Research Exchange: September 2023

Selected Outside Research

Bank Capital Notice of Proposed Rulemaking: A Look at the Provisions Affecting Mortgage Loans in Bank Portfolios

The notice of proposed rulemaking on regulatory capital recently issued by the U.S. bank regulatory agencies has worrisome implications for mortgage lending to low- and middle-income (LMI), Black, and Hispanic borrowers and communities by large banks, according to the analysis presented in this report. The proposal would increase regulatory capital requirements applied to loans with loan-to-value (LTV) ratios above 80 percent, beyond what is specified by the global capital standards set by the Basel III requirements and beyond what is currently mandated. The analysis finds that the proposed capital requirements are more stringent than what is needed to maintain the safety and soundness of the financial system. In particular, they are “higher than what the expected losses for the 2020–21 bank portfolio composition would obligate, even if the current portfolio were to undergo the same high stress levels of the Great Recession.” The analysis also shows that the proposed disincentives to high-LTV lending would disproportionately disadvantage LMI, Black, and Hispanic borrowers, who compose greater shares of borrowers with high-LTV loans. Thus, the proposed changes, contrary to the goals of the Community Reinvestment Act, “would disproportionately disincentivize lending to LMI, Black, and Hispanic borrowers and communities.” Bank Capital Notice of Proposed Rulemaking | Urban Institute

Resilience Redux in the U.S. Treasury Market

Since 2007, the total size of primary dealer balance sheets has not kept pace with Treasury market volume, with balance sheet size per dollar of Treasuries declining by a factor of nearly four, due to large U.S. fiscal deficits and to regulatory capital constraints. This paper presents new empirical evidence along with supporting theory demonstrating that “the current intermediation capacity of the US Treasury market impairs its resilience.” It also discusses the costs and risks associated with this loss of resilience, which include loss of market efficiency, higher costs of deficit financing and risks to financial stability. Improvements in Treasury market structure and other measures that could increase the market’s intermediation capacity under stress are also examined. Resilience Redux in the U.S. Treasury Market

Margins, Debt Capacity, and Systemic Risk

This paper develops a risk accounting framework for analyzing the systemic risk implications of reliance on collateralized borrowing or on synthetic leverage in derivatives markets by nonbank financial intermediaries (NBFIs). Two key features of this framework are that “the debt capacity of an investor is increasing in the debt capacity of other investors… and leverage thus enables greater leverage,” and that an increase in margin requirements “can set off a generalized deleveraging that leads to system-wide spillovers.”  Moreover, the deleveraging channel of risk propagation can manifest itself as a “dash for cash.” The framework highlights how systemic risk can arise from “externalities that originate from the distress faced by a market participant and that adversely affect others, typically in the form of non-fundamental price movements.” This form of systemic risk “can be routed through disruptions to liquidity/maturity transformation or through fluctuations in leverage” and does not require insolvencies or defaults. The findings “have important implications for the design of non-bank financial intermediary (NBFI) regulations and of central bank backstops,” including that the presence of externalities provides a rationale for macroprudential policies to mitigate procyclicality, such as minimum initial margins. Margins, debt capacity, and systemic risk (bis.org)

Banks’ Credit Loss Forecasts: Lessons from Supervisory Data

Credit risk estimates inform banks’ business decisions and are integral to banks’ compliance with regulatory capital requirements. This paper compares banks’ confidential regulatory credit risk estimates – which are collected by national supervisors and compiled by the Basel Committee on Banking Supervision – with vendor data on the same banks’ actual credit losses. These data cover 65 institutions, including 26 global systemically important banks, from 2009 to 2022. The analysis finds that while banks’ risk estimates do not accurately forecast the evolution of credit losses, tending to be excessively optimistic during boom times when profits are high, they reliably rank-order losses across institutions. The divergence of modeled, expected loss estimates from actual losses largely reflects the through-the-cycle nature of the estimates. Banks’ credit loss forecasts: lessons from supervisory data

Fintech-Issued Personal Loans in the U.S.

