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.

Tri-Party Repo

FRBNY: Tri-Party Repo Market Showing Improvement (February). Two years ago, a Federal Reserve Bank of New York Task Force released a report to guide the work needed to (i) achieve a reduction in the usage of discretionary intraday credit extended by the tri-party clearing banks, and (ii) foster progress in market participants’ liquidity and credit risk management practices. Earlier this year, FRBNY released a statement citing progress in industry tri-party repo reform, highlighting a variety of improvements and noting that intraday credit usage has lessened from 100% of daily volume in 2012 to 20% today. The statement added that additional work is still needed and highlighted that the full integration of the General Collateral Finance Repo will not be completed by year-end as intended by the Task Force. The statement also warned that the risk of destabilizing fire sales of repo collateral by tri-party repo investors in the event of a large tri-party repo borrower default is not being addressed by industry participants. FRBNY said that fire sales remain a “critical concern” and that “regulators may be forced to use the tools they have to take steps to reduce this risk.”

Tri-Party Repo Infrastructure Task Force (2014), “Update on Tri-Party Repo Infrastructure Reform,” Federal Reserve Bank of New York, February 13.

Capital

Fitch Ratings: G-SIBs Have Met Basel III Capital Requirements (January). Fitch Ratings released a report finding that G-SIBs have already met the capital requirements under Basel III, with an average Tier 1 common equity ratio of 10.1% at the end of Q3 2013.

Hansen, Martin, Christian Scarafia, Joo-Yung Lee and Gordon Scott (2014), “Basel III Common Equity Tier 1: Early Delivery,” Fitch Ratings, January 29.

Calomiris et al: Capital Rule Reciprocity Critical (January). A paper entitled Identifying Channels of Credit Substitution When Bank Capital Requirements Are Varied by Columbia University professor Charles Calomiris et al. focuses on identifying and comparing the relative strength of different channels of credit substitution in response to changes in banks’ minimum capital requirements. The paper finds that when the capital requirements in one country are raised, capital requirements on foreign branches operating in that country will be raised correspondingly by their home country regulator. This finding validates the importance of the reciprocity component of the new regulatory framework that is being addressed with current regulatory initiatives, such as Basel III and the CRD IV directive.

Aiyar, Shekhar, Charles Calomiris and Tomasz Wieladek (2014), “Identifying channels of credit substitution when bank capital requirements are varied,” Bank of England, Working Paper, 485, (January).

BOE Economists: Increased Capital Requirements Lead to Initial Decline in Loan Growth (January). The Impact of Capital Requirements on Bank Lending, coauthored by six economists from the Bank of England, investigates the effects of changes in regulatory capital requirements on bank capital and lending. The paper finds that following an increase in capital requirements, banks gradually rebuild the buffers that they initially held over the regulatory minimum. Furthermore, the results show that in the year following an increase in capital requirements, banks cut loan growth for commercial real estate (CRE), other corporates, and household secured lending. The paper also finds that, except for CRE lending, loan growth mostly recovers within three years.

Bridges, Jonathan, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia and Marco Spaltro (2014), “The impact of capital requirements on bank lending,” Bank of England, Working Paper, 486, (January).

Calomiris: Costs of Capital Understated by Admati (January). In a short article entitled Reforming Banks without Destroying Their Productivity and Value, Calomiris argues that, in their book The Bankers’ New Clothes, Anat Admati and Martin Hellwig overstate the benefits and understate the costs of their proposal to force banks to fund 25% of their assets in the form of equity. Calomiris notes that because equity must be evaluated in relation to risk, increasing required book equity ratios will not necessarily reduce the risk of bank failure significantly. Furthermore, he notes that raising equity also reduces banks’ willingness to lend. Calomiris writes that “regulators or politicians who follow the authors’ policy advice run the risk of going too far and too fast in a single-minded focus on very high book equity requirements or on breaking up global banks”.

Calomiris, Charles (2013), “Reforming Banks Without Destroying Their Productivity Value,” Journal of Applied Corporate Finance, 25 (4), 14-20.

Resolution

‘Second-Generation’ Resolution Mechanisms Necessary for SIFI Resolution (February). In Making Bank Resolution Credible, Oxford University professor John Armour identifies three problems that remain with regard to new resolution mechanisms, namely: the difficulty of transferring assets of a very large financial institutions over a typical timescale of traditional resolution procedures, the difficulty of cross-border resolution, and the need for certain liabilities to be underwritten upon the transfer of remaining assets. In the instance of the failure of a large, complex financial institution, Amour outlines the need for effective ‘second generation’ resolution mechanisms that provide a credible alternative to bailouts for large, complex financial institutions. These involve more robust ex ante planning, sufficient and effective multinational coordination of supervision, and a workable bail-in tool. The author concludes that “for the resolution of large complex financial institutions to be credