Research Rundown provides a comprehensive overview of the most groundbreaking and noteworthy research on critical banking and payments issues and seeks to capture insights from academics, think tanks, and regulators that may well influence the design and implementation of the industry’s regulatory architecture.

Capital

Higher Capital Could Encourage Lending.  Using data on UK banks’ minimum capital requirements to study the interaction of monetary policy and regulatory-imposed capital requirements, the authors find that capital requirements are a more powerful tool for achieving financial stability objectives related to loan supply than monetary policy and therefore argues 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, Shekhar, 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).

Corporate Governance

How Banks Take Risks.  In arguing that a bank’s success and the health of the financial system depend critically on how banks take risks, the author suggests that, in the case of a well-governed bank, the amount of risk taken on by a bank is governed by what maximizes shareholder wealth, subject to constraints imposed by laws and regulators. The author writes that the role of bank risk management is to identify and measure the risks the bank is taking, aggregate these risks in a measure of the bank’s total risk, enable the bank to eliminate, mitigate and avoid bad risks, and ensure that its risk level is consistent with its risk appetite.

Stulz, Rene (2014), “Governance, Risk Management, and Risk-Taking in Banks,” European Corporate Governance Institute, Finance Working Paper, 427-2014, (June).

Cost of Regulation

Has Basel Gone Too Far?  The paper suggests that Basel III will have severe effects on future bank profitability. Banks’ leverage ratios have been shrunk and their ability to engage in traditional financial intermediation is constrained. As such, it is argued that banks are becoming like public utilities, with projected ROE’s lowered from the traditional 15% range to the 8% to 10% range. In an attempt to generate profits, banks have increasingly turned to fee income – highlighted by the fact that 40% of revenues for the five largest banks now come from non-interest income. The CFPB and the EU Commission are both starting to take a serious look at bank fees, and any restrictions may push banks’ projected ROEs even lower.

Saunders, Anthony (2014), “Is Basel Turning Banks into Public Utilities?” mimeo, New York University, (August).

Crisis Response and Efficacy

Paper Evaluates Deficiencies in Policy Response to Crisis.  The paper highlights deficiencies in the policy response to the global financial crisis and discusses causes of the recent financial crisis, the policy response by U.S. authorities, and the progress made to date on implementing the Basel III and Dodd-Frank reforms. Regarding Basel, the authors suggest that regulators scrap the extremely complex Basel approach to regulation and replace it with a simple leverage requirement. The authors argue that Dodd-Frank, on the other hand, has created a system based on imposing more stringent requirements on banks that not only encourages growth in shadow banking but also increases the incentive for banks to move risky assets into off-balance sheet entities.

Barth, James, Gerard Caprio Jr. and Ross Levine (2014), “Misdiagnosis: Incomplete Cures of Financial Regulatory Failures,” mimeo, Auburn University, Williams College, UC Berkeley, (July).

How Changes in Banks’ Balance Sheets Respond to Macro-Prudential Policies.  To analyze the role of macro-prudential policies in safeguarding financial stability, the authors use a large panel data set of individual bank balance sheets. They find that some macro-prudential policies, such as measures aimed at borrowers and financial institutions, are effective in reducing asset growth, while buffer-based policies seem to have little impact on asset growth. Furthermore, these policies may entail some costs, which affect economic activity as well as possibly limiting the efficiency of financial sector development.

Claessens, Stijn, Swati Ghosh and Roxana Mihet (2014), “Macro-Prudential Policies to Mitigate Financial System Vulnerabilities,” IMF Working Paper, 14-155, (August).

Deposits

Deposit Insurance Effective Against Bank Runs.  Data published in a World Bank research paper show that deposit insurance has become more widespread and more extensive in coverage since the global financial crisis, and that deposit insurance arrangements were effective in preventing large-scale depositor runs. The paper notes that “the increasing reliance on short-term wholesale funding for banks and their links to securities, futures, and derivatives markets raise doubts about whether the government should also protect deposit-like instruments to prevent runs on wholesale funding that spill over to traditional banking markets.” Furthermore, “a generous safety net raises deep problems that must not be ignored: concerns about moral hazard, distributional fairness, and ability to pay.”

