Research Exchange: May 2022

Selected Outside Research

Does the Current Expected Credit Loss Approach Decrease the Procyclicality of Banks’ Lending?

The Current Expected Credit Loss approach to accruing reserves for credit losses, adopted by the Financial Accounting Standards Board in the wake of the financial crisis, applies a front-loaded recognition of loan losses that proponents argued would decreases banks’ lending procyclicality. This paper provides the first, direct empirical assessment of this aspect of CECL, using data from the FR Y9-C filings of U.S. bank holding companies for the 13 quarters from 2018Q1 to 2021Q1 along with manually collected data on banks’ CECL adoption status as of the first quarter of 2020. The analysis finds that banks that adopted CECL prior to the COVID-19 pandemic reduced loan growth during the accompanying recession more than other banks, and that this effect is stronger for adopting banks with low regulatory capital. The analysis also demonstrates that adopting banks increased their loan loss provisions during the recession more than other banks. The results are consistent with the CECL approach increasing banks’ lending procyclicality. Read More ⇨

The Digital Transformation in the Italian Banking Sector

Using a survey of almost 280 Italian banks, this paper examines the digital transformation of the Italian banking sector between 2007 and 2018. In particular, the paper develops a composite indicator of the digital supply of financial services and examines the correlations between the degree of digitalization, bank profitability and the structure of the branch network. The analysis finds that the adoption of digital technologies, which accelerated after 2013, started in payment services and then spread to asset management, but has lagged in lending. In addition, the analysis shows that “digitalization is positively correlated with bank profitability and negatively correlated with the number of branches.” The latter relationship provides evidence of substitutability between physical branches and digital channels. Read More ⇨

Cryptocurrencies and Decentralized Finance

This paper presents an overview of cryptocurrencies and decentralized finance and describes their potential benefits and limitations in comparison to traditional financial intermediation structures. The discussion highlights that “the DeFi architecture might have the potential to reduce transaction costs, similar to the traditional financial system.” However, “endogenous constraints to competition” can arise from network externalities and economies of scale, as well as at the customer level from lack of financial sophistication or behavioral biases of some consumers. Moreover, “the permissionless and pseudonymous design of DeFi generates challenges for enforcing tax compliance, anti-money laundering laws and preventing financial malfeasance.” The paper also suggests ways to regulate DeFi system that may preserve most of benefits of the underlying blockchain architecture. Read More ⇨

Cyberattacks and Financial Stability: Evidence from a Natural Experiment

First- and second-round effects of a unique, multi-day, cyberattack incident on a technology service provider are examined in this paper using confidential, daily data. In the first round, the ability of banks that directly relied on the subject provider to send payments over Fedwire became impaired, despite the Federal Reserve extending the time those banks had to submit payments. This caused a second-round effect whereby other banks received fewer payments. In this second round, banks  with sufficient reserves drew their reserves down, while among those lacking sufficient reserves, smaller banks borrowed from the discount window and larger banks borrowed in the federal funds market. These responses prevented the second-round effect from spilling over into broader financial instability. The findings “highlight the important role for bank contingency planning, liquidity buffers and the Federal Reserve in supporting the financial system’s recovery from a cyberattack.” Read More ⇨

Enhancing Stress Tests by Adding Macroprudential Elements

This paper argues that the macroprudential goals of stress tests could be significantly enhanced by incorporating elements that project spillovers across individual institutions. The paper develops two examples of how this can be accomplished. The first example uses a simple exogenous shock to the cost and availability of short-term wholesale funding. The second incorporates spillovers between the health of participating banks and the cost of short-term wholesale funding to generate a dynamic shock that responds to the evolution of bank-capital and GDP growth over the projection horizon. Other models of spillovers, including fire sales and the feedback between the macroeconomy and the financial system, also are discussed. The paper emphasizes the need for balancing “the benefits of promoting new macroprudential goals” against “costs of increased complexity or the potential to inhibit the goals that are promoted by existing macroprudential elements.” Read More ⇨

Climate Regulatory Risk and Corporate Bonds

This paper tests the hypothesis that corporate bond risk assessment and pricing are affected by investor concerns about firms’ exposure to climate and other environmental regulatory risks. The analysis demonstrates that “firms with poor environmental profiles or high carbon footprints tend to have lower credit ratings and higher yield spreads, particularly when their facilities are located in states with stricter regulatory enforcement.” In addition, using the Paris Agreement as a shock to investors’ expectations regarding climate-risk regulation, the analysis provides evidence that “climate regulatory risks causally affect bond credit ratings and yield spreads, and that the composition of institutional ownership also changes after the Agreement. Read More ⇨

Tracing Banks’ Credit Allocation to their Funding Costs

Direct and indirect effects of banks’ funding costs on their lending behavior is examined in this study. For identifying these effects, the analysis uses administrative credit-registry data and regulatory bank data from France and “exploits banks’ heterogeneous liability structure and the existence of regulated deposits in France whose rates are set by the government.”  The study finds that a one percentage-point increase in funding costs reduces credit by 17%. In addition, the analysis suggests that  banks reach for yield and rebalance their lending towards smaller and riskier firms when faced with an increase in funding costs, with corresponding effects on firms’ aggregate investment. Read More ⇨

Central Bank Digital Currency and Banks

This paper discusses how introducing a central bank digital currency may affect bank deposit-taking and lending. A dynamic model that quantifies the importance of several frictions and symmetries between deposit-taking and lending in determining the impact of a CBDC is developed and estimated. The model suggests that a “CBDC can replace a significant fraction of bank deposits, especially when it pays interest” but that “CBDC has a much smaller impact on bank lending because banks can replace a large fraction of any lost deposits with wholesale funding.” Substitution to wholesale funding, however, “makes banks’ funding costs more sensitive to changes in short-term rates, increasing their exposure to interest rate risk.” The analysis also demonstrates that a CBDC amplifies the impact of monetary policy shocks on bank lending. Read More ⇨

Does Automated Collateral Evaluation Lower Mortgage Credit Risk Relative to Home Appraisal Valuations?

