Research Exchange: February 2022

Selected Outside Research

Do Net Interest Margins for Small and Large Banks Vary Differently with Interest Rates?

Bank net interest margins—the difference between interest income from loans, securities, and other assets and interest expenses on deposits and other liabilities—are a core component of bank profitability, and tend to decline when the effective federal funds rate declines, as occurred after 2019. Since small community banks generate most of their income from interest on loans, while large banks typically have more sources of noninterest income, declining net interest margins raise concerns about viability of small banks. This paper reviews bank profitability across different bank size categories through varying interest rate environments. The study finds that the recent decline in NIMs is largely driven by changes to the interest rate environment rather than by changes in the distribution of bank portfolios, and that it has disadvantaged smaller banks. It also demonstrates that the profitability relationship is not always symmetrical—rising interest rates are not always more advantageous for smaller banks.  Read More ⇨

The Many Facets of Bank Competition: Evidence from An Extraordinary Dataset

Unlike most previous research on banking competition, this paper examines bank deposit markets from the depositors’ viewpoints, using a unique, large dataset comprising over 800,000 certificate-of-deposit accounts from more than 500 banks covering two decades. One important finding is that bank financial health matters more in determining deposit rate spreads than traditional market competition measures. The latter, in fact, exhibit minimal association with deposit spreads. Depositors that have a pre-existing transaction account relationship with the bank are associated with lower spreads, which the authors interpret as reflecting banks’ ability to exploit information rather than inertia in the depositor relationship. The study additionally finds that competition from large banks and credit unions has less effect on community bank pricing behavior than competition from other community banks. Read More ⇨

Market Structure and Availability of Credit: Evidence from Auto Credit

This paper presents evidence that the Comprehensive Capital Analysis and Review stress tests affected the availability of auto loans. The analysis finds that the introduction of CCAR was followed by a decline in the stress tested banks’ share of auto lending, with larger declines evident in non-urban areas. Other lenders did not fully offset this reduction, leading to an overall decline in auto loan originations in areas more reliant on CCAR banks. One key takeaway is that “policies geared toward financial stability asymmetrically impacted local credit conditions and inadvertently amplified the urban-rural divide.” Read More ⇨

Caution: Do not cross! Capital Buffers and Lending in COVID-19 Times

Using granular data from the credit registry of the European System of Central Banks, this paper shows that European banks were unwilling to draw on capital buffers to absorb losses during the COVID-19 crisis. To the contrary, banks engaged in pro-cyclical behavior seeking to preserve regulatory capital ratios. Isolating credit supply effects, including by controlling for pandemic-related support measures, the authors find that banks with less headroom above regulatory capital buffers reduced their lending more relative to other banks, rather than drawing on their capital buffers. Thus, the findings highlight some of the unintended effects of the capital framework and potential conflicts between fiscal and prudential policies during stress periods. Read More ⇨

The Future of Payments Is Not Stablecoins

Despite the rapid growth in stablecoin issuance from just $5.7 billion in December 2019 to $155.6 billion as of late January 2021, this blog post argues that stablecoins will not play a major role in the future of payments. The post argues that stablecoins are not “the best possible money that can be used as a means of payment.” It argues that stablecoins either tie up liquidity unnecessarily or are by construction riskier and less fungible, and that there are other forms of digital money, such as tokenized deposits, that are more efficient as transfer mechanisms and have a more promising, future role. Read More ⇨

A Lawyer’s Perspective on U.S. Payment System Evolution and Money in the Digital Age

This note presents a broad overview of the current U.S. payment system and the ways it is evolving, from a legal perspective, emphasizing the roles of “network effects” and “interoperability.” The note begins with a discussion of the current structure of the U.S. payment system, highlighting how “a sound legal framework is an important foundation for network effects within the payment system,” by incentivizing more parties to join the system. The note then examines the role of the Federal Reserve in the U.S. payment system, focusing on the central bank’s role in promoting safety and efficiency, and currently by serving as a “network hub” connecting some of the system’s forms of money. Finally, the evolving structure of the U.S. payment system is examined, including the growth of payment services offered by nonbank companies, the increased use of electronic payments, the convergence of payments and data, and the entry of big technology companies into payment services.

