Research Exchange: May 2024

Selected Outside Research

Bank Geographic Diversification and Funding Stability

This paper presents new evidence on the benefits associated with geographic diversification of bank branch networks. Greater geographic diversification of banks’ deposit bases is found to be associated with greater cross-sectional variation in deposit growth rates but with lower volatility of growth rates over time, implying more stable funding. The analysis further shows that the improved funding stability enables increased liquidity creation, including more small business lending, and it reduces bank risk. These benefits of geographic diversification are “distinct from previous findings on the benefits of diversification on banks’ asset side.” https://ssrn.com/abstract=4788627

Interest Rate Risk Regulation and Bank Lending: A Regression Discontinuity Approach

Recent changes to regulation of banks’ interest rate risk in Germany require banks to conduct interest rate stress tests as part of the supervisory review process, with the aim of identifying banks that carry high interest rate risk. Banks identified as belonging to the high-risk category are then subject to intensified supervisory monitoring and to capital surcharges. This paper assesses the potentially unintended effects of this regulation on bank lending. Increases in supervisory monitoring are found to have no material effect on lending behavior. However, the mandatory capital surcharges for high interest rate risk cause banks to decrease lending activity, especially with respect to loans with longer maturities. https://ssrn.com/abstract=4811267

Stress Testing Lessons from the Banking Turmoil of 2023

The recent turmoil in the banking system, as reflected in the failure of several high-profile institutions that were subject to bank runs, revealed weaknesses in the current regulatory stress testing and capital regime according to this paper, which argues for a reevaluation of the stress tests. Specifically, the paper offers four recommendations for enhancing the stress tests: 1. a wider spectrum of scenarios to investigate a larger array of risks; 2. transparent assessment of the stressed fair market value of all securities on the banks’ balance sheets; 3. attention to funding and liquidity risk as a component of stress tests; 4. expanding the set of banks subjected to the stress test. https://ssrn.com/abstract=4811157

Transformation of Activities and Risks between Bank and Non-Bank Financial Intermediaries

This paper examines the implications for financial stability regulation of nonbanks having grown to play a larger financial intermediation role than banks globally while remaining less tightly regulated. The paper argues that there is an entanglement of intermediation activities and risks between nonbank and bank financial intermediaries that regulators must recognize and adapt to if systemic risks are to be effectively mitigated. Their operations should be seen as mutually influential as opposed to merely parallel. Important interrelationships are present in corporate and mortgage lending, short-term funding and contingent funding activities, as well as the growth of bank loans to such intermediaries. Transformation of activities and risks between bank and non-bank financial intermediaries | CEPR

Private Debt versus Bank Debt in Corporate Borrowing

Recent growth in nonbank private debt financing alongside the longstanding utilization of bank debt in corporate borrowing, and the resulting high rate of private companies leveraging both types of debt, warrant investigations into how the two types of debt interact with one another. This study conducts such an analysis, using administrative data on U.S. bank loans combined with data on U.S. nonbank private debt deals. The study documents that about half of private debt borrowers in the U.S. also rely on bank loans and that these dual borrowers “are typically larger, riskier middle market firms, with fewer tangible assets”. The analysis also finds that relative to banks, private debt lenders provide larger loans, while banks provide more senior loans, often through credit lines. When corporate borrowers add bank debt after an initial financing from private debt, the bank debt will come with higher spreads.  https://ssrn.com/abstract=4821158

Deposit Insurance and Bank Funding Stability: Evidence from the TAG Program

During the 2008 financial crisis, the FDIC implemented the Transaction Account Guarantee program, which provided full insurance coverage on noninterest-bearing transaction accounts until Dec. 31, 2010. It was one of the few federal support programs available to small banks. This study examines the effects of the program’s unlimited insurance guarantee and finds that banks that decided to opt out of the program experienced major and persistent declines in noninterest-bearing deposits. Conversely, slow growth in NIBDs decreased the likelihood of banks opting out of TAG, presumably because of confidence that the unlimited deposit insurance would attract more NIBD funds. The results of the study support the notion that targeted deposit insurance protections can successfully stem deposit outflows during periods of instability in bank deposit markets. Deposit Insurance and Bank Funding Stability: Evidence from the TAG Program (fdic.gov)

Bank Runs and Interest Rates: A Revolving Lines Perspective

Both sudden withdrawals of deposits and widespread drawdowns from corporate revolving credit lines have the potential to destabilize the banking sector. This paper analyzes drawdown behavior using regulatory data collected for stress testing purposes to assess the risks that corporate revolving credit lines in the U.S. may pose to financial stability. The analysis finds that credit line utilization is highly sensitive to movements in interest rates, and that the potential for a run on credit lines is greatest during periods when precautionary motives are high (due to uncertainty about continued access to credit lines) and interest rates have been declining. A revolving line run becomes less likely during periods characterized by higher interest rates. In addition, the analysis shows that banks with a higher threat of deposit outflows in response to interest rate increases historically faced a lower threat of revolving line drawdowns because their drawdowns are less interest-sensitive. https://ssrn.com/abstract=4827005