Over the past decade, fintech companies have gained a major share of the personal loan market, alongside traditional lenders, including banks, credit unions and finance companies. This note provides insights into the role of the fintech sector gleaned from two novel data sources: The Federal Reserve Bank of New York Consumer Credit Panel (CCP)/Equifax data supplemented with a specially constructed fintech sector identifier, and data from Mintel Comperemedia on monthly acquisition offers (solicitations) for personal loans. In particular, the analysis identifies the main banks engaged in partnerships with fintech companies, of which the leading bank participants are WebBank (57 percent of offerings) and Cross River Bank (38 percent of offerings.) The analysis also finds that fintech companies’ partnerships with certain banks are allowing them to bypass low interest rate ceilings on consumer loans in various states, from which nationally chartered banks are exempt, as reflected in a high concentration of mail solicitations from fintech lenders partnering with banks in these states. In addition, the note examines fintech companies’ market share and highlights differences in borrower and loan characteristics across lender segments; for instance, fintech companies tend to target near- and low-prime borrowers. The Fed – FinTech-Issued Personal Loans in the U.S. (federalreserve.gov)

Size and Survival of Entrants to Retail Banking

This note presents descriptive statistics on the size and survival of new bank branches established from 1976 to 2020, using a dataset with a novel time-consistent identifier that enables tracking of every bank branch location in the U.S. across time until its closure. The analysis finds that more than 113,000 new branches were established during this period, and the banking industry evolved from 65,000 branches in operation and almost $8 trillion in deposits (denominated in 2020 dollars) to 86,000 branches in operation and $18 trillion in deposits. In addition, the analysis demonstrates that: (1) new bank branches are slow to mature; (2) new branches, including those that grow, have high closure rates; (3) branches of de novo banks grow faster than new branches of established banks; (4) new branches of large banks grow faster than those of small banks. The Fed – Size and Survival of Entrants to Retail Banking (federalreserve.gov)

The Reserve Supply Channel of Unconventional Monetary Policy

Evidence that central bank reserves injected by QE crowd out bank lending is presented in this paper. A structural model for deposit and loan demand is estimated, demonstrating that larger reserve holdings increase banks’ cost of supplying loans, which in turn raises loan rates, reducing loan demand. The analysis implies that “a large injection of central bank reserves has the unintended consequence of crowding out bank loans because of bank balance sheet costs.” The Reserve Supply Channel of Unconventional Monetary Policy | NBER

What Caused the U.S. Pandemic-Era Inflation?

This study co-authored by former Federal Reserve chairman Ben Bernanke and former IMF chief economist Olivier Blanchard investigates the causes of the recent inflation by estimating a simple dynamic model of prices, wages, and short-run and long-run inflation expectations. The model incorporates direct and indirect effects of product-market and labor-market shocks on prices and nominal wages. The analysis finds that most of the inflation surge that began in 2021 was the result of shocks to prices given wages. These price shocks included sharp increases in commodity prices reflecting strong aggregate demand, and sectoral price spikes resulting from shifts in the sectoral composition of demand and constraints on sectoral supply. Although tight labor markets have thus far not been the primary driver of inflation, the study finds that the effects of overheated labor markets on nominal wage growth and inflation are more persistent than the effects of product-market shocks. The authors conclude that “controlling inflation will thus ultimately require achieving a better balance between labor demand and labor supply.” What caused the U.S. pandemic-era inflation?

Examining CBDC and Wholesale Payments

Central bank money for wholesale transactions currently consists of depository institution balances at the Federal Reserve (Reserve Banks) used for Fedwire® Funds Service (Fedwire) payments and transfers. The increasing use within the private sector of distributed ledger technology (DLT) for making payments or transferring assets has prompted  increasing public sector interest in DLT. This note examines whether creation of a central bank digital currency is necessary for conducting wholesale transactions using DLT platforms, or whether the existing form of central bank money would suffice. The note reviews the technology attributes and arrangements associated with a DLT payments platform and argues that a new settlement asset in the form of a wholesale CBDC is not essential for a DLT-based wholesale payment system. The Fed – Examining CBDC and Wholesale Payments (federalreserve.gov)

Chart of the Month

Mortgage Regulatory Risk Weights

The bar on the left shows the aggregate risk weight for mortgage credit risk under the U.S. banking agencies’ Basel III proposal, as applied to first-lien conventional home purchase loans originated in 2022 by banks subject to the proposed rule, based on information in HMDA data. This is compared against (1) the aggregate risk weight under the 2017 BCBS standardized approach; and (2) the average aggregate risk weight for first-lien residential mortgages under the U.S. Advanced Approaches, as calculated from the quarterly FFIEC 101 reports of U.S. Advanced Approaches banks since 2014. These comparisons demonstrate the proposal’s punitive aspect. Under the U.S. agencies’ proposal, aggregate risk weights for first-lien conventional home purchase loans would be 53 percent, significantly higher than the 33-percent risk weight under the BCBS standardized approach being adopted in other countries. The average risk weight for U.S. banks using the advanced approaches, which is allowed in other jurisdictions but not here, is about 25 percent.

