Funding Costs
Financial Firms Less Risky than Other Industries. The authors compare size-related funding cost differentials across industries to determine how size affects the cost of funding. Using pricing data on credit default swaps and bonds over the period 2004 to 2013, the paper finds that credit spreads of financial firms are no more sensitive to size than those of non-financial firms. They find evidence that financial firms as a group, particularly banking firms, have lower average costs of borrowing compared with similar firms in other industries. This suggests that financial firms may be viewed as less risky compared to firms in other industries. The authors conclude that “too-big-to-fail subsidies may be overestimated if they do not take into account the lower borrowing costs of larger firms across a variety of industries.”
Ahmed, Javed, Christopher Anderson and Rebecca Zarutskie (2014), “Are Borrowing Costs of Large Financial Firms Unusual?” mineo, Federal Reserve Board, Harvard Business School, (September).
Lender of Last Resort
Rethinking the Lender of Last Resort. As part of a series on the future design of lender of last resort (LOLR), Paul Tucker discusses criticism central banks face when they inject liquidity into the financial system. The author states that central bank criticism is about the “political economy” and such criticism serves as an “important challenge to the legitimacy” of central banks. He discusses the criticisms related to the LOLR function of central banks and contends that once central banks are “perceived as having overstepped the mark in bailing out bust institutions, critics look for overreach in their more overtly macroeconomic interventions.” Tucker asserts that this is currently the critique of the Fed in the U.S. The “most serious accusation” by critics of central bank aid to insolvent firms, he argues, is that this support reaches beyond the central bank’s “legal authority.” He attempts to demonstrate that when financial firms become “deeply reluctant to turn to the LOLR,” via the discount window, it leaves the financial system fragile in “ways that are hard for regulation to undo.”
Tucker, Paul (2014), “The lender of last resort and modern central banking: principles and reconstruction,” BIS Papers, 79, (September).
Anonymous Lending Important in Restoring Confidence. The authors argue that there is a missing ingredient in “Bagehot’s Dictum.” Walter Bagehot, a 19th century British journalist and economist, wrote that “in times of financial crisis central banks should lend freely to solvent depository institutions, only against good collateral and at interest rates that are high enough to dissuade those borrowers that are not genuinely in need.” The missing ingredient, according to the authors, is secrecy – three kinds in particular: (i) central bank lending, (ii) borrower identity, and (iii) presence of borrowing from the central bank in the borrower’s portfolio.
Gorton, Gary and Guillermo Ordoñez (2014), “How Central Banks End Crises,” PIER Working Paper, 14-025, (September).
Costs of Regulation
Impact of Liquidity Regulation on Lending to Non-Financial Sector. The authors use the implementation of the Individual Liquidity Guidance (ILG) regulation in the UK in 2010 to investigate how banks respond to tighter liquidity regulation. Under this regulation, a subset of banks were required to hold a sufficient stock of high quality liquid assets (HQLA) to cover net outflows of liabilities under two stress scenarios lasting either 14 days or 3 months. The authors find that rather than adjusting the size of their balance sheet to meet tighter liquidity regulation, banks subject to the ILG altered the composition of their assets and liabilities. On the asset side, banks significantly increased the share of HQLA to total assets, and on the liability side, ILG banks increased funding from more stable deposits and decreased their reliance on less stable short-term wholesale and non-UK funding. The authors do not find evidence that liquidity regulations have a negative impact on bank lending to the non-financial sector, either in terms of quantity or price of lending. They conclude that because the ILG significantly reduced intra-financial claims without having a measurable impact on the price or quantity of lending to the real economy, liquidity regulation could be a useful macroprudential tool.
Banerjee, Ryan and Hitoshi Mio (2014), “The Impact of Liquidity Regulation on Banks,” BIS Working Papers, 470, (October).