Risk-averse Dealers in a Risk-free Market – The Role of Internal Risk Limits

Dealers in the U.S. Treasury market operate under self-imposed risk appetite thresholds. This paper examines the effects of these thresholds using granular and high-frequency regulatory data on U.S. dealers’ trading desk positions and desk-level risk exposures. The analysis finds that dealers are significantly more likely to reduce their positions as they approach their risk limits, which suggests that it is costly for traders to breach the limits. The analysis also finds that traders sell longer-term securities to distance themselves from the limits and require increased compensation for getting closer to the limits. Thus, the study demonstrates that self-imposed risk limits can explain risk-averse behavior by dealers and that policy prescriptions such as deregulation “may not be sufficient to induce risk-taking by dealer intermediaries in times of crisis.” https://ssrn.com/abstract=4824250

Commercial Real Estate and Bank Systemic Risk

This paper presents a detailed analysis of the aggregate default risk exposure of U.S. banks’ commercial real estate loan portfolios based on year-end 2023 bank regulatory data. The analysis suggests that due to the lack of demand for commercial properties, prolonged elevated interest rates and the increases in CRE loan concentration at many banks, the banking system currently faces significant potential for a wave of CRE defaults, implying significant systemic risk. The paper concludes that these defaults “could render a very large number of banks market value insolvent” and lead to a resulting wave of bank failures that may “test the public’s confidence” and stretch resources of the federal deposit insurance safety net. https://www.aei.org/articles/commercial-real-estate-and-bank-systemic-risk/

Tracing Bank Runs in Real Time

This paper uses data on high-frequency interbank payments to trace the movement of deposits in March 2023 and identify banks that suffered a run on deposits and investigate the nature of these runs. The analysis finds that “twenty-two banks suffered a run, significantly more than the two that failed but fewer than the number that experienced large negative stock returns.” Additionally, the analysis finds that the runs were driven by large (institutional) depositors, as opposed to small (retail) depositors, where the running depositors “disproportionately flee to the largest banks with assets over $250 billion”. Public signals appeared to play an important coordinating role in that run banks were disproportionately publicly traded. The analysis also sheds light on how banks survived runs, documenting that banks “shore up liquidity with new borrowing instead of asset sales” and that they “prefer borrowing from Federal Home Loan Banks (FHLBs) over borrowing from the Federal Reserve’s lender-of-last-resort facilities.” These findings call into question “the assumptions underlying liquidity regulations, which implicitly offset runnable liabilities with liquid assets including securities.” sr1104.pdf (newyorkfed.org)

Reconsidering the Regulatory Uses of Stress Testing

This article assesses the effectiveness of the annual regulatory stress tests that are currently used to set minimum capital requirements for large banks. Its objective is “to prompt a policy debate on whether stress testing should remain the basis for large bank minimum capital requirements in the United States”. It argues that the stress testing framework has become overly “routinized and predictable”, lacking the “dynamism required to realize the benefits of stress testing”. The article first provides background on how the stress testing regime has evolved since its first historical implementation, and then examines the advantages and limitations of the current use of annual stress testing to determine the minimum capital requirements of large banks. It then presents policy options for the role of stress testing going forward. WP92_Tarullo-stress-testing.pdf (brookings.edu)

Chart of the Month

This table summarizes results from a pilot climate stress testing exercise undertaken by six major banks to assess their ability to measure climate risks. Shown here are the average projected credit risk effects on the banks’ residential and commercial lending exposures from the two physical risk (extreme weather) scenarios included in the exercise—a common scenario specified for all banks and bank-specific (idiosyncratic) scenarios. These projected probability-of-default increases are minimal when compared to those arising from the annual CCAR stress tests. (Source: BPI blog post on the Federal Reserve’s pilot climate scenario exercise, summarized below.)

Featured BPI Research

Basel III Endgame: Why a Comprehensive Quantitative Impact Analysis and Reproposal are Essential

The Basel III Endgame proposal aims to enhance banking stability through stricter capital requirements but exhibits significant procedural and analytical shortcomings. The agencies prematurely released the proposal without providing the necessary quantitative impact study data for public comment, violating the Administrative Procedure Act’s requirements. The proposal excludes a role for banks’ internal models for credit risk, increases capital requirements for mortgages and consumer loans without proper justification and overlaps with existing stress tests, leading to duplicative charges. Lack of consideration of the shift of credit intermediation from bank to nonbank financial institutions represents another salient flaw, along with a need for general evaluation of the broader economic implications of stricter capital requirements. To correct these issues, the agencies must release a comprehensive QIS analysis and repropose the rule based on its findings and public feedback received. The reproposed rule should include a comprehensive justification for the proposed changes and address the shortcomings of the original proposal and should provide a balanced regulatory framework that enhances financial stability without unnecessarily burdening banks and their customers. Basel III Endgame: Why a Comprehensive Quantitative Impact Analysis and Reproposal are Essential – Bank Policy Institute (bpi.com)