A key takeaway is that the payment system has traditionally served consumers and business needs well largely because of the Federal Reserve’s stabilizing role.  Contrarily, today’s innovations would not serve the U.S. payment system well if the new services and products are poorly understood, poorly constructed and do not “interoperate” with other forms of money from a legal standpoint. Read More ⇨

Financial Stability Considerations for Monetary Policy: Theoretical Mechanisms

This paper reviews the theoretical literature on financial vulnerabilities and their relation to macroeconomic factors. The discussion highlights how financial vulnerabilities can work as amplifiers such that a small shock to fundamentals or change to beliefs can create a self-reinforcing mechanism affecting credit provision, asset prices and economic activity. Overall, the literature suggests that effects of monetary policy on financial vulnerabilities are context dependent, as theoretical models typically showcase the effects in isolation. For example, low interest rates can help firms’ creditworthiness and improve bank balance sheets but may also spur the accumulation of leverage. The paper underlines that impacts of monetary transmission channels on the buildup of vulnerabilities are dependent on the state of the economy. Read More ⇨

Financial Stability Considerations for Monetary Policy: Empirical Evidence and Challenges

From an empirical perspective, the relationship among vulnerabilities in the financial system, the economy and monetary policy also presents certain limitations. While financial vulnerabilities build up over time, as risk appetite and risk-taking rise during economic expansions, leading to real economic effects, it is empirically difficult to specifically link monetary policy to vulnerabilities. The authors suggest this is in part because of the long duration of financial cycles making it difficult to isolate changes to monetary policy from other business cycle effects.

This paper reviews the literature on empirical relationships between vulnerabilities in the financial system and the macroeconomy and how these are affected by monetary policy, drawing three main conclusions. First, during economic expansions, financial vulnerabilities increase alongside increased risk taking, although financial cycles are longer than business cycles. Second, financial crises “are to some extent predictable,” and have severe economic consequences, particularly when they are tied to heightened risk taking in the form of increased leverage coupled with high asset valuations. Third, “evidence on the link between monetary policy and financial vulnerabilities is limited, in part because financial cycles have long durations, and it is difficult to empirically separate changes in monetary policy from other business cycle effects.” Read More ⇨

How Does Monetary Policy Affect Prices of Corporate Loans?

Monetary policy news around FOMC announcements can have a heterogenous impact on credit spreads across different debt categories. This paper finds that, following an unanticipated tightening shock to monetary policy, corporate loan spreads do not increase as much as bond spreads do, and riskier loans have a relatively weak spread reaction. Also, spreads in the secondary market are more responsive than those in the primary market loan spreads. A decomposition of the spread responses indicates that heterogeneous response of bond and loan risk premia is the main driver behind the results. Read More ⇨

Pricing Liquidity without Preemptive Runs

This blog post describes how changes to the fee structure of prime money market mutual funds could reduce preemptive redemption and mitigate their vulnerability to runs, such as those that occurred in September 2008 and March 2020. In particular, “swing pricing” is highlighted as a safer way to price liquidity compared to the current mechanism of fees and gates. This pricing mechanism reduces the incentive for preemptive runs by imposing a higher cost on redemptions on days the funds are facing larger outflows, so that the liquidity cost of redemptions would be more equally shared between leaving and remaining investors. This pricing mechanism has been demonstrated successfully in European mutual funds. Read More ⇨

Exorbitant Privilege? Quantitative Easing and the Bond Market Subsidy of Prospective Fallen Angels

This paper assesses capital misallocation in the U.S. corporate bond market driven by quantitative easing (QE), whereby firms just above the IG rating cutoff enjoyed subsidized bond financing. The paper documents how the firms used this privilege to fund risky acquisitions and increase their market share, adversely affecting employment and investment at their competitors, but ultimately making them more fragile. These “prospective fallen angels” suffered comparatively severe downgrade at the onset of the pandemic. The paper also documents adverse spillover effects in the form of reduced employment, investment, markups, and sales growth at competitors of the subsidized firms. Read More ⇨

Mortgage-Backed Securities

The U.S. residential mortgage-backed security market, which emerged in the 1980s, has developed into one of the largest and most liquid global fixed-income markets in the world, with over $11 trillion of securities outstanding. This paper reviews the MBS market with a focus on Agency residential mortgage securities. This paper examines the market’s institutional structure, security design, risks and pricing, and its economic effects, assembling descriptive statistics on market size, growth, composition, and activity and highlighting insights from the large academic literature. Read More ⇨

