Research Exchange: November 2023

Selected Outside Research

Effects of Bank Capital Requirements on Lending by Banks and Nonbank Financial Institutions

This paper looks at spillover effects of bank capital regulation and the resulting overall distribution of risks. Specifically, the paper uses German credit registry data to examine the effects on the unexpected and significant increase in bank capital requirements imposed by the European Bank Authority (EBA) within the capital exercise framework in 2011 on lending activity of directly affected banks and of nonbank financial institutions (NBFIs). The analysis finds that after the capital exercise, NBFIs expand their corporate lending activity relative to EBA banks. This observed substitution towards NBFI funding is more pronounced in riskier and more competitive borrower segments. https://ssrn.com/abstract=4630645

Merchants of Death: The Effect of Credit Supply Shocks on Hospital Outcomes

Hospitals in the U.S. often rely on bank borrowing for their financing needs. This study exploits the U.S. bank stress tests as “exogenous shocks to credit access for hospitals that have lending relationships with tested banks” to assess the impact of credit shocks on hospital operating decisions and on patient health outcomes. First, it presents evidence that bank stress tests constitute a negative credit shock to their hospital borrowers, including by demonstrating that loan spreads increase while loan amounts and maturity periods decrease for affected hospitals. The analysis then compares operating decisions and patient health outcomes between affected hospitals and those that did not experience a credit shock and finds that affected hospitals shift their operations to increase resource utilization but reduce the quality of their care to patients across a variety of measures. The study concludes that “access to credit can affect the quality of healthcare hospitals deliver.” https://ssrn.com/abstract=3834149

Where Do Banks End and NBFIs Begin?

Banks and nonbank financial intermediaries (NBFIs) often are viewed as substitutes, such that expansion of the NBFI sector implies a shift of financial risks to NBFIs from banks. In contrast, this paper argues that banks and NBFIs have “interwoven businesses and risks”, and that systemic risk regulation must recognize this interdependence. In particular, regulation must consider the special role banks play as liquidity providers to NBFIs, whereby they are “effectively responsible for supporting NBFI intermediation activities through stress conditions.” The paper supports these assertions with new data and with a review of various case studies, and theoretical and empirical research studies. In particular, the Federal Reserve System’s new “From Whom to Whom” data are used to show that banks and NBFIs finance each other, with NBFIs especially dependent on banks. In addition, the paper reviews various case studies and data demonstrating that banks remain exposed to credit and funding risks that have seemingly migrated to NBFIs, and that such exposure can be on-balance-sheet or off-balance-sheet via banks’ provision of significant contingent liquidity to NBFIs. The paper concludes with a discussion of implications for macroprudential regulation. Where Do Banks End and NBFIs Begin? 

Financial Accounting and Disclosure in Banking

During banking crises, some features of the accounting system are pointed to as a potential contributing factor to the crisis. As a result, rules governing financial accounting and disclosure in the banking industry have evolved in response to crises. Recent bank failures, including three of the four largest bank failures in U.S. history (i.e., First Republic Bank, Silicon Valley Bank, and Signature Bank), have renewed concerns about accounting standards and bank regulations, particularly regarding the role of fair value versus amortized cost accounting; the effectiveness of internal controls and financial audits; loan loss provisioning; and stress test disclosure. This article reviews the recent literature on these topics. The paper focuses on research conducted primarily since the Global Financial Crisis that is related to these recurring concerns. In addition, the article discusses recent developments in econometrics related to identifying the effects of rule changes, and it suggests “potentially fruitful avenues for future research related to each of these areas.” https://ssrn.com/abstract=4611592

Contingent Credit Under Stress

The past two decades have seen an expanding supply of contingent credit in the form of bank credit lines as a primary source of corporate borrowing. This paper reviews the academic literature on bank supply of contingent credit. The discussion focuses on the rationales for banks’ provision of liquidity insurance in the form of credit lines, the significance of the lines in managing corporate liquidity, and the reasons and circumstances under which firms opt to utilize them. It highlights how “the options for firms to both draw down and repay credit lines are exercised by firms in a correlated manner during periods of widespread stress with adverse effects on bank intermediation thereafter.” The discussion also explores the bank capital and the bank funding channels that can drive such adverse effects. Additional issues examined include the expanding supply of bank credit lines to nonbank financial intermediaries and the role of stress tests and monetary policy in managing the risks of contingent credit under stress. https://ssrn.com/abstract=4625908

The Unraveling of the Federal Home Loan Banks  

The Federal Home Loan Bank (FHLB) system was created about a century ago to provide loans to thrift institutions that would post high-quality mortgages as collateral, thereby helping to support availability of mortgage credit. This paper reviews the history of the FHLB system and argues that although it worked as intended in the first decades of its existence, changes in housing finance have limited its ability to support small banks’ mortgage lending, the purpose for which it was initially designed. It has increasingly become a “lender of next to last resort” to large institutions close to failure such as SVB and Washington Mutual. Considering these facts, the author discusses ways in which the system can be reformed. The author proposes reviving the original model of the FHLB adapted to today’s financial system, so that they again primarily serve smaller financial institutions and community credit needs, which may entail broadening their mandate beyond mortgages to support of small business and community development lending. https://ssrn.com/abstract=4626125

