Research Exchange: February 2023

Selected Outside Research

Nonbank Lending during Crises

Nonbank financial institutions have steadily increased their global footprint over the past decade and now account for around half the global financial system’s assets. However, little is known about the behavior of global nonbank lending during crises. This paper provides new, cross-country evidence on nonbank lending during financial crises, using data from the global syndicated loan market. The analysis indicates that nonbanks cut their syndicated credit by significantly more than banks during crises, and that differences in the value of lending relationships explain most of the lending gap. The study suggests that while a lending relationship with a bank benefits borrowers, “relationships with nonbanks – whether measured by duration or intensity – do not improve borrowers’ access to credit during crises.” Read More ⇨

Understanding the ‘Inconvenience’ of U.S. Treasury Bonds

Although the U.S. Treasury market is one of the most liquid financial markets in the world, since the Global Financial Crisis, long-maturity U.S. Treasury bonds have traded at a yield exceeding the interest rate swap rate of the same maturity, which suggests that Treasury bonds have become “inconvenient,” at least relative to interest rate swaps. This post explores reasons for this negative swap spread or “inconvenience” premium, highlighting the role of dealers’ balance sheet constraints. For instance, for dealers, “the main difference between holding a Treasury bond and holding an interest rate swap is that the Treasury bond stays on the dealer’s balance sheet, but the swap is off-balance-sheet. The tightening of the non-risk-weighted leverage ratio constraint post-GFC makes a large balance sheet costly for banks, even if the underlying positions have little risk.” Read More ⇨

Money Market Mutual Funds: Pandemic Revealed Unresolved Vulnerabilities

During the 2007-2009 financial crisis, investors in money market mutual funds “ran” — attempted to avoid losses by cashing in their shares at the same time. In 2014, the Securities and Exchange Commission tried to prevent runs by revising its rules governing MMFs, especially by allowing funds to impose a “gate” to temporarily block investors’ access to shares if the funds were low on cash and assets easily sold for cash. But during the COVID-19 pandemic, investors ran again, indicating continued vulnerability of MMFs to runs. Currently, MMFs hold around $5 trillion in assets, and a run on MMFs can spread to other entities and financial markets because MMFs are interconnected to financial firms and the financial system. This report from the U.S. Government Accountability Office reviews (1) the SEC’s reforms designed to reduce run risk at MMFs exposed by the 2007–2009 financial crisis, (2) available evidence on the effectiveness of MMF reforms in reducing run risk during the pandemic, and (3) current actions SEC is taking to reduce run risk at MMFs. Read More ⇨

Why Are Central Banks Reporting Losses? Does it Matter?

This paper uses supervisory, loan-level data from Germany to investigate how adoption of the expected credit loss accounting standard for loss reserving (IFRS 9) affected banks’ internal ratings assignments for corporate exposures. The analysis exploits a cutoff for the level of provisions at the investment-grade threshold based on banks’ internal rating of a borrower, comparing the rating assignments of adopting versus non-adopting banks in a neighborhood of this threshold. Results indicate that the banks required to adopt the new rules assign better internal ratings to the same borrowers compared to non-adopters, consistent with a strategic use of ratings discretion. These banks also reduce their lending exposure to borrowers at the highest risk of being downgraded to below the cutoff, such that these loans would be associated with additional provisions in future periods. Read More ⇨

Did CECL Improve Banks’ Loan Loss Provisions and Earnings Quality during the COVID-19 Pandemic?

Proponents of the current expected credit loss provisioning standard that took effect in 2020 during the onset of the COVID-19 pandemic argue that it will provide timelier provisions. Others have expressed concern that it may lead to greater volatility of reported earnings. This paper investigates the impact of CECL on the volatility of banks’ loan loss provisions and on earnings quality. The analysis indicates that during 2020, banks adopting CECL increased their loss reserves by more at the onset of the pandemic when the economic outlook deteriorated sharply and reduced them by more when the economy came roaring back, compared to non-adopters. In addition, both the dispersion of analysts’ earnings forecasts and the level of discretionary earnings during the first two quarters of 2020 are larger for adopting banks compared to non-adopters. The authors interpret these results as evidence of “greater accounting noise and reporting bias caused by the adoption of CECL during high economic uncertainty.” Read More ⇨

Financial Sanctions, SWIFT and the Architecture  of the International Payments System

This article examines the evolving use of the infrastructure of cross-border payments for international sanctions. The article begins with a historical overview of financial sanctions since World War II, including some specific examples of sanctions episodes and the types of activities included. It then describes the infrastructure of cross-border payments and how restricting access to it can potentially disrupt tourism, remittances, foreign exchange trading, international trade financing and other activities requiring that access. The discussion then focuses on the international payments network maintained by the Society for Worldwide Interbank Financial Telecommunication, which currently carries the vast majority of communications necessary for international payments, and the use of financial sanctions restricting access to SWIFT. Finally, the article discusses some of the alternative systems some countries have created to limit the dependency on this single network, which have not yet gained broad use in cross-border activity. Read More ⇨

Funding Liquidity Creation by Banks

One traditional view of the liquidity role of banks in the economy holds that banks create deposits through their funding of loans — a process referred to as “funding liquidity creation”. This paper describes how private money creation by banks enables lending to not be constrained by the supply of cash deposits and measures how much funding liquidity the U.S. banking system creates. The analysis finds that “during the 2001–2020 period, 92 percent of bank deposits were due to funding liquidity creation, and during 2011–2020 funding liquidity creation averaged $10.7 trillion per year, or 57 percent of GDP.” In addition, using natural disasters data, the paper provides evidence that “better-capitalized banks create more funding liquidity and lend more even during times when cash deposit balances are falling.” Read More ⇨

Bank Relationships and the Geography of PPP Lending

This paper explores how bank relationships affected the timing and geographic distribution of Paycheck Protection Program lending, via an empirical analysis of the relationship among branch distance, bank PPP activity and origination timing. The analysis finds that half of banks’ PPP loans went to borrowers within 2 miles of a branch, mostly indicative of relationship lending. In addition, businesses located near less active PPP lenders were relatively likely to rely on fintechs and other distant lenders, receiving only slightly lower loan volumes but at a lag compared to other borrowers. Read More ⇨

Chart of the Month

The chart depicts a widening gap in loan growth between large and small banks, which coincides with increases in capital requirements for large banks. There are three factors that may be contributing to this trend. First, the rise in interest rates resulted in unrealized losses on available-for-sale securities, lowering the capital ratios of banks not subject to the AOCI filter. Second, the stress capital buffer increased after the release of stress test results in 2Q22. And third, the GSIB surcharge increased at the end of 2022. The weaker loan growth at large banks, in comparison to smaller banks, provides indirect evidence of the impact of capital requirements on loan growth.

Featured BPI Research

Basel Finalization: The History and Implications for Capital Regulation – Part III

This is the third post in a series informing readers about a proposal by U.S. regulators to implement the Basel Finalization agreement, expected in the first half of 2023. The first post in this series discussed the background and principles of the Basel framework and its development, leading to the 2017 revisions. The second covered potential options for the structure and scope of U.S. implementation. In this post, the authors focus on potential modifications to the Basel package or other elements of the U.S. capital framework to improve its risk sensitivity and mitigate its procyclicality whereby bank lending activity is impeded during an economic downturn. Read More ⇨

Deep Dive: DFAST 2023 Stress Test Scenarios

On Feb. 9, 2023, the Federal Reserve released two stress test scenarios, the baseline and the severely adverse, as well as the Global Market Shock (GMS) add-on component for organizations with large trading operations. The main innovation in this year’s scenarios was the introduction of an additional “exploratory” market shock to evaluate trading losses due to increased inflationary pressures; it will only be applied to the U.S. global systemically important banks (GSIBs). The results of the exploratory market shock component will not affect GSIBs’ capital requirements and it is likely intended to test the feasibility of multiple scenarios in future stress tests. Aside from the introduction of this shock, the 2023 stress scenario is more challenging than the one from the previous year and features a higher rise in unemployment, a larger decrease in real GDP growth and a significant drop in house prices. Consequently, stressed loan losses are anticipated to rise, although aggregate pre-provision net revenue may increase mainly due to stronger net interest income, and the projections will also depend on whether model coefficients have been updated. Additionally, some of the GMS risk factors are less severe compared to the previous year, and the advanced approaches banks are expected to see an increase in the fair value of their available-for-sale securities. Overall, the authors project that the severely adverse scenario will result in a marginally higher reduction in projected bank capital ratios compared to the results of last year’s stress tests. Moreover, differences in losses between the two market shocks will highlight the banks’ sensitivity to interest rate risk in their trading books. Read More ⇨

Is It Time for a Holistic Review of Liquidity Requirements?

The management of liquidity risk is central to banking. Banks fund themselves in large part with deposits redeemable on demand, and they invest largely in illiquid loans. An important component of bank examination therefore has always been assessing how well a bank is managing liquidity risk, including ensuring that the bank has robust plans for dealing with adverse liquidity contingencies. The nature of those assessments underwent a sea change in the years after the Global Financial Crisis (GFC). Instead of viewing the supply of liquidity broadly—including drawing on committed lines of credit from financial institutions and the central bank, for example—liquidity regulations were amended to define the supply of liquidity exclusively as the bank’s stock of high-quality liquid assets (HQLA). These consist almost entirely of a bank’s holdings of reserve balances (deposits at a Federal Reserve Bank), Treasury securities and, to a lesser extent, agency (that is, mostly Fannie Mae- or Freddie Mac-guaranteed) mortgage-backed securities. The change had several motivations: primarily preventing a freeze in short-term funding markets from creating financial instability, but also a desire to reduce interconnectedness. This note has two parts. First, the author reviews how bank liquidity was conceived before the Global Financial Crisis, how it is conceived now and what caused the change. Then the author proposes a holistic review of liquidity assessments, as well as some specific adjustments that would reduce the social cost of ensuring appropriate levels of liquidity without reducing safety and soundness or financial stability. Read More ⇨

Capital Requirements, Nonbank Finance and Financial Fragility

This blog post evaluates some of the results in a recent paper by Begenau and Landvoigt (2022), which examines the impact of bank capital requirements on migration of credit intermediation activity to nonbanks. While this paper provides valuable insights, it also has some limitations that need to be acknowledged for readers to fully understand its implications for bank capital requirements. While quantitative general equilibrium models, like the one used in the paper, are useful in assessing the qualitative impact of policy changes on economic agents, they do not account for many important factors, making it challenging to rely on their quantitative findings. The blogpost highlights two main limitations of the analysis, such that the model does not capture effectively: (i) the size and impact of the shadow banking sector during economic recessions, and (ii) the stylized format of banks’ balance sheets, including the absence of consideration for the significant amount of safe assets that banks hold in their balance sheets, as well as the long-term debt that can be converted to equity upon bank failure. By accounting for these factors, the model’s quantitative findings could be adjusted, providing a more accurate optimal capital requirement for U.S. banks. Read More ⇨

The “Branch Destruction” Fiction | Part I

The post critiques a research paper co-authored by a group of Federal Reserve Board economists that was presented at the OCC’s Symposium on Bank Mergers, held on February 10. This research paper analyzes detailed data on banking market structure, deposit growth and deposit account interest rates in the U.S. from 1980 to 2014. The period covered in this paper saw a significant amount of bank consolidation as well as a significant increase in the number of bank branches. The study obscures these facts by shifting the focus to neighborhood-level comparisons, arguing that mergers cause “branch destruction” and therefore the traditional, market concentration approach to assessing competitive effects needs reconsideration. However, more accurately described, the paper finds that number of bank branches (on average) grew more slowly in local markets where merging banks had closely overlapped networks compared to those with no overlap. So, for example, if a merged bank ended up with two branches on the same or a nearby block, it would be likely to close one of them. The post concludes that the paper presents a well-developed analysis of how the effects of bank mergers can vary depending on the degree of spatial overlap of the merging banks’ branch networks, but the statistical results do not, in fact, support the paper’s narrative that the current approach to competitive analysis of bank mergers is flawed. 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.