&Ls: How Banks Lost a Half Trillion Dollars during 2022 by Rebel A. Cole, Brian Silverstein, Jon Taylor, Lawrence J. White, Susan M. Wachter :: SSRN

Noisy Experts? Discretion in Regulation

The institutional framework of banking supervision incorporates a role for examiner discretion in decisions assessing bank safety and soundness. This study addresses this role and its consequences, determinants and trade-offs. Relying on detailed data on the supervisory ratings of U.S. banks, the study documents that examiners’ decisions “deviate substantially from algorithmic benchmarks and can be predicted by examiner identities, holding bank fundamentals constant,” consistent with the exercise of significant personal discretion. The analysis further indicates that “examiner discretion has a large and persistent causal impact on future bank capitalization and supply of credit, leading to volatility and uncertainty in bank outcomes, and a conservative anticipatory response by banks.” Disagreement across examiners is found to contribute both to high average weight assigned to the subjective assessment of banks’ management quality, as well as to heterogeneity in weights attached to capital adequacy. The analysis also suggests that “moderate limits on discretion can translate to more informative and less noisy predictions.” Noisy Experts? Discretion in Regulation | NBER

Is the Decline in the Number of Community Banks Detrimental to Community Economic Development?

Over the past two decades there has been a steady decline in the number of community banks due to consolidations and failures, generating concerns about adverse effects on community development, since community banks are disproportionately engaged in small business lending. This paper examines whether the declining number of community banks has led to a decrease in lending to small businesses with adverse effects on community investment and economic development. The analysis finds that small business lending positively affects community economic development, and that in aggregate, community bank consolidation in a county is associated with a significant subsequent increase in SBL originations. The effect is relatively strong in counties with a high share of deposits at community banks and for deals in which the consolidated bank retains a presence in the affected county and is “partially driven by the increased SBL lending activity of other local community banks.” Finally, the study documents that while “the effect is less pronounced when the acquirer is a large bank, it is also the case that “large banks have increased their SB lending to small firms and small SB loans over the same period likely driven by the growth of small loan lending technology.” The authors conclude that “a one size fits all response to a reduction in the number of community banks is not the right approach to enhance community investment and county level characteristics and consolidated entity decisions should be key considered in any policy response.” Working Paper 24-02: Measuring Homeownership Sustainability for First-Time Homebuyers | Federal Housing Finance Agency (fhfa.gov)

Is This Time Different: How Are Banks Performing during the Recent Interest Rate Increases Compared to 2004-2006?

This article investigates the performance of the largest U.S. banks during the recent interest rate hikes of 2022-2023 and compares it with their performance during the 2004-2006 tightening cycle, with particular attention to trends in the composition of banks’ assets and liabilities, as well as interest rate pass-through in yields and costs. The analysis demonstrates that the profitability of large banks’ interest rate-sensitive operations increased during the recent cycle, since loan growth has been robust and asset yields have increased more than funding costs in aggregate. Compared to 2004-2006, the pass-through for deposit rates in the current cycle was more muted in the aggregate, while at the bank level it was more heterogeneous. For some non-deposit categories, namely other borrowed money and trading liabilities, the pass-through rate has been much higher in the 2022 cycle. Large banks had a much higher share of securities at the start of the 2022 cycle compared to the earlier cycle, partially explained by the adoption of the liquidity coverage ratio and the Federal Reserve’s large-scale asset purchases. The Fed – Is This Time Different: How Are Banks Performing during the Recent Interest Rate Increases Compared to 2004-2006? (federalreserve.gov)

Learning by Bouncing: Overdraft Experience and Salience

This paper assesses awareness of bank overdraft fees and policies among consumers based on a survey conducted by the Federal Reserve Bank of New York. The survey indicates that about four out five respondents reported zero overdrafts in the previous year, consistent with findings from previous surveys that a small fraction of depositors pays most overdraft fees. The majority of those who overdrew said they never expected to overdraw, suggesting that most overdrafts are accidental. However, those who overdrew more frequently were more likely to expect their overdrafts. Similarly, while only half of all respondents knew the overdraft fee charged by their bank, a much higher proportion (84 percent) of those who had experienced an overdraft in the previous year knew the fee, suggesting that consumers learn from their overdraft experience. The survey indicates more limited knowledge of other overdraft terms. Learning by Bouncing: Overdraft Experience and Salience – Liberty Street Economics (newyorkfed.org)

Chart of the Month

Complaints by Lender Type and Issue Category

This chart, replicated from a recent BPI research note, shows the number of consumer complaints filed with the CFPB about personal loans between midyear 2017 and year-end 2022 by complaint issue category and type of lender. In most issue categories banks have a small share of complaints versus fintechs and other nonbanks, when compared against banks’ share of loan originated in this market.

Featured BPI Research

Incorporating Discount-Window Borrowing Capacity into a Liquidity Requirement

The failures of Silicon Valley Bank, Signature Bank and First Republic Bank in March 2023 highlighted the shortcomings of the discount window and led to calls for requiring banks to pre-position collateral and test access to the window. This article examines the liquidity positions, measured as cash assets plus discount window borrowing capacity, of large regional banks (Category III and IV banks) comparing these positions to the ex-ante capacities of the three failed banks. The analysis shows that the failed banks in 2023 were quite illiquid, holding only 7 percent of their uninsured deposits in cash, with limited borrowing capacity at the discount window, plus some additional borrowing capacity at their Federal Home Loan Bank. In contrast, the surviving large regional banks analyzed were in a better liquidity position even before the 2023 crisis, with average cash holdings of 19 percent and discount window borrowing capacity of 25 percent of uninsured deposits in late 2022. After the crisis in March 2023, the large regional banks further increased their liquidity buffers, with average cash of 26 percent and discount window borrowing capacity of 39 percent of uninsured deposits by the end of 2023. The article argues regulators should reduce the stigma around discount window borrowing, such as by revising supervisory guidance and recognizing discount window capacity in liquidity metrics, to encourage banks to make appropriate use of their borrowing capacity. It also notes the need to better account for differences in uninsured deposit characteristics across banks when designing new liquidity requirements. Incorporating Discount-Window Borrowing Capacity into a Liquidity Requirement – Bank Policy Institute (bpi.com)