LCR Premium in the Federal Funds Market

The liquidity coverage ratio (LCR), a regulation introduced following the Great Financial Crisis, requires banks to hold high-quality liquid assets to cover short-term funding outflows. Because it affects the attractiveness of wholesale funding, it has implications for the determination of short-term interest rates and monetary policy implementation. This paper presents evidence of a regulatory premium in the federal funds market related to the full implementation of the LCR in January 2017 using confidential bank level data on borrowing in the fed funds and Eurodollar markets. Reflecting differences in lender composition across overnight funding markets, the LCR treatment of borrowing markets varies. The analysis demonstrates that following the implementation of the LCR, banks subject to daily reporting of their liquidity profile were willing to pay higher rates for borrowing in the fed funds market, where the primary lenders are the Federal Home Loan Banks (FHLBs), which have a relatively favorable LCR treatment. In addition, “on the days that banks borrowed in both the fed funds and Eurodollar markets, daily reporters paid a higher rate than other banks for their borrowing in the fed funds market but not for their borrowing in the Eurodollar market.” The Fed – LCR Premium in the Federal Funds Market (federalreserve.gov)

The Deposit Business at Large vs. Small Banks

This paper explores whether the difference in deposit-pricing behavior between large and small banks reflects differences in customer preferences and bank technologies. In particular, the paper examines why, “despite the fact that the locations of large-bank branches have demographics typically associated with greater financial sophistication, large-bank customers earn lower average deposit rates.” A conceptual framework is developed and extensive empirical evidence is presented supporting the notion that large banks offer superior liquidity services and locate where customers value their services, thus rationalizing lower deposit rates. This explanation for differences in deposit pricing behavior between large and small banks “challenges the idea that deposit pricing is mainly driven by pricing power derived from the large observed degree of concentration in the banking industry.” https://ssrn.com/abstract=4607440

Will the Real Stablecoin Please Stand Up?

This paper reviews the evolution of stablecoins and evaluates whether stablecoins have, as they presumably are designed to do, maintained stable values over time. The analysis relies on a unique dataset covering 68 stablecoins encompassing four types: Fiat-backed, Crypto-backed, Commodity-backed, and Unbacked stablecoins. The analysis finds that none of the stablecoins examined have been able to consistently maintain parity with their peg, irrespective of a coin’s size or type of backing. It also indicates a lack of transparency regarding availability and quality of reserves held by stablecoin issuers, implying that “there is no guarantee that the stablecoin issuers have the assets required to be able to redeem the coins at all times”. In addition, the paper identifies several data gaps which would have to be filled in to fully assess the uses, users and risks of stablecoins. The authors conclude that “the stablecoins we see today do not live up to their name, nor do they meet the key criteria for being a safe store of value or a trustworthy means of payment for the real economy.” Will the real stablecoin please stand up? (BIS)

How Do Banks Lend in Inaccurate Flood Zones in the Fed’s Second District?

Flood maps delineate areas subject to comparatively high risk of a catastrophic flood (those considered to have a 1 percent annual flood risk). Being in a flood zone affects cost and availability of mortgage credit, as borrowers in a flood zone are generally required to obtain flood insurance. However, flood maps can be inaccurate due to improvements in the local infrastructure or a lack of updates. This study uses data on the accuracy of flood maps to investigate bank lending in relation to the accuracy of flood risk assessments. The analysis finds that banks seem to be aware of the level of accuracy of the maps they rely on to assess flood risk. Banks are generally less likely to lend in areas for which the maps are inaccurate, as evidenced by a marginally lower average acceptance rate for jumbo loan applicants in such areas. How Do Banks Lend in Inaccurate Flood Zones in the Fed’s Second District? (Federal Reserve Bank of New York)

Chart of the Month

This chart shows the effect of the long-term debt proposal on funding costs for Category II–IV banks. It breaks down the underestimated effects of the proposal on bank funding costs into four categories: (1) fulfilling the debt requirement at the bank subsidiary level and restoring the liquidity coverage ratio at the bank holding company level; (2) the increase in risk-weighted assets resulting from the implementation of the Basel proposal; (3) the necessity for management buffers above the minimum requirements; and (4) the application of a more precise measure of credit spreads for each bank. Taking all these factors into consideration, the total funding costs for Category II-IV banks are expected to reach $4.5 billion, which is three times the proposal’s initial cost estimate of $1.5 billion.

