Research Exchange: March 2024

Selected Outside Research

Paying Too Much? Borrower Sophistication and Overpayment in the U.S. Mortgage Market

This study combines data from several sources, including data on rates and terms offered by mortgage lenders and those obtained by borrowers, along with measures of borrowers’ shopping behavior and financial knowledge, to assess the extent to which borrowers may be “overpaying” on their mortgages. The analysis indicates that “many homeowners significantly overpay for their mortgage, with overpayment varying across borrower types and with market interest rates.” In addition, the analysis reveals that “borrowers’ mortgage knowledge and shopping behavior strongly correlate with the rates they secure” but finds no evidence that borrowers obtaining higher-cost loans have superior “borrowing experience” such as a smoother application process. The study concludes that “limited borrower sophistication may provide lenders with market power” despite the highly competitive structure of the mortgage origination market. Paying Too Much? Borrower Sophistication and Overpayment in the US Mortgage Market (papers.ssrn.com)

Risk in Card Portfolios: Risk Appetite and Limits

Banks develop risk appetite frameworks, which encompass a collection of risk metrics and thresholds, as an important tool for enterprise-wide risk management. This paper examines the risk appetite frameworks of four large banks as applied to their credit card portfolios, focusing on metrics related to outstanding balances with particular attention to how often and why the frameworks are modified. The study finds that these banks monitor between 40 and 50 metrics, and it identifies 79 metrics related to outstanding balances. The frameworks are observed to be “sticky,” in that they are infrequently adjusted and adjustments are generally marginal. The study also finds that breaches of risk appetite thresholds are rare, and most breaches result in risk-mitigating measures, such as tightened credit standards. Managing Risk in Cards Portfolios: Risk Appetite and Limits – Federal Reserve Bank of Boston (bostonfed.org)

Effects of Capital Requirements on Banks’ Balance Sheets: Causal Evidence from Qualifying Trust-Preferred Securities

The Dodd-Frank Act stipulated that the inclusion of trust preferred securities in tier 1 capital by institutions with over $15 billion in assets must be phased out by 2013. Employing an empirical, regression discontinuity approach, this paper examines how banks responded to the more stringent capital requirements implied by this rule. The analysis finds that banks just above the $15 billion threshold lowered their reported tier 1 capital and total consolidated assets each year from 2014 to 2018. These findings indicate that “tighter capital requirements caused affected banks to shrink in size.” Effects of Capital Requirements on Banks’ Balance Sheets: Causal Evidence from Qualifying Trust-Preferred Securities (papers.ssrn.com)

Bank Sentiment and Loan Loss Provisioning

The switch to the Current Expected Credit Loss framework for loan loss provisioning by banks implies reliance on forward-looking projections of loan losses that depend, in part, on discretionary modeling assumptions or other discretionary choices by bank managers. This paper argues that the discretionary aspects of the framework insert subjective elements into loss provisioning. It tests this hypothesis by assessing the impact of bank managerial sentiment on loan loss provisioning. The analysis uses various large-language models to extract banks’ sentiment measures from their 10-K filings and finds that “banks with more negative sentiment increase their loan loss provisions above the level warranted by key economic fundamentals and their future loan charge-offs.” Moreover, banks with more excess sentiment-driven loan loss provisions reduce their lending in the future, with this effect being more pronounced during the recessionary periods, which suggests that “sentiment can amplify the counter-cyclicality of loan loss provisions and the pro-cyclicality of bank lending.” Overall, “the findings suggest that the discretion-based loan loss provisioning driven by bank sentiment can exacerbate the pro-cyclicality of bank lending.” Bank Sentiment and Loan Loss Provisioning (papers.ssrn.com)

The Failure of the Bank of the Commonwealth: An Early Example of Interest Rate Risk

This article offers a historical case study of the collapse and subsequent bailout of the Detroit-based Bank of the Commonwealth in 1972, which resembles the 2023 failures of Silicon Valley Bank and First Republic. One stated goal of the article is “to provide a more complete picture of Commonwealth’s rise and fall than exists in the literature.” Another is to compare the similarities and differences between the Commonwealth failure and the two more recent ones. Both Commonwealth and SVB had tripled in size in just a few years; both invested in long-duration, fixed-rate securities; and both had unstable funding bases, which were contributing factors to their failure. One key difference is that the Bank of the Commonwealth was dependent on wholesale sources of funding and price-sensitive out-of-market time deposits, while SVB and First Republic were dependent on uninsured deposits. As described in the article, the late 1960s and the 2021–2023 period were both marked by increased inflation and tight monetary policy, so comparisons of bank failures across these two periods are of particular interest. The Failure of the Bank of the Commonwealth: An Early Example of Interest Rate Risk (clevelandfed.org)

Why Do Net Interest Margins Behave Differently across Banks as Interest Rates Rise?

Rising market interest rates can influence bank profitability positively or negatively through their impact on net interest margins. Rising market rates can reduce margins and profitability by requiring banks to pay higher deposit rates, or they can increase them through higher payments from borrowers with floating-rate loans. This article explores the effects on bank profitability of the Federal Reserve’s rate increases during 2022-23. The analysis demonstrates that differences in NIMs across banks widened over this period, largely reflecting banks’ underlying business models. In particular, “margin-decreasing” banks had greater capital markets involvement, “with higher shares of trading assets and non-deposit funding even prior to the rate hike cycle”, such that the declines in NIMs at these banks were tied to the rising cost of their non-deposit funding. The analysis further indicates that these margin-decreasing banks have increased their exposure to commercial real estate (CRE) post-pandemic, making them relatively more exposed to CRE concentration risk. Why Do Net Interest Margins Behave Differently across Banks as Interest Rates Rise? – Federal Reserve Bank of Kansas City (kansascityfed.org)

Measuring Homeownership Sustainability for First-Time Homebuyers

In general, research on homeownership has focused on static, cross-sectional analysis, with little attention to transitions in or out of homeownership or to what happens after a home is sold. This paper examines the paths of ownership and mortgage activity of first-time homebuyers over time, relying on a nationally representative panel. In particular, the analysis develops three new, dynamic measures of homeownership “sustainability”: current homeownership, time until first exit from homeownership and cumulative time since first purchase that individuals have remained owners. The analysis finds that FTHBs tend to remain homeowners through time. Moreover, across all three measures and “across all homeowner demographics like race or ethnicity, regions of the country, and mortgage lending submarkets,” the persistence of ownership has increased over time. Working Paper 24-02: Measuring Homeownership Sustainability for First-Time Homebuyers | Federal Housing Finance Agency (fhfa.gov)

The Evolution of Banking in the 21st Century: Evidence and Regulatory

This study builds on an examination of banking industry trends over the past 25 years to assess how regulators should respond to the persisting risk of bank runs and failures that drove the three large bank failures in the spring of 2023. The analysis shows that on the liability side, bank deposits — especially uninsured deposits — have grown rapidly. On the asset side, there has been a significant shift from traditional bank lending towards longer-term securities such as MBS and long-term Treasuries. Moreover, banks with the most rapid growth in deposits have had the biggest declines in loans as a share of assets. Thus, the analysis demonstrates that “while the banks that failed in early 2023 were arguably extreme cases, they reflect broader trends, especially among larger banks.” In addition, the study highlights expanding deposit insurance and strengthening liquidity regulation as the main regulatory options to reduce the risk of destabilizing bank runs. It argues — on the basis of the documented trends — in favor of the latter option, and suggests modifying the liquidity coverage ratio to require banks to pre-position sufficient collateral at the Federal Reserve’s discount window to ensure that they have enough liquidity to withstand a run on their uninsured deposits. Some implications for interest rate risk regulation and merger policy are also discussed. The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications (brookings.edu)

Chart of the Month

recent trends in loans and securities at commercial banks

The chart plots the annualized growth rates of loans and securities at commercial banks in the post-COVID period. Following the Federal Reserve’s decision to raise interest rates in response to the economic recovery and rising inflation concerns, banks’ holdings of securities initially experienced a period of contraction. However, in recent months, securities growth has rebounded and turned positive, suggesting that banks are adjusting their balance sheets. Despite the sharp rise in interest rates, loan growth has remained in positive territory, albeit at a slower pace compared to the earlier stages of the post-COVID recovery.

Featured BPI Research

An Analysis of Credit Card Pricing Disparities Between Large and Small Issuers

The article critiques a report from the Consumer Financial Protection Bureau that finds significant interest rate disparities between large credit card issuers and smaller ones. Utilizing data from the Terms of Credit Card Plans survey, the CFPB concludes that smaller issuers offer substantially lower interest rates. The BPI analysis demonstrates, however, that the CFPB’s approach is seriously flawed. These shortcomings include the lack of differentiation between small banks and credit unions, the failure to account for specialty card programs and the failure to adequately control for credit score ranges and credit limits. Utilizing the most recent data available from the TCCP survey and conducting a more rigorous analysis, the article demonstrates that the APR differences between large and small issuers are mostly accounted for by special features of credit unions and the effects of card program type and credit risk profile. The article concludes by questioning the representativeness of the TCCP data for smaller issuers, suggesting that the CFPB’s findings may overstate the availability of lower-rate cards from smaller issuers. An Analysis of Credit Card Pricing Disparities Between Large and Small Issuers – Bank Policy Institute (bpi.com)

The Federal Reserve Board’s 2024 Stress Test and the Comment Letter that Never Was: How the 2024 Macroeconomic Scenario Violates the Board’s Own Guidance

The Federal Reserve’s annual stress test estimates a bank’s losses and capital decline under hypothetical macroeconomic and market shocks. The results of the stress tests are used to set a capital charge on large banks. This blog post examines this year’s stress test scenarios, focusing on the increase in the unemployment rate, the decline in real GDP and other macroeconomic indicators. The post argues that the 2024 scenarios deviate significantly from historical economic downturns and fail to adhere to the Federal Reserve’s own guidelines. For instance, the projected increase in unemployment and decline in real GDP are much more abrupt than observed in past severe recessions. The post also points out that these hypothetical scenarios have been established without prior notice and public comment, which violates the Administrative Procedure Act. The article concludes by urging the Federal Reserve to align future stress test scenarios more closely with historical recession patterns to enhance the credibility of the process and the resulting capital charges. The Federal Reserve Board’s 2024 Stress Test and the Comment Letter that Never Was: How the 2024 Macroeconomic Scenario Violates the Board’s Own Guidance – Bank Policy Institute (bpi.com)

Collateral Sharing Arrangements Between Federal Home Loan Banks and Federal Reserve Banks

The blog post gives a quick review of how Federal Reserve Banks and Federal Home Loan Banks divide up each FHLB member bank’s collateral, which is particularly relevant given the recent heightened attention on discount window collateral. The post points out that the relevant FHLB and FRB enter into a unique collateral-sharing agreement for each borrowing commercial bank, and notes that at the end of 2023, FHLBs had outstanding advances to more than half of all banks. As collateral for their borrowing from FHLBs and FRBs, banks pledge loans in addition to securities, and both FHLBs and FRBs only lend against collateral in which they have a perfected security interest. The discussion also highlights that FHLBs commonly utilize blanket lien agreements, which may result in a relatively large percentage of commercial bank assets being encumbered. The discussion emphasizes the need to address such complexities as efforts to encourage banks to maintain generous amounts of collateral prepositioned at the discount window progress. Collateral Sharing Arrangement Between Federal Home Loan Banks and Federal Reserve Banks – Bank Policy Institute (bpi.com)

Conferences & Symposiums

3/29/2024
Macroeconomics and Monetary Policy Conference
Federal Reserve Bank of San Francisco
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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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4/12/2024
2024 State-of-the-Field Conference on Cyber Risk to Financial Stability
Federal Reserve Bank of New York
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4/12/2024
2024 Fintech Conference: The Evolution of Fintech, AI, Payments, and Financial Inclusion
Federal Reserve Bank of San Francisco
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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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4/18/2024 – 4/19/2024
Cowles Foundation Conference on Rethinking Optimal Deposit Insurance
Yale University
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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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5/19/2024 – 5/22/2024
2024 Financial Markets Conference: Central Banking in the Post-Pandemic Financial System
Federal Reserve Bank of Atlanta
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5/21/2024
Governance and Culture Reform Conference
Federal Reserve Bank of New York
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6/5/2024 – 6/7/2024
OCC Bank 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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6/14/2024
University of Maryland and Federal Reserve Board Short Term Funding Markets Conference: Announcement and Call for Papers
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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9/19/2024 – 9/20/2024
FDIC Bank Research Conference: Announcement and Call for Papers
Arlington, VA
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10/1/2024 – 10/2/2024
2024 Conference on Technology-Enabled Disruption
Federal Reserve Bank of Atlanta
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10/24/2024 – 10/25/2024
Inflation: Drivers and Dynamics 2024 Conference
Federal Reserve Bank of Cleveland
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10/24/2024 – 10/25/2024
Workshop on Changing Demographics and Housing Demand: Announcement and Call for Papers
Federal Reserve Bank of Philadelphia
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11/21/2024 – 11/22/2024
2024 Financial Stability Conference: Emerging Risks in a Time of Interconnectedness and Innovation
Federal Reserve Bank of Cleveland
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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.