Using Cost-Benefit Analysis to Determine Capital Requirements. The author posits that: (i) bank regulators have used a process that he calls “norming” (i.e., choosing capital levels that weed out the worst banks but leave most banks untouched); (ii) norming is a bad way to regulate banks, as it produces excessively generous rules that allow most banks to take excessive risks; (iii) inadequate capitalization of banks contributed to the financial crisis of 2007-2008; and (iv) if regulators had been required to use cost-benefit analysis rather than norming, they would have issued stricter capital adequacy rules.
Posner, Eric (2014), “How Do Bank Regulators Determine Capital Adequacy Requirements?” University of Chicago Coase-Sandor Institute for Law & Economics Research Paper, 698, (September).
Imposing Basel III Liquidity Regulations Reduces Bank Lending. The authors look at the macroeconomic impact of introducing a minimum liquidity standard for banks on top of existing capital adequacy requirements. The authors find that imposing a liquidity requirement would: (i) lead to a steady-state decrease of about 3% in the amount of loans made; (ii) an increase in banks’ holdings of securities of at least 6%; (iii) a fall in the interest rate on securities of a few basis points; and (iv) a decline in output of about 0.3%.
Covas, Francisco and John Driscoll (2014), “Bank Liquidity and Capital Regulation in General Equilibrium,” Board of Governors of the Federal Reserve System, Federal Reserve Board- Division of Monetary Affairs, (September).
Cross-Border Banking
Cross-Border Banking and Liquidity. The authors investigate global factors associated with bank capital flows. They create a model where global banks interact with local banks and find that local currency appreciation is associated with higher leverage of the banking sector, thereby providing a bridge between exchange rates and financial stability. Given the preeminent role of the U.S. dollar as the currency used to denominate debt contracts, the authors shed light on why dollar appreciation constitutes a tightening of global financial conditions and why financial crises are associated with dollar shortages.
Bruno, Valentina and Hyun Song Shin (2014) “Cross-border banking and global liquidity,” BIS Working Papers, 248, (August).
Regulating Cross-Border Bank Flows Lowers the Risk of Financial Crisis. Using data on bilateral cross-border bank flows from 31 sources to 76 recipient countries over 1995–2012, and combining this information with new data on various capital controls and prudential measures in these countries, the authors examine whether cross-border capital flows can be regulated by imposing capital account restrictions at both source and recipient country ends. They find that capital account restrictions (CARs) can significantly influence the volume of cross-border bank flows. Given the close connection between cross-border bank flows and risks to global financial stability, the authors suggest that “adoption of relevant CARs in boom times could help to dampen the procyclicality of these flows, thereby lowering the risk of systemic financial crises.”
Ghosh, Atish, Mahvash Qureshi and Naotaka Sugawara (2014), “Regulating Capital Flows at Both Ends; Does it Work?” IMF Working Paper, 14, 188, (October).
Payments
Digital Currencies. The authors discuss recent developments in payment systems, specifically focusing on the emergence of privately developed, internet-based digital currencies. The article argues that the key innovation of digital currencies is found in the “distributed ledger” technology that allows a payment system to operate exclusively in a decentralized fashion, without any intermediaries such as banks. The authors contend that this key innovation represents a fundamental change in how payments can be made to work. The article also provides an overview of how digital currencies work, as well as how new currency is created.
Ali, Robleh, John Barrdear, Roger Clews and James Southgate (2014), “Innovations in payment technologies and the emergence of digital currencies,” Bank of England Quarterly Bulletin, 2014 Q3.
Non-banks in Retail Payments. CPMI finds a significant presence of nonbanks in all stages of the payment process and across different payment instruments. The study analyzes all activities in the payment chain, such as credit and debit cards, credit transfers, direct debits, checks, e-money products and remittances. The paper finds that while the role of nonbanks in retail payments is increasing, most nonbanks ultimately rely on the credit/debit transfer services provided by banks for their funds settlement. Ultimately, the paper concludes that competition from nonbanks is driving banks to offer more efficient or faster payment services, which suggests that properly managed cooperation and competition between banks and nonbanks could enhance the security and efficiency of retail payments to the benefit of end users.