Featured BPI Research

Internal Models Should Be Allowed for Credit Capital Requirements

The Basel finalization proposal issued by the U.S. banking agencies would prohibit the use of internal credit risk models for setting banks’ credit risk capital requirements, based on the view that these models rely on subjective modeling assumptions and have resulted in variability of capital requirements across banks. This note reviews the evidence cited by the banking agencies to support their claim, along with other academic evidence, and finds lack of justification for disallowing the use of internal models for credit risk capital requirements. The U.S. banking agencies cite two research studies to justify the prohibition of internal models, but these studies do not support the argument that use of internal models has resulted in observed unwarranted variability of credit risk capital across banks. Additionally, other academic research has shown that regulatory supervision of internal credit risk models is indeed effective, providing no basis to the claim that banks have underestimated credit risk by using internal models. Internal Models Should Be Allowed for Credit Capital Requirements – Bank Policy Institute (bpi.com)

The Basel Proposal: What It Means for Retail Lending

This note assesses whether the capital rule proposed by the banking agencies will affect consumer cards and other consumer credit products, finding that the proposal lacks empirical support and is unduly punitive to U.S. consumers. The analysis finds that the all-in credit risk capital charge for credit cards amounts to a risk weight of 174 percent. This risk weight far exceeds the applicable risk weight under the Basel agreement and what historical loss data would support. Furthermore, the proposed credit risk capital charge for other consumer loans, as well as the treatment of operational risk for cards and other consumer loans, are also higher than what would be deemed reasonable. Therefore, the proposed rule might have significant negative effects on consumers and financial inclusion, as the excessive risk weights would drive up the cost of card borrowing and reduce the affordability of card credit. Moreover, the higher capital requirement for credit cards incorporates a substantial component for undrawn lines (which currently have zero risk weight), above what can be rationalized based on historical experience. This could lead to banks reducing credit limits on or canceling infrequently used lines, raising concerns about effects on households that maintain unused line amounts for occasional or unanticipated large expenses. The Basel Proposal: What It Means for Retail Lending – Bank Policy Institute (bpi.com)

The Federal Reserve Should Revise the U.S. GSIB Surcharge Methodology to Reflect Real Risks and Support the Economy

In this note, the authors explain how the U.S. methodology for assessing a capital surcharge on global systemically important banks (GSIBs) differs from international norms, overstating the risk presented by U.S. GSIBs and placing them at a competitive disadvantage. It also provides recommendations for appropriately calculating the surcharge, and thereby enhancing the lending capacity of these banks and enhancing liquidity in U.S. capital markets. The analysis suggests that implementing these adjustments would reduce GSIB surcharges by roughly 1 percentage point, which would expand lending and market-making capacity by over $1 trillion and boost economic growth by roughly $25 billion per year without harming bank safety and soundness. The Federal Reserve Should Revise the U.S. GSIB Surcharge Methodology to Reflect Real Risks and Support the Economy – Bank Policy Institute (bpi.com)

Statistics on Collateral Pledged to the Discount Window

This note describes and analyzes data on discount window loans provided by the Federal Reserve System for the four most recent quarters of available data, 2020Q4 to 2021Q3, focusing on the type and amount of collateral provided. The analysis finds that consumer and commercial loans make up the largest share of collateral pledged by all banks, consistent with the notion that banks use the discount window to pledge relatively illiquid assets such as consumer loans in exchange for short-term liquidity. Borrowing from the discount window by larger banks was more common compared to smaller banks over this period, and the distribution of type of collateral pledged varied by bank size. Lastly, the note compares the lendable value of discount window collateral pledged by commercial banks as a share of uninsured deposits, finding that a relatively small percentage of uninsured deposits are covered by total collateral pledged. The authors conclude that investigating the distribution of coverage would be an interesting next step in the analysis. Statistics on Collateral Pledged to the Discount Window – Bank Policy Institute (bpi.com)  

Stability Pass-through: Federal Reserve Liquidity Provision and Interbank Networks of Shadowy Banks

This research paper co-authored by BPI economist Haelim Anderson examines the historical role of the Federal Reserve System in promoting stability of the banking system through discount window lending, focusing on the specific case of liquidity provision by the Federal Reserve Bank of Richmond during the 1920-1921 recession. Using newly digitized data on interbank borrowing and deposits for Virginia state banks, the analysis shows how the Richmond Fed’s support of member banks supported financial stability more broadly. The paper documents how the Richmond Fed’s liquidity provision to members enabled them in turn to provide liquidity to nonmembers that had experienced large deposit outflows, thus preventing the mass withdrawal of interbank deposits. The analysis also finds that the banks engaged in interbank borrowing “reduced interbank deposits placed in lending banks, implying that these correspondents provided liquidity to nonmembers through both interbank loans and deposits.” https://ssrn.com/abstract=4637562

Conferences & Symposiums

2/8/2024
Symposium on the Tokenization of Real-World Assets and Liabilities
Office of the Comptroller of the Currency, Washington, D.C.
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2/29/2024
2024 Research Conference on Bank Regulation: Announcement and Call for Papers
Columbia University and Bank Policy Institute
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3/4/2024 – 3/7/2024
2024 National Interagency Community Reinvestment Conference
Portland, Oregon
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3/15/2024
Consumer Research Symposium: Announcement and Call for Papers 
Federal Deposit Insurance Corporation, Arlington, VA
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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: Announcement and Call for Papers
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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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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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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.