Mergers Involving GSIBs Do Not Inherently Increase Financial Stability Risk

A well-designed merger policy is essential for fostering a dynamic and competitive banking system. Mergers can help banks spread fixed costs, such as technology investments, over larger revenue volumes. However, recent proposals by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation impose new thresholds that effectively restrict mergers involving global systemically important banks and large regional banks without providing a transparent empirical support. Contrary to these proposals, BPI’s analysis shows that mergers involving GSIBs and large regional banks can reduce systemic risk, especially when the target bank has a strong retail deposit base. This is because such mergers lower the combined entity’s reliance on short-term wholesale funding. This suggests that the proposed arbitrary asset caps and presumptions of disapproval are not justified. Rather, merger policies should be informed by data-driven analysis and the specific characteristics of the merging banks. Mergers Involving GSIBs Do Not Inherently Increase Financial Stability Risk – Bank Policy Institute (bpi.com)

The Fed Pilot Climate Scenario Analysis Exercise: A Review

In September 2022, the Federal Reserve mandated six major banks to undertake a pilot climate scenario exercise to assess their ability to measure climate risks. The exercise included both physical risk scenarios involving extreme weather events affecting residential and commercial credit exposures, and transition risk scenarios predominantly affecting corporate and commercial real estate loans. Results of the exercise, released in early 2024, showed that climate risks do not reach the severity of capital-level risks and do not pose systemic threats to the financial system. The post argues that consequently, “there is no reason for the regulatory authorities to elevate these risks into a special category, such as in the recent Pillar 3 disclosure requirements proposed by the Basel Committee.” The Fed Pilot Climate Scenario Analysis Exercise: A Review – Bank Policy Institute (bpi.com)

Is the Subprime Segment of the Credit Card Market Concentrated?

A recent criticism of the proposed Capital One acquisition of Discover Financial Services is that the deal would raise the concentration of the credit card market to a level that is potentially anti-competitive, if subprime borrowers were considered in a separate category. According to this view, subprime borrowers – those with lower credit scores and higher-risk credit profiles – would be more vulnerable to price increases through higher fees and interest rates because they would have fewer options available to them than borrowers presenting lower credit risk. This post examines the proposed merger’s impact on concentration in the subprime and prime segments of the credit card market, based on more comprehensive data than relied on by previous commentators that more fully accounts for card issuers with a major presence in the subprime market. The analysis shows that even if subprime is considered a separate market (although there is little reason to think it should be) for evaluating the competitive effects of the proposed merger, concentration would not rise to a level that raises competitive concerns. Is the Subprime Segment of the Credit Card Market Concentrated? – Bank Policy Institute (bpi.com)

Conferences & Symposiums

6/5/2024 – 6/7/2024
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
7th Annual Short-Term Funding Markets Conference
Federal Reserve Board and University of Maryland
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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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6/21/2024
New York Fed-ECB Workshop on Non-Bank Financial Institutions
Federal Reserve Bank of New York
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7/8/2024
9th Annual Cambridge Conference on Alternative Finance
University of Cambridge, England
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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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8/9/2024
Yale Program on Financial Stability Annual Research Conference: Announcement and Call for Papers
Yale University
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9/19/2024 – 9/20/2024
23d Annual Bank Research Conference: Announcement and Call for Papers
FDIC Center for Financial Research
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10/1/2024 – 10/2/2024
Conference on Technology-Enabled Disruption 
Federal Reserve Bank of Atlanta
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10/11/2024 – 10/12/2024
Federal Reserve Stress Testing Research Conference: Announcement and Call for Papers
Federal Reserve Bank of Boston
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10/18/2024 – 10/19/2024
The 10th Anniversary Wharton Conference on Liquidity and Financial Fragility: Announcement and Call for Papers
Philadelphia
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10/24/2024 – 10/25/2024
Workshop on Changing Demographics and Housing Demand
Federal Reserve Bank of Philadelphia
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10/24/2024 – 10/25/2024
Inflation: Drivers and Dynamics
Federal Reserve Bank of Cleveland
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11/21/2024 – 11/22/2024
Conference on Financial Stability: Announcement and Call for Papers
Federal Reserve Bank of Cleveland and Office of Financial Research
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11/22/2024
Pacific Basin Research Conference
Federal Reserve Bank of San Francisco 
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11/25/2024 – 11/26/2024
III CEMLA-Dallas Fed-IBEFA Workshop on Financial Stability: Announcement and Call for Papers
Mexico City
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11/26/2024
10th Annual U.S, Treasury Markets
Federal Reserve Bank of New York
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12/5/2024 – 12/6/2024
The Evolving Structure of the Financial Services Industry: Announcement and Call for Papers
Federal Reserve Bank of Atlanta and Georgia State University
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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.