Research Exchange: June 2023

Selected Outside Research

Why Does the Yield Curve Predict GDP Growth? The Role of Banks

Using detailed data on banks’ lending activities, this paper explores the effect of changes in the slope of the yield curve on bank lending and associated economic activity. The analysis demonstrates that a steeper yield curve that derives from higher term premiums (rather than from higher expected short rates) boosts bank profits and the supply of bank loans. This effect is stronger for banks that are more leveraged initially. The paper characterizes this effect as driven by an increase in banks’ expected profits from maturity transformation—the higher term premium makes maturity transformation more profitable, which in turn incentivizes bank lending. Read More ⇨

“Let Us Put Our Moneys Together”: Minority-Owned Banks and Resilience to Crises

Minority-owned banks, through specialization in lending based on knowledge gained through close community ties, may have an advantage in serving community needs through times of financial and economic crises. This study explores that hypothesis by analyzing individual banks in their local market context from 2006 to 2020. The analysis finds that minority-owned banks promoted economic resilience in their communities during the global financial crisis and the COVID-19 crisis through increased small business and household lending.  However, fewer benefits are found during other phases of the business cycle. The results imply that “if all U.S. banks behaved in a manner consistent with minority-owned banks through the GFC, at least 1.9 million more minority jobs would have been maintained and at least $50 billion more in credit would have been available to small businesses on an annual basis.” Read More ⇨

Using Mortgage Reserves to Advance Black Homeownership

Mortgage reserve accounts are savings accounts established alongside a mortgage to provide a source of funds in the event that the borrower experiences temporary financial setbacks, helping to prevent delinquency and foreclosure. This paper presents a blueprint for a pilot mortgage reserve account program, by which lenders could explore and test critical design and implementation aspects of a program before going to scale. According to the paper, mortgage reserve accounts “could meaningfully preserve homeownership for vulnerable homeowners because of their unusual combination of product features and flexibility.” In particular, “if the foreclosure rate for Black mortgage borrowers decreased to the average foreclosure rate among white mortgage borrowers, an estimated 300,000 more Black homeowners would keep their homes and have the opportunity to build generational wealth.” Read More ⇨

Small Mortgages Are Too Hard to Get

Previous research has explored mortgage access at different loan sizes, finding that small loans are relatively scarce and that applications for small mortgages are more likely to be denied than those for larger loans, even when applicants have similar credit scores. However, the existing research provides limited understanding of the factors contributing to the shortage of small mortgages. This study seeks to fill that gap, by exploring nationwide real estate transaction and mortgage origination data and results from a 2022 survey of homebuyers who have used financing alternatives to traditional mortgages, such as land contracts and rent-to-own agreements. One key finding is that small mortgages became less common between 2004 to 2021 in part due to home price appreciation. Another is that homebuyers who cannot access small mortgages and cannot pay with cash typically resort to alternative financing arrangements that tend to be riskier and costlier than mortgages. In addition, the study finds that structural and regulatory barriers limit the profitability of small mortgage lending, in part by increasing the fixed costs of originating a mortgage, which are disproportionally high for smaller loans. Read More ⇨

Will Central Bank Digital Currency Disintermediate Banks?

The effect of a central bank digital currency (CBDC) on the banking system is explored in this paper by means of a stylized model. The analysis finds that a one-dollar introduction of CBDC replaces bank deposits by around 80 cents on the margin, while bank lending falls by one-fourth of the drop in deposits, because banks partially replace lost deposits with wholesale funding. This substitution, however, raises banks’ interest-rate risk exposure and lowers their resilience to negative equity shocks.  If the CBDC bears interest or is intermediated through banks, it captures a greater share of deposits and has a greater impact on lending.  The analysis also indicates an amplified effect on lending for small banks, for which wholesale funding is more expensive. Read More ⇨

Global Liquidity: Drivers, Volatility and Toolkits

Global liquidity—large volumes of financial flows that are largely intermediated through global banks and nonbank financial institutions—can move at relatively high frequencies across borders and can propagate international spillovers of monetary policy and risk sentiment. This paper examines global liquidity through analysis of granular economic and financial data and draws three primary lessons. First, “prudential policies, effective supervision and liquidity facilities from the source countries of global liquidity dampen the global financial cycle” through stability-enhancing spillover effects. Second, access to internal organizational liquidity and official-sector liquidity can mitigate the global effects of financial stress events. Third, risk migration across types of financial intermediaries poses challenges to moderating the amplitude of global liquidity flows. Read More ⇨