Exploratory Scenarios in the 2024 Stress Tests: Why Transparency is Important

The Federal Reserve’s stress-testing framework, crucial for evaluating large banks’ capital adequacy, faced criticism for not including scenarios accounting for rising interest rates before Silicon Valley Bank’s failure in 2023. In response, the Fed introduced “exploratory” scenarios for the 2024 stress tests to broaden the range of economic outcomes considered, though these scenarios won’t affect capital requirements. Projections of net interest income, highly sensitive to interest rate changes, are a key component of this framework, but the Fed’s methodology for projecting net interest income lacks full transparency, preventing an understanding of what drives the substantial differences in the projections across institutions. Additionally, the funding shocks in the 2024 tests lack clarity and consistency, prompting calls for a more standardized approach to modeling them. The stress testing process needs greater transparency, plausible macroeconomic scenarios and refined methodologies to ensure reliable and comparable results. Exploratory Scenarios in the 2024 Stress Tests: Why Transparency is Important – Bank Policy Institute (bpi.com)

The Credit Card Market is Not Even Close to Being Overly Concentrated

The Department of Justice’s revised merger guidelines from December specify thresholds for market concentration and change-in-concentration to assess competitive concerns in mergers. These guidelines use the Herfindahl-Hirschman Index to determine market concentration, where a market is highly concentrated if the HHI exceeds 1,800. Critics of the proposed Capital One and Discover merger argue that the consumer credit card market is overly concentrated, but analysis shows that market concentration remains far below DOJ thresholds even after the merger. When excluding Credit Unions, the top 50 issuers in the credit card market have an HHI of 1,010, which would only rise to just 1,235 post-merger. Additionally, the competitive landscape includes not only banks but also nonbanks and fintechs offering credit products. Comparative analysis reveals that other everyday industries (such as breakfast cereal and air transportation) are more concentrated than the credit card industry. Moreover, the merger is expected to enhance competition in payment networks by creating a stronger competitor against Mastercard and Visa. The Credit Card Market is Not Even Close to Being Overly Concentrated – Bank Policy Institute (bpi.com)

Lender Performance in the Personal Loan Market from the Perspective of Consumer Complaints

This note compares the lending performance across these three categories of lenders in the personal loan market—banks, fintech companies and other nonbanks—regarding complaints submitted to the Consumer Financial Protection Bureau. The analysis relies on the CFPB’s complaint database covering the period 2015 through 2022, supplemented with a specially and meticulously constructed lender-type classification. Various performance metrics, including trends in complaint volume, share of complaints by type and frequency of remuneration or remediation provided, are compared across three lender categories: banks, traditional finance companies and fintechs. By most of these metrics, banks have provided superior customer experience. Both fintechs and other nonbanks have a comparatively high concentration of complaints in the arguably most concerning complaint category, alleged deceptive practices. Fintechs are overrepresented in the critical category of disputed information in the credit report, accounting for close to half of the complaints in this category, with a positive trend over the analysis period. Banks’ share of complaints has declined significantly relative to their share of originations since 2015, suggesting that the quality of banks’ lending conduct has improved. For nearly every complaint category, banks have provided both monetary and non-monetary restitution more frequently than either fintechs or other, more traditional nonbank lenders. Lender Performance in the Personal Loan Market from the Perspective of Consumer Complaints – Bank Policy Institute (bpi.com)

Conferences & Symposiums

4/5/2024
Financial Stability Implications of Digital Assets Products and Activities: Stablecoins and Tokenization Federal Reserve Banks of Boston and New York (virtual)
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4/18/2024 – 4/19/2024
Inaugural Fintech and Financial Institutions Research Conference
University of Delaware and Federal Reserve Bank of Philadelphia
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4/19/2024
Rethinking Optimal Deposit Insurance: Announcement and Call for Papers
Yale University
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5/2/2024 – 5/3/2024
7th Annual CFPB Research Conference: Announcement and Call for Papers
Consumer Financial Protection Bureau, Washington, D.C.
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5/9/2024 – 5/10/2024
Conference on Fixed Income Markets and Inflation: Announcement and Call for Papers
Federal Reserve Bank of San Francisco
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5/12/2024 – 5/14/2024
Boulder Summer Conference on Consumer Financial
Decisionmaking: Announcement and Call for Papers
Leeds School of Business, University of Colorado
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5/15/2024 – 5/16/2024
Mortgage Market Research Conference: Announcement and Call for Papers
Federal Reserve Bank of Philadelphia
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5/17/2024
The 17th New York Fed/NYU Stern Conference on Financial Intermediation: Announcement and Call for Papers
New York City
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6/5/2024 – 6/7/2024
Research Symposium on Depositor Behavior, Bank Liquidity, and Run Risk: Announcement and Call for Papers
Office of the Comptroller of the Currency, Washington, D.C.
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6/19/2024 – 6/21/2024
Economics of Financial Technology Conference: Announcement and Call for Papers
University of Edinburgh Business School
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7/18/2024 – 7/19/2024
Exploring Conventional Bank Funding Regimes in an Unconventional World
Federal Reserve Bank of Dallas
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8/9/2024
Yale Program on Financial Stability Annual Research Conference: Announcement and Call for Papers
Yale University
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Disclaimer:

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.