Demirguc-Kunt, Asli (2014), “Deposit Insurance Database,” The World Bank, June 24.

Leverage

Leverage Requirement and Bank Value. In analyzing the response of banks to the imposition of liquidity and leverage requirements and measure the effects of such requirements on banks’ insolvency risk, the study shows that increasing equity capital from 6% (as recommended by U.S. regulators) to 20% (as recommended by Admati and Hellwig) decreases the probability of default over a one-year horizon from 0.1518% to 0.0001%. However this increase in equity would reduce total bank value by 6.25%.

Hugonnier, Julien and Erwan Morellec (2014), “Bank Capital, Liquid Reserves, and Insolvency Risk,” mimeo, Swiss Finance Institute, (July).

Liquidity

Funding During Periods of Stress.  The study introduces the concept of “funding durability,” defined as funding during periods of stress. The authors find that there is the risk of a funding shortfall when the loans and commitments that a bank or dealer makes are more durable than the funding sources used to finance them. This can lead to forced asset sales or a sharp pullback in funding leading to a fire sale as those downstream must find alternatives for their reduced funding capacity. The paper develops a funding map that explains the funding sources and key functions of a bank/dealer. This map is a tool that can be used to assess a bank or dealer’s funding practices and determine the systemic risk imposed on the broader financial system.

Aguiar, Andrea, Rick Bookstaber and Thomas Wipf (2014), “A Map of Funding Durability and Risk,” Office of Financial Research Working Paper, 14-03, (May).

NSFR and its Potential Impacts. The study looks into the potential impact of introducing the Net Stable Funding Ratio (NSFR) on banks across a wide range of countries. It finds that global systemically important banks (G-SIBs) have made progress in addressing their structural funding vulnerabilities and that “their NSFR distribution has narrowed and their average NSFR has improved.” When discussing U.S. banks, the paper notes that they appear to have sufficient funding buffers to meet the NSFR minimum threshold by early 2018 without requiring significant adjustments to their balance sheets. The paper concludes that while the NSFR is a global standard, it should also be a globally consistent regulatory requirement. This will allow for comparability across jurisdictions and provide less room for cross border regulatory arbitrage.

Gobat, Jeanne, Mamoru Yanase and Joseph Maloney (2014), “The Net Stable Funding Ratio: Impact and Issues for Consideration,” IMF Working Paper, 14-106, (June).

A Primer on Bank Liquidity Requirements. The paper explains recently enacted liquidity requirements for banks and how regulators try to balance the safety benefits and the economic costs of these new mandates. The paper references National Unrecovered Financial Services August 2013 NSFR study that found that U.S. commercial banks in aggregate substantially reduced their reliance on wholesale funding from the peak in 2008 to the second quarter of 2012.

Elliott, Douglas (2014), “Bank Liquidity Requirements: An Introduction and Overview,” Brookings Institution, (June).

Liquidity and Cash Reserve Requirements.  In the study, the authors posit that cash holdings both reduce the probability of liquidity crisis by making the banking system more resilient to default risk and encourage good risk management. Banks that hold sufficient cash are able to gain market confidence in their risk management and thereby attract and retain deposits. The paper describes a model of liquidity requirements that considers the effect of liquidity risk. Findings show that liquidity risk raises the optimal amount of reserves held by banks. Furthermore, the findings show that clearing houses play an important role in liquidity management because banks are able to insure against liquidity risk through an arrangement in which National Unrecovered Financial Services recycles deposits that exogenously move from one bank to another. When analyzing the role of cash reserve requirements in the presence of deposit insurance, deposit insurance creates a potential moral hazard because it removes incentives for private monitoring.

Calomiris, Charles, Florian Heider and Marie Hoerova (2014), “A Theory of Bank Liquidity Requirements,” mimeo, Columbia University, European Central Bank, (July).