Featured BPI Research

The Basel Proposal: What it Means for Mortgage Lending

This article examines the proposed risk weights for U.S. residential mortgages by the federal banking agencies. These risk weights are more than double compared to those adopted by other Basel Committee members. Furthermore, they exceed what historical evidence is justifiable for the U.S. mortgage market. Under the proposal, U.S. banks would encounter not only higher risk weights for credit risk but also an additional capital charge for operational risk, on top of which would be layered the substantial capital buffer charge imposed by the stress tests. Consequences of the proposed implementation would affect U.S. consumers through higher mortgage rates, with low- to middle-income households and minority households being affected the most. Additionally, the authors point out that the proposed rule by the banking agencies is not supported by data or analysis and lacks a cost-benefit analysis. The increased charges will most likely shift a larger share of the mortgage market to nonbanks, which is considered problematic as the market becomes less competitive and nonbank lending tends to be more procyclical. The Basel Proposal: What it Means for Mortgage Lending – Bank Policy Institute (bpi.com)

How Can the New Market Risk Capital Requirements Be Fixed?

The new market risk component of the Basel III Endgame, the “Fundamental Review of the Trading Book” (FRTB), is evaluated in this note, which argues the FRTB is overly complicated and generates an excessive increase in capital requirements. It will raise market risk capital requirements of the largest banks, mostly U.S. financial institutions, by almost 70 percent. This expected increase in market risk capital will raise the cost of debt and equity financing, which play a larger role in corporate financing in the U.S. than elsewhere. Moreover, the capital increase will be amplified by the global market shock (GMS) component of the stress tests, which imposes an additional, severe capital requirement for largely the same risks. Beyond highlighting the flaws in the FRTB, the  note recommends ways to improve it and to mitigate the duplicative aspects of the GMS. How Can the New Market Risk Capital Requirements Be Fixed – Bank Policy Institute (bpi.com)

U.S. Bank Capital Levels: Aligning With or Exceeding Midpoint Estimates of Optimal

The Basel III Endgame capital proposal recently released by the Fed, OCC and FDIC that would result in a significant increase in the capital requirements for larger banks reflects a belief that current bank capital levels are low relative to various estimates of optimal capital levels. This note examines the range of estimates for optimal capital that are cited by the banking agencies as well as other estimates offered in recent academic studies. The authors find that current bank capital levels are not at the low end of the range as has been asserted, but in fact above the midpoint of the range of optimal estimates as cited by banking agencies and are in the upper end of the range of optimal estimates as stated in recent academic literature. The authors also point out that many of the estimates presented in papers listed by banking agencies to justify the increase in capital requirements rely on the so-called “long term economic impact” framework, which was introduced in 2010 by the Basel Committee on Banking Supervision. This approach has been criticized for several conceptual shortcomings. In contrast, more recent academic papers utilize so-called “quantitative general equilibrium models” to identify the optimal level of banks capital, leading to estimates that suggest the current U.S. bank capital levels are at the upper end of the range of optimal capital levels. U.S. Bank Capital Levels: Aligning With or Exceeding Midpoint Estimates of Optimal – Bank Policy Institute (bpi.com)

Will a De Facto Tightening of Regulations Cause a Recession and an Early End To QT?

BPI and other observers have pointed to examination failures as contributing factors to the failures of SVB and Signature Bank. Specifically, examiners failed to limit the risks posed to SVB from making unhedged investments in longer-term fixed-rate securities and the risk posed by heavily relying on concentrated uninsured deposits for funding. Although these recent bank failures demonstrated shortcomings in bank supervision, legally imposing a de facto tightening in bank regulation could tip the economy into a recession, as was the case in the Basel I-induced recession in the early 1990s. FOMC participants noted that the substantial tightening of monetary policy and the effects of the tightening of bank credit conditions pose as sources of downside risk to the economy, showing that there is a material possibility that tighter bank regulation could lead to a recession. Additionally, a de facto tightening of bank regulation could also lead to the Fed having to end its balance sheet runoff earlier than anticipated, possibly leading to an early end of QT and preventing the Fed from continuing its efforts to become smaller. Will a De Facto Tightening of Regulations Cause a Recession and an Early End To QT? – Bank Policy Institute (bpi.com)

Conferences & Symposiums

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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11/16/2023
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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11/30/2023 – 12/1/2023
2nd CEMLA/Dallas Fed Financial Stability Workshop
Federal Reserve Bank of Dallas
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3/4/2024 – 3/7/2024
2024 National Interagency Community Reinvestment Conference
Portland, Oregon
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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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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.