Chart of the Month

The chart above, from a recent Federal Reserve Bank of Richmond Economic Brief, shows the time series for High-Quality Liquid Assets (HQLAs), including the three main categories of assets that can be used as collateral at the Federal Reserve’s Standing Repo Facility (U.S. Treasuries, U.S. Agency and GSE debt, and GSE Residential MBS). As noted in the Reserve Bank’s report, while excess reserves have fluctuated significantly since 2011, eligible collateral holdings increased steadily from about $1 trillion to just under $3 trillion in the third quarter of 2021.

Featured BPI Research

Deep Dive: DFAST 2022 Stress Test Scenarios

This research note analyzes the most recent stress test scenarios, DFAST 2022, as released by the Federal Reserve, as well as the Global Market Shock (GMS) add-on component applicable to organizations with large trading operations. Analysis indicates that the 2022 stress scenarios are modestly more severe compared to the 2021 stress scenarios. Also, since the heightened stress in CRE markets assumed in last year’s stress scenarios is maintained in DFAST 2022, the authors expect that the banks that did not participate in 2021’s stress tests and are exposed to CRE markets would see an increase in capital requirements relative to DFAST 2021. Overall, the DFAST 2022 severely adverse scenario is likely to result in little change in capital requirements of large U.S. banks when the results are released later this year. Read More ⇨

Five Important Facts about the Competitiveness of the U.S. Banking Industry

This blog post analyzes whether consolidation over in the banking industry over past decades has made the U.S. banking industry less competitive. The post documents five important facts that clearly demonstrate the contrary—a highly competitive banking environment:

  • Nationally, the commercial banking industry concentration is modest compared with other consumer-facing industries.
  • National concentration in commercial banking has been trending downward.
  • Concentration in U.S. commercial banking is low relative to banking sectors in other advanced economies.
  • Local banking market concentration is low on average, with no indication of an increasing trend.
  • If the banking industry had in fact evolved to become too concentrated over the last 30 years, then one would expect to see profit margins increasing; to the contrary, evidence shows that profit margins have remained flat in this period.

Read More ⇨

Informal Symposium on Monetary Policy, Bank Regulations, and Money Markets

This blog post summarizes the knowledge shared and views presented at a Feb. 17 symposium, sponsored by BPI, on monetary policy, bank regulations, and money markets. Participants included current and senior policymakers from multiple government agencies and central banks; academic experts on monetary policy and financial markets; and market practitioners including bank treasurers, rate strategists from buy-side and sell-side firms, and chief economists. The symposium covered four topics: the outlook for deposit rates and deposit levels, the prospects for the Fed’s new Standing Repo Facility (SRF), how the Fed’s balance sheet and money market rates will evolve as the Fed tightens policy, and Treasury market functioning as the Fed switches from purchases to redemptions. Read More ⇨

More Taxis Sitting Idle

This blog post enumerates 10 steps that can be taken to address the interrelated problems of discount window stigma and lack of usability of high-quality liquid assets. Banks’ traditional reluctance to use these tools increases their demand for reserve balances – deposits at the Fed. The post argues that the two main obstacles to reform are “inertia” and “politics” and that if the Fed wants to shrink its balance sheet, it must take these steps. Implementing these actions would “further policy objectives it purportedly supports – encouraging banks to both use their liquidity reserves when under stress and see the discount window and SRF as viable sources of contingent liquidity.” Read More ⇨

Federal Reserve Support for Market Functioning

In March 2020 the Federal Reserve intervened massively in the U.S. Treasury markets to restore balance to the markets after widespread selling by investors had overwhelmed the intermediation capacity of the securities dealers that ordinarily provide liquidity. Given the importance of the Treasury markets to the U.S. government and to U.S. and global financial stability, these purchases clearly were appropriate. This post argues, however, that before assuming an ongoing role as a “market liquidity provider of last resort,” the Fed should carefully consider the potential drawbacks of such a role. These include moral hazard, potential conflicts with monetary policy objectives, and effects on the allocation of credit, and they are potentially significant. Before assuming such a role, the Fed should give thought as how to minimize those drawbacks and should consult with the public and seek guidance from Congress on what its role should be. 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.