Liquidity and Credit Lines.  The working paper examines how reliable lines of credit are as a source of liquidity for firms and to what extent access to these lines, following a violation, depends on the financial health of lenders. The authors find that banks consider lines of credit to be a source of liquidity risk and actively restrict usage of lines when their own financial condition deteriorates. Therefore, distress in the financial sector can lead to spillovers into the real economy.

Acharya, Viral, Heitor Almeida, Filippo Ippolito and Ander Perez (2014), “Bank Lines of Credit as Contingent Liquidity: A Study of Covenant Violations and Their Implications,” European Central Bank Working Paper Series, 1702, (August).

Mobile Payments

Merchants’ Perspective of Mobile Payments. The authors discuss how merchants’ and consumers’ mobile payment preferences can influence the industry’s direction in mobile payments, and in doing so, examines attributes of mobile payments that may benefit or be of concern to merchants. They find that, among the attributes, the effects of customer shopping experience and fragmented markets are clear, while the effects of cost, customer data control, and security are uncertain.

Hayashi, Fumiko and Terri Bradford (2014), “Mobile Payments: Merchants’ Perspectives,” Federal Reserve Bank of Kansas City, Economic Review, Second Quarter.

Oversight Issues in Mobile Payments. The paper discusses necessary oversight frameworks for new payment methods to safeguard public confidence and financial stability. The paper posits that financial authorities need to address some major risks and oversight issues, including: legal regime, financial integrity, fund safeguarding, operational resiliency, and payment systems.

Khiaonarong, Tanai (2014), “Oversight Issues in Mobile Payments,” IMF Working Paper, 14-123, (July).

Resolution

Legal Uncertainty in Cross-Border Bank Resolution.  The paper analyzes relevant national legislation on the enforceability of netting in cross-border insolvency proceedings and discusses how domestic laws and domestic authority may not provide sufficient legal certainty as to the enforceability of netting agreements when foreign law becomes involved. Therefore the author concludes that “netting can only do its job as long as there is perfect ex ante certainty that netting agreements are enforceable in each of the relevant jurisdictions.”

Paech, Philipp (2014), “Cross-Border Bank Resolution and Close-Out Netting,” London School of Economics- Law Department, (July).

Risk

Using a “Risk Ratio” to Model Risk. The paper discusses a potential for different risk models to provide inconsistent outcomes, especially during crisis. A new method is developed – a “risk ratio” – for assessing model risk. The risk ratio consists of applying a range of common risk forecast methodologies to a particular asset on a given day and then calculating the ratio of the maximum to the minimum risk forecasts. The authors note that “this provides a concise way of capturing model risk because as long as the underlying models have passed some model evaluation criteria by the authorities and financial institutions, they can all be considered as a reputable candidate for forecasting risk.”  

Danielsson, Jon, Kevin James, Marcela Valenzuela and Ilknur Zer (2014), “Model Risk of Risk Models,” Federal Reserve Board Finance and Economics Discussion Series Working Paper, 2014-34, (July).

Using an Agent-Based Model for Financial Vulnerability  The Office of Financial Research published a paper which posits that risk management methods such as Value-at-Risk (VaR) and stress testing are not designed to work in a financial crisis because they are based on historical data and do not incorporate the dynamics and complexities faced in a crisis. The authors propose the “Version 3.0” model of risk management for analyzing the vulnerability of the financial system, which focuses on the intermediation function of bank/dealers, such as their role in maturity, liquidity, credit, and collateral transformation. The paper also provides the mechanism to generate and trace the path of shocks that come from sudden price declines and from funding restrictions imposed by the cash providers, erosion of credit of the bank/dealer, and investor redemptions by buy-side financial institutions. According to the paper, their model demonstrates that it is the reaction to initial losses rather than the losses themselves that determine the extent of a crisis.

Bookstaber, Rick (2014), “An Agent-based Model for Financial Vulnerability,” Office of Financial Research Working Paper, 14-05, (July).