Leveraged Finance

The leveraged loan and high-yield bond markets, which together comprise “leveraged finance”, have grown dramatically over the past two decades and become an important source of credit for large firms, reaching more than $1.3 trillion and $1.5 trillion respectively as of 2021. This paper provides an in-depth introduction to leveraged finance markets, reviews the academic research relevant to understanding them, and suggests areas for future research. The paper argues that the elevated credit risk of leveraged borrowers distinguishes these markets from the market for investment-grade bonds. In addition, because leveraged loans are large and require multiple lenders to fund the debt, the market for leveraged loans operates differently from the traditional bank loan market. The paper also provides an in-depth discussion of the credit contracts that underlie the two markets, arguing that these “serve to mitigate myriad incentive conflicts that arise between debtholders and the borrowers.” Read More ⇨

Information Acquisition and Rating Agencies

A common narrative is that agency ratings of corporate and other debt became less trustworthy when it became common practice for issuers to pay for ratings. This paper compares the strengths and weaknesses of the issuer-pays versus investor-pays framework for agency ratings. The analysis demonstrates that under either arrangement, agencies have a reputation incentive to provide sound assessments of credit worthiness and their ratings add value. It also shows that the investor-pays version can lead to under-provision of information due to a free rider problem (non-paying third parties benefit from the information revealed by the rating), whereas the issuer-pays version may lead to systematic distortion in the revealed information. In addition, the paper also suggests that “regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them.” Read More ⇨

Finance and Climate Resilience: Evidence from the Long 1950s U.S. Drought

This study examines how availability of bank credit affected the ability of communities to adapt during the long 1950s U.S. drought. The study finds that drought-exposed areas with limited initial access to bank finance experienced sharp declines in bank lending, net immigration and population growth. In contrast, drought-exposed areas with better access to bank finance experienced increases in agricultural investment and long-run productivity, “even allowing some of these areas to leapfrog otherwise similar areas in the subsequent decades”. In addition, the study finds that “unequal access to finance can drive migration from drought-hit finance-poor communities to finance-rich communities”. Thus, the study suggests that “broadening access to finance can enable communities to adapt to large adverse climatic shocks and reduce emigration.” Read More ⇨

Market Concentration in Fintech

This study examines the evolving structure of the market for residential mortgages from 2011 to 2019. It finds that the market share of nonbanks, including that of fintechs, has grown dramatically. Overall concentration in mortgage lending has declined, driven mostly by a reduction in concentration among bank lenders. However, concentration among fintech lenders has increased and is significantly higher than for bank lenders and other nonbank lenders, which “may have important implications for regulatory policy and financial stability.” The study also presents a simple model demonstrating that “changes in lender financial technology (interpreted as improvements in quality of loan services) explain more than 50 percent of the increase in fintech market shares and 43 percent of the increase in fintech concentration.” Read More ⇨

Interconnected DeFi: Ripple Effects from the Terra Collapse

This paper outlines a generalizable economic theory of blockchains that highlights how decentralized finance offers consumers distinct blockchain networks as competing choices, differentiated by several key characteristics. In addition, the paper provides a technical account of the financial mechanisms that facilitated the growth and eventual collapse of the Terra Network, utilizing insights from the theory. The analysis finds evidence that “bridges between programmable blockchain networks create increased risk of spillover effects to other blockchains’ programmable environments in the wake of a major shock event like Terra’s collapse.” Specifically, “blockchains suffered a time-bound loss of market share and the likelihood of this loss grew approximately 40% for each additional bridge that was deployed in common with Terra at the time of Terra’s collapse.” Read More ⇨

Chart of the Month

Weighted Average SCB by Bank Group

The stress capital buffer (SCB) is a component of large banks’ risk-weighted capital requirement. The SCB is added to the minimum requirement of 4.5 percent, any GSIB surcharge and any CCyB to determine the bank’s requirement. The SCB is defined as the maximum decline in a bank’s common equity tier 1 capital ratio in the stress tests plus four quarters of dividends and is subject to a floor of 2.5 percent. The chart above depicts the weighted average of banks’ SCBs by bank category for the last two years. This year’s stress test yielded marginally lower average SCBs for the bank’s that participated in this year’s stress tests, reflecting reduced SCBs for the GSIB category; marginally higher SCBs for other large domestic banks and a relatively large increase in SCBs for intermediate holding companies (IHCs).

