Research Exchange: August 2022

Selected Outside Research

Leverage Regulations and Treasury Market Participation

This study explores the effects of the supplementary leverage ratio requirement (SLR) on large banks’ participation in U.S. Treasury markets. The paper relies on confidential supervisory data on daily holdings of Treasury securities of the five U.S. banks with the largest footprint in that market. The analysis indicates that banks offset exogenous decreases in their SLR buffers resulting from credit line drawdowns by shedding Treasury securities, which reduces their overall exposures and restores the buffers. In addition, the analysis finds that higher SLR buffers attenuate the negative relation between drawdowns and Treasury market participation. The findings “support the hypothesis that banks’ ability to participate in markets for safe assets may be curtailed by leverage regulations.” Read More ⇨

Liquidity Dependence: Why Shrinking Central Bank Balance Sheets is an Uphill Task

This paper develops a framework for understanding how central bank balance sheet expansion and contraction affects liquidity claims on the banking system, also examining how this process has unfolded empirically. In this framework, when the central bank expands its balance sheet with asset purchases, it issues reserve balances to finance the purchases, which are held by commercial banks, which in turn finance them with demandable deposits as well as increasing the provision of lines of credit. Empirically, the paper demonstrates that when the Federal Reserve halted its balance-sheet expansion in 2014 and commenced quantitative tightening in 2017, there was no commensurate shrinkage of the claims on liquidity. As a result, the banking sector was left more sensitive to potential liquidity shocks, necessitating Fed liquidity provision in September 2019 and again in March 2020. The study concludes that shrinkage of the Fed balance sheet “is not likely to be an entirely benign process and will require careful monitoring of the size of on- and off-balance-sheet demandable claims on the banking sector.” Read More ⇨

The Optimal Amount of Central Bank Digital Currency in Circulation

One of the key challenges of issuing a central bank digital currency is the risk of bank disintermediation through substitution of the CBDC for bank deposits, which could harm monetary and financial stability.  This article provides some preliminary empirical evidence on the expected impact of CBDCs on bank lending behavior and profitability.  It also presents and applies a theoretical framework to investigate the relevant trade-offs. The authors conclude that the optimal amount of CBDC is between 15 and 45 percent of GDP.  For comparison, paper currency in the United States is currently 9 percent of GDP. Read More ⇨

Pre-Positioning and Cross- Border Financial Disintermediation

Challenges in cross-border cooperation during the 2008 financial crisis spurred central banks to develop and enact new measures to improve joint oversight of internationally active financial institutions. These measures in part included the “pre-positioning” of capital and liquid assets at the affiliates and in the jurisdictions most likely to need them in an emergency. This article demonstrates, using a game-theoretic framework, “how pre-positioning requirements can improve welfare in ordinary market conditions, allow for participation in a Single Point of Entry (“SPOE”) regime in resolution, and provide the certainty necessary to prevent market fragmentation.” In addition, it highlights areas where the disparity between home and host resources has deteriorated since the 2008 financial crisis and discusses ways that oversight of internationally active financial institutions can be further strengthened. (For a related discussion, see this 2020 blog post from BPI that uses the same game theory tools to study cross-border cooperation and fragmentation.) Read More ⇨

Investing in Bank Lending Technology: IT Spending in Banking

This paper analyzes investment in information technologies by U.S. commercial banks during the past decade, relating the nature of banks’ IT investments to their lending activities. The analysis “exploits policies that affect geographic regions differentially” to explore how banks adapt their IT investment based on evolving loan demand.  Increased demand for small business credit is met by increasing their spending on communication IT that enhances their ability to collect and manage soft information. Increased demand for mortgage credit is met by increasing investment in software that enhances their capacity to process hard information. In addition, the study finds that the entry of fintech has spurred commercial banks to increase their investment in IT. Read More ⇨

The Procyclicality of FDIC Deposit Insurance Premiums

This paper examines the implications of procyclicality of FDIC deposit insurance premiums by exploiting unique changes to premium rate schedules set by regulatory agencies during the financial crisis. Using confidential FDIC data to control for bank risk and treating credit unions (which are not subject to the same deposit insurance premium regulations as banks) as a control group, the analysis provides new evidence of the procyclical effects of deposit insurance premiums on bank lending. The analysis also finds that community banks are disproportionately affected. The results support the view that deposit insurance policy should be countercyclical. Read More ⇨

Loan Modifications and the Commercial Real Estate Market

Banks have more flexible loan modification policies for CRE loans compared to CMBS, contributing to better loan performance when property incomes decline. However, banks have higher delinquency rates for less-stressed loans. This paper develops a model to explain these differences, in which lenders vary in their modification technologies, such that CMBS attract borrowers seeking higher leverage but are subject to frictions that discourage modification or strategic renegotiation. The model suggests that reducing modification frictions of CMBS would decrease welfare by restricting debt capacity for the borrowers that prefer higher leverage. Observed, cross-lender differences in LTVs and spreads are consistent with those implied by the model. Read More ⇨

Chart of the Month

US Government Securities Liquidity Index
The chart shows the daily price of the US Government Securities Liquidity Index, which measures the deviation of Treasury yields from a fitted yield curve. When liquidity conditions are favorable, the index is low, because yield deviations are quickly arbitraged away. Its rapid expansion during 2021 into early 2022 shows rising illiquidity, which respondents to the most recent Fed’s Senior Credit Officer Survey (available here) attributed to swings in the policy outlook, unbalanced order flow, and reduced dealer capacity.