Committee on Payments and Market Infrastructures (2014), “Non-banks in retail payments,” Bank for International Settlements, (September).
Risk Management
Market Risk and Internal Models. The Basel Committee presents results from the first of two trading book test portfolio exercises, which focused on the revised internal models-based approach for market risk and is based on hypothetical portfolios. The second exercise focuses on banks’ actual portfolios and is being conducted in parallel with the Basel III monitoring exercise. The Basel Committee reports that the hypothetical portfolio exercise on the internal models approach provided encouraging results supporting the new market risk framework. Over 40 banks from various jurisdictions were able to implement the requirements for internal models. Banks were able to leverage the existing risk systems and perform the computation for the new risk measures within two quarters of the publication of the consultative document.
Basel Committee on Banking Supervision (2014), “Analysis of the trading book hypothetical portfolio exercise,” Bank for International Settlements, (September).
How Credit Default Risk Affects Bank Lending? The authors find that: (i) an increase in provisioning decreases bank lending and economic activity; and (ii) banks decrease provisioning as a percentage of total bank assets as bank lending increases. Therefore, banks take on more risk during upswings by building up relatively low provisions while they build up more loan loss provisions during downswings.
Pool, Sebastiaan, Leo de Haan and Jan Jacobs (2014), “Loan loss provisioning, bank credit and the real economy,” DNB Working Paper, 445, (October).
Systemic Risk
Structural GARCH Model Provides Earlier Signals of Financial Firm Distress. The authors propose a new model of volatility the authors call “Structural GARCH”, which they then apply to the leverage effect and systemic risk measurement. While normal GARCH models do not include the volatility-leverage connection, the Structural GARCH provides a framework for empirical modeling of asset volatility, equity volatility, and leverage. The Structural GARCH model for systemic risk measurement provides earlier signals of financial firm distress. Additionally, the authors define a new measure they call “precautionary capital,” which determines how much equity firms need to add today in order to ensure an arbitrary level of confidence that the firm will not go bankrupt in a future crisis.
Engle, Robert and Emil Siriwardane (2014), “Structural GARCH: The Volatility-Leverage Connection” OFR Working Paper, 14-07, (October).
Impact of Systemic Risk on Bank Failure. The authors find that: (i) the impact from systemic risk on bank failure appears to be strong over the one-year forecast horizon but weakens over the one-quarter horizon; (ii) firms with higher capital ratios are more affected by systemic risk, suggesting that the buffer provided by higher capital ratios is weakened during the period when systemic risk is high; (iii) small banks are equally affected by systemic risk; and (iv) local housing market conditions are a major determinant of bank failure.
Wu, Deming and Xinlei Zhao (2014), “Systemic Risk and Bank Failure,” mimeo, Office of the Comptroller of the Currency, (August).
Interchange Fees
Interchange Fee Income Significantly Reduced for Banks. The authors find that Regulation II reduced income at large banks by nearly $14 billion a year or more than 5% of core total noninterest income. Furthermore, in response to the decreased revenue for card transactions banks increased their deposit fees which offset roughly 30% of the lost interchange income.
Kay, Benjamin Mark Manuszak and Cindy Vojtech (2014), “Bank Profitability and Debit Card Interchange Regulation: Bank Responses to the Durbin Amendment,” Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board.
Bank Structure
Ring Fencing Foreign Affiliate Increases Stress on Parent Bank. The authors find a significant positive correlation between parent banks’ and their foreign subsidiaries’ default risk. This risk is lower for subsidiaries operating in countries that impose higher capital, reserve, provisioning, and disclosure requirements and tougher restrictions on bank activities. The authors note that although tighter host banking regulations seem to help insulate foreign subsidiaries from changes in the default risk of parent banks during crises, ring fencing measures taken by authorities in one country could increase stress on the banking group’s legal entities in other jurisdictions or for the banking group as a whole. Furthermore, ring fencing may create inefficiencies in the allocation of capital and liquidity within multinational bank groups.