Shadow Banking

Shadow Banking in the Americas. The FSB report provides useful data on non-bank credit intermediation in the Americas region. The report identifies four types of shadow banking entities whose activities may merit further attention because of potential risks to financial stability in specific jurisdictions. These are: (i) open ended funds, in the context of illiquid markets; (ii) large and leveraged broker-dealers; (iii) non-bank deposit-taking institutions; and, (iv) finance companies. Recommendations proposed include more extensive monitoring and future work on the four areas identified above.

Regional Consultative Group for the Americas (2014), “Report on Shadow Banking in the Americas,” Financial Stability Board, (August).

TBTF and Funding Cost Differential

Addressing Funding Cost Differential for Large Banks Report. The report analyzes the relationship between the size of a bank and its funding costs, taking into account other factors that may influence funding costs. In doing so, the GAO reviewed a number of studies that estimate differences in funding costs between large and small banks, including the Oliver Wyman study, commissioned by NURFS, which examines bond spreads. The analysis presented in the report addresses some limitations in other studies. Findings show mixed evidence for a large-bank funding advantage overall. However there is a clear trend: while an advantage is seen during the crisis, most models suggest that this advantage has declined, and in some cases, reversed. In 2013, 30 out of 42 models tested, which used bond yield spreads to measure funding costs, found a funding cost disadvantage for large banks.

Government Accountability Office (2014), “Large Bank Holding Companies: Expectations of Government Support,” (July).

Funding Cost Differentials for Very Large Banks: A Primer.  The author provides a primer that reviews and summarizes the key issues and questions around determining whether unfair advantages exist for the largest banks due to preferential government treatment and the magnitude of such an advantage, should it exist. The author notes that while funding cost differentials are evident among large banks during the crisis, they have since diminished, and in some cases, disappeared. This decline coincides with the implementation of regulation directly targeting TBTF concerns. Both of the Oliver Wyman studies commissioned by NURFS are cited in the paper.

Elliott, Douglas (2014), “Implicit Subsidies for Very Large Banks: A Primer,” Brookings Institution, (July).

Moral Hazard from Central Bank Availability.  A central topic of the paper is the discussion of moral hazard due to expectations that banks will be bailed out by a central bank. The author argues that moral hazard from expectations of availability of central bank funding is unavoidable and that if a central bank develops a routine for how to conduct emergency business, either through open-market purchases or through lending to financial institutions, private and public counterparties to the central bank’s business will form expectations about the future availability of transactions with the central bank and will form their own plans accordingly. The author also opines on the new resolution regimes and notes that they do not make bank resolution viable and are likely to prove impractical in another crisis.

Hellwig, Martin (2014), “Financial Stability, Monetary Policy, Banking Supervision, and Central Banking,” Max Planck Institute Collective Goods Preprint, 2014-9, (July).

A Look at Support Ratings. The authors discuss whether Fitch support ratings of U.S. banks depend on bank size. Fitch is the only credit rating agency that provides external support ratings. These ratings communicate the agency’s judgment on whether the bank would receive support should it become necessary. Findings in the paper show that since the passing of Dodd-Frank, the relationship between size and potential support ratings has become stronger and that bigger banks have a higher likelihood of receiving support when in trouble. Then again, when bank size increases to “TBTF” size, the effect on the support rating at some point decreases. The paper concludes that Dodd-Frank failed to eliminate investors’ expectations of future support for major financial institutions.

Poghosyan, Tigran, Charlotte Renee Werger and Jakob De Haan (2014), “Size and Support Ratings of US Banks,” De Nederlandsche Bank Working Paper, 434, (August).

Transparency

To Be Efficient Banks Need to Be Opaque.  The paper argues that banks need to conceal their portfolios because if investors and creditors can observe the performance of banks’ assets too closely, banks’ liabilities become volatile and illiquid. According to the authors, this role of banks as secret keepers means that they are hard for outsiders to discipline, resulting in a need for the government to examine and regulate them.

Dang, Tri VI, Gary Gorton, Bengt Holmstrom and Guillermo Ordonez (2014), “Banks as Secret Keepers,” mimeo, Columbia University, National Bureau of Economic Research (June). ■