Featured BPI Research

The Bank of England Just Released Its Plan for Getting Smaller. The Fed Could Learn from it.

On August 2, 2022, the Bank of England’s Monetary Policy Committee announced that it plans to reduce the size of its balance sheet. The Bank of England (BoE) intends to shed assets until it is as small as possible in the short term, and it plans to further shrink over time. This note compares the BoE plan to the Federal Reserve plan for “normalizing” it’s balance sheet, which entails retaining a huge balance sheet that could potentially grow bigger over time.  The note explains why the BoE plan is better for both monetary policy and broader economic reasons and recommends ways that the Fed could adapt the BoE plan to U.S. conditions. The note concludes by describing a way that the Fed could get even smaller while also allowing banks to lend more to businesses and consumers and less to the federal government with no degradation in safety and soundness. Read More ⇨

The Reverse Repo Bank

Currently, the Federal Reserve is obtaining a significant share of its funding through overnight reverse repurchase agreements with money market mutual funds. This blog post aims to show that the leverage ratio continues to be a key factor discouraging banks from holding riskless reserve balances. The authors show that reserve balances inflate banks’ risk-based capital buffers in multiple ways. Therefore, even if the Fed makes changes to banks’ capital requirements to ensure that the supplementary leverage ratio (SLR) serves as a backstop to risk-based capital requirements, global systemically important banks (GSIBs) would likely continue to limit low-risk balance-sheet-intensive activities, such as making markets in Treasuries or meeting demands from others for repo financing for Treasuries. Read More ⇨

FDIC Investment Yield Projection

On July 12, 2022, BPI published a note that reworked the FDIC’s recently published projections of the ratio of reserves to insured deposits, applying two changes to the FDIC’s assumptions. With those changes, the reserve ratio was forecast rise to its statutory requirement by the middle of next year, four to 12 years earlier than the FDIC’s projection. In that note, the authors did not prepare a projection of the yield on the FDIC’s portfolio. This note fills in that gap, presenting a projection of the investment yield of the FDIC’s portfolio based on recent market quotes and confirms the previous note’s logic. The projection applies a simple rule for the FDIC’s investment strategy and estimates that the investment yield on the FDIC’s portfolio should be expected to be between 2.5 and 3 percent going by market outlook. Read More ⇨

Conferences & Symposiums

Events:

9/6/2022 – 9/7/2022
2022 TCH + BPI Annual Conference
The Pierre, New York City
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9/9/2022
Climate Implications for Financial Stability Conference
Office of Financial Research (Virtual)
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9/14/2022 – 9/16/2022
FDIC 21st Annual Bank Research Conference
New York City
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9/28/2022 – 9/29/2022
Community Banking in the 21st Century Research and Policy Conference 2022
Federal Reserve Bank of St. Louis
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9/29/2022 – 9/30/2022
Inflation: Drivers and Dynamics Conference 2022
Federal Reserve Bank of St. Louis
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9/30/2022
Financial Stability Considerations for Monetary Policy
Federal Reserve Bank of New York
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10/6/2022 – 10/7/2022
Conference on Real Time Data Analysis: Applications in Macroeconomics and Finance
Federal Reserve Bank of St. Louis
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10/6/2022 – 10/7/2022
2022 Federal Reserve Stress Testing Research Conference
Federal Reserve Bank of Boston
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10/19/2022 – 10/20/2022
MIT Golub Center for Financial Research 9th Annual Conference (co-sponsored by Barclays)
Cambridge, MA
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10/21/2022
Johns Hopkins Carey Finance Conference 2022
Johns Hopkins Carey Business School, Johns Hopkins University, Baltimore, MD
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10/26/2022 – 10/27/2022
The Fourth Workshop on Payments, Lending, and Innovations in Consumer Finance
Federal Reserve Bank of Philadelphia
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11/7/2022 – 11/8/2022
The Implications of Financial Technology for Banking: Announcement and Call for Papers
Office of the Comptroller of the Currency
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11/17/2022 – 11/18/2022
Global Research Forum on International Macroeconomics and Finance
Federal Reserve Bank of New York
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11/17/2022 – 11/18/2022
2022 Financial Stability Conference: Announcement and Call for Papers
Federal Reserve Bank of Cleveland and Office of Financial Research
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12/15/2022 – 12/16/2022
CFPB Research Conference 2022: Announcement and Call for Papers
Consumer Financial Protection Bureau
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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.