Anginer, Deniz, Eugenio Cerutti and Maria Soledad Martinez Peria (2014), “Foreign Bank Subsidiaries’ Default Risk During the Global Crisis,” World Bank, Policy Research Working Paper, 7053, (October).
Capital
Leverage Based Capital Constraint Superior When Monitoring Loan Portfolios. The paper investigates whether a bank faced with a leverage based capital constraint monitors its loans better than a bank under a risk-based capital constraint. It finds that the biggest banks will monitor their portfolios when faced with leverage-based capital constraints, and will not monitor their portfolios when faced with risk-based capital constraints. According to the report, it appears that leverage ratios have better pre-crisis predictability than risk based approaches.
Balasubramanyan, Lakshmi (2014), “Differential Capital Requirements: Leverage Ratio versus Risk-Based Capital Ratio from a Monitoring Perspective,” Federal Reserve Bank of Cleveland Working Paper, 14-15, (October).
More Capital Would Improve Resilience. The authors use data on UK banks’ minimum capital requirements to study the interaction of monetary policy and regulatory-imposed capital requirements. They find that capital requirements are a more powerful tool for achieving financial stability objectives related to loan supply than monetary policy and therefore argue that “minimum capital requirement changes might offer a more potent tool for improving the resilience of the financial system, by moderating bank lending, over the cycle.”
Aiyar, Shhekhar, Charles Calomiris and Tomasz Wieladek (2014), “How does credit supply respond to monetary policy and bank minimum capital requirements?” Bank of England Working Paper, 508, (September).
Stress Testing
What Governs Recovery from Banking Crises? The authors find that banks that are tougher on extending credit to their riskiest customers tend to recover from sudden declines in profitability. Based on this finding, the authors propose that regulators adjust bank stress tests to keep track of which customers’ loans would go bad during a crisis, and to consider how readily a bank can manage these problems. They conclude that indiscriminant reductions in lending seem to be less important than managing the risk associated with the riskiest borrowers.
Kashyap, Anil and Emilia Bonaccorsi di Patti (2014), “Which Banks Recover from Large Adverse Shocks?” Chicago Booth Research Paper, 14-34, (September).
Bank Balance Sheets
Non-Traditional Bank Income Is Associated with Higher Bank Profitability. The authors examine how banks’ non-traditional activities affect profitability and risk taking. Using data from bank Call Reports, they examine whether a higher ratio of non-interest income (i.e., bank’s non-core activities) to interest income (i.e., bank’s core deposit-taking and lending activities) is linked to higher bank profitability and risk taking. The authors find that a higher fraction of non-interest to interest income is associated with higher profitability, and that the higher profitability does not result from higher risk taking. Furthermore, the they find that banks which generate a higher fraction of their income from non-traditional business have a lower probability of bank insolvency.
Saunders, Anthony, Markus Schmid and Ingo Walter (2014), “Non-Interest Income and Bank Performance: Is Banks’ Increased Reliance on Non-Interest Income Bade?” mimeo, New York University, University of St. Gallen, (October).
CCPs
Assessing the ‘Cover 2’ Standard for CCP Regulation. The authors address the safety and soundness of CCPs, specifically looking at the regulatory standard for CCPs, called ‘cover 2’, which states that systemically important clearing houses must have sufficient financial resources to ‘cover’, or be robust under the failure of, their two largest members in extreme circumstances. They argue that this is an unusual standard because it does not take into account the number of members a CCP has and question the prudency of the ‘cover 2’ standard for different sizes of CCP. The authors determine that CCPs meeting the ‘cover 2’ standard are not highly risky assuming that tail risks are not distributed uniformly amongst CCP members. However, the findings support the conclusion that CCPs and their supervisors should monitor this distribution as central clearing evolves.
Murphy, David and Paul Nahai-Williamson (2014), “Dear Prudence, won’t you come out to play? Approaches to the analysis of central counterparty default fund adequacy,” Bank of England, Financial Stability Paper, 30, (October).