This paper examines differences in the credit risk of mortgages originated using automated valuation models relative to those originated using traditional appraisals, by modeling conditional default rates in relation to the appraisal channel. The analysis relies on data from Freddie Mac, which distinguishes loans originated through Freddie Mac’s Automated Collateral Evaluation (ACE) program form those originated with appraisals. The analysis demonstrates that ACE loans have about 9.6% lower default risk in comparison to otherwise similar loans originated with appraisals, and attributes this superior default performance to the AVM process employing data beyond that found in a traditional appraisal, and the more efficient utilization of available information through statistical modeling. Read More ⇨

Does Giving CRA Credit for Loan Purchases Increase Mortgage Credit in Low-to-Moderate Income Communities?

The Community Reinvestment Act obligates banks to meet the credit needs of low- and moderate-income communities, and this obligation can be met either directly through loan originations or by purchasing (and thereby funding) loans made by others. This paper evaluates whether offering banks CRA credit for loan purchases has increased the availability of mortgage credit. The analysis shows that while banks are more like to purchase loans financing properties in low- or moderate-income neighborhoods, these purchases do not translate into increased overall lending. Read More ⇨

Chart of the Month

Selected sources of the change in the number of insured depository institutions
As shown in the chart above, the pace of new bank creation has dropped essentially to zero since the Global Financial Crisis, (reportedly as a result in part of increased regulatory compliance costs), while the annual reduction in the number of banks owing to mergers stepped down after the wave of interstate consolidation subsided.

Featured BPI Research

How Has the Size Distribution of Banks Evolved Over the Last 30 Years?

The FDIC is currently analyzing the effectiveness of existing policies governing the merger of insured depository institutions. The results of their analysis indicate bank mergers have been the dominant force driving the shift in the size distribution toward larger banks over the past 30 years. This note shows that the FDIC analysis contains an important methodological flaw that results in a material overstatement of the increase in the number of large banks over the past 30 years. In addition, it demonstrates that the collapse of entry into banking has been an important driver of the decline in the number of smaller banks, a development the FDIC analysis does not mention. Read More ⇨

Financial Stability Considerations for Bank Merger Analysis

Since enactment of the Dodd-Frank Act in 2010, the federal banking agencies have been required by statute to consider risks to financial stability when evaluating proposed bank mergers and acquisitions. The agencies have not issued regulations to define an approach to evaluating financial stability effects but have discussed the financial stability factors in public orders reviewing proposed mergers. This note describes those orders and outlines a more comprehensive approach for conducting a systematic analysis of financial stability effects for future reviews. Read More ⇨

Obstacles to Household Financial Inclusion: Do Branch Accessibility and Bank Size Matter?

This research note conducts a detailed examination of recent patterns and trends in household financial inclusion across U.S. urban areas (metropolitan or micropolitan statistical areas) and across rural portions of states. It explores the factors associated with variation across geographic areas in the proportion of households that are unbanked, defined as no one in the household having a checking or savings account at a bank or credit union. In addition, it examines whether evolving accessibility of bank branches or a changing mix of large versus small banks helps explain why some localities saw greater improvement in financial inclusion between 2013 and 2019 than others. The analysis indicates that neither a reduction in bank branches nor an increase in the proportion of branches owned by large banks over this period has a material effect on household financial inclusion. Consistent with the notion that mobile banking promotes financial inclusion, change in percent unbanked is inversely related to the change in share of households with a smartphone. Read More ⇨

Lax Supervision of Fintechs Harms Consumers

The CFPB recently announced it will ramp up supervision of nonbank financial firms to help protect consumers and level the regulatory playing field between banks and nonbanks. Investigative reporting, complaints and survey data and recent lawsuits demonstrate harmful aspects of consumers’ experience with neo-banks (fintechs that offer deposit-type banking services on the internet) and with fintech lenders. In addition, new research papers by academic economists and legal scholars provide even more rigorous evidence of potential harm to consumers. This note reviews the evidence on problematic aspects of the consumer experience, offering a preliminary blueprint for heightened supervision of fintech firms. Read More ⇨

How To Measure The Change In Financial Stability Risk Resulting From a Merger: Some Technical Considerations

This note breaks down some technical considerations on how to compare the financial stability risks of two banks before a merger to the potential risks posed by the bank created by the merger. The comparison uses the “expected systemic cost of failure” – which is simply the probability of failure times the systemic cost of failure (SCF). In particular, the sum of the expected SCF of each of the two merging banks should be compared with the expected SCF of the merged entity. An alternative approach would be to ignore the probability of failure and simply assess whether the SCF (not the expected SCF) of the merged entity exceeds some threshold, but such an approach would be incorrect. 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.