Featured BPI Research

The CFPB’s Deeply Flawed Proposal on Credit Card Late Fees – Part 3

This post is the last in a three-part series on the CFPB’s proposed, large reduction in the safe harbor limit for credit card late payment penalties (such that a fee within this safe harbor is presumed to be permissible under the rules set by the 2009 CARD Act.) This post describes significant errors in the CFPB’s purported cost-based calculation used to derive the proposed $8 safe harbor limit. It demonstrates how the data and procedure used in this calculation are inadequate and insufficient for determining that an $8 limit would cover issuers’ costs related to late or missed payments. In particular, the data used by the Bureau exclude many of the costs associated with late or missed payments, including important costs related to credit card collections; the Bureau arbitrarily excludes collection costs incurred after an account is charged off; and the period covered by the Bureau’s analysis period of analysis is not representative of a typical economic cycle. Read More ⇨

A Preview of DFAST 2023 Results

The Federal Reserve announced that the 2023 Dodd-Frank Act Stress Test (DFAST) results will be released on June 28. The stress test results determine a stress capital buffer (SCB) requirement for each bank subject to the test, which is a component of the bank’s overall capital requirement. This note provides some analytical predictions for bank performance in the DFAST 2023, including a projection that the key metric of the Fed’s stress tests—the trajectory of the aggregate common equity tier 1 (CET1) capital ratio over the projection horizon—will decline from an initial 12.4 percent to a minimum of 9.2 percent. This represents a slightly greater decline in comparison to the 2022 DFAST for the same set of banks. The note also critiques the lack of any reported updates to the stress test methodology, noting in particular that because of the lack of updating, the models are likely to generate underestimation of bank revenues. Read More ⇨

CLF Notes – What is a Committed Liquidity Facility?

The failures of SVB and Signature Bank revealed that deposits can run much faster than previously thought. This revised view of deposit stickiness calls into question the assumptions for deposit outflows in banks’ liquidity requirements. However, dialing up the outflow rate assumptions would require banks to devote even more of their balance sheets to lending to the government in the form of Treasury securities and deposits at the Federal Reserve rather than lending to households and businesses. A type of central bank lending facility new to the United States may be the key to balancing heightened liquidity needs with banks’ financing of the economy. This note explains what Committed Liquidity Facilities are and how they could be offered in the United States. CLFs are lines of credit sold to banks by the Fed for a fee, collateralized by loans to businesses and households. They would enable banks to become better prepared for any future rapid outflows of deposits without shifting even more of their balance sheets into loans to the government and away from loans to the real economy. Read More ⇨

Some Sound Advice From the BIS

In its Annual Report released on June 25, 2023, the Bank for International Settlements (BIS) offered some straightforward advice to the world’s central banks, including the Federal Reserve, to keep their balance sheets “as small and as riskless as possible, subject to delivering successfully on their mandate.” This post elaborates on that advice as it relates to the Federal Reserve, whose balance sheet has grown enormously since prior to the global financial crisis, now amounting to close to a third of GDP. The note reviews how the Federal Reserve reached this point, and how that is largely attributable to a dramatic change in how it conducts monetary policy. The post also reviews more detailed advice in the BIS’s Annual Report and what the Federal Reserve can take away from it. Read More ⇨

Conferences & Symposiums

The 8th Annual Cambridge Conference on Alternative Finance
University of Cambridge Center for Alternative Finance
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7/10/2023 – 7/28/2023
National Bureau of Economic Research Summer Institute 2023
Cambridge, MA and Virtual
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7/12/2023 – 7/13/2023
The Fifth Biennial Conference on Auto Lending
Federal Reserve Bank of Philadelphia
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Yale Program on Financial Stability Conference
Yale University, New Haven, CT
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8/31/2023 – 9/1/2023
Inflation: Drivers and Dynamics Conference
Federal Reserve Bank of Cleveland and European Central Bank
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9/7/2023 – 9/8/2023
Seventh Annual Fintech Conference
Federal Reserve Bank of Philadelphia
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9/28/2023 – 9/29/2023
22nd Annual Bank Research Conference
Federal Deposit Insurance Corporation Center for Financial Research
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10/4/2023 – 10/5/2023
Community Banking Research Conference
Federal Reserve Bank of St. Louis
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10/6/2023 – 10/7/2023
Ninth Wharton Conference on Liquidity and Financial Fragility
Wharton School of the University of Pennsylvania, Philadelphia
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10/19/2023 – 10/20/2023
New Perspectives on Consumer Behavior in Credit and Payments
Federal Reserve Bank of Philadelphia
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10/19/2023 – 10/20/2023
Federal Reserve Stress Testing Research Conference
Federal Reserve Bank of Boston and Virtual
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10/19/2023 – 10/20/2023
Annual Financial Stability Conference: Interest Rate Variability and the Financial Sector
Federal Reserve Bank of Atlanta
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The 2023 U.S. Treasury Markets Conference
Federal Reserve Bank of New York
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11/16/2023 – 11/17/2023
2023 Financial Stability Conference
Federal Reserve Bank of Cleveland and Office of Financial Research
Cleveland, OH and Virtual
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11/16/2023 – 11/17/2023
2023 Asia Economic Policy Conference
Federal Reserve Bank of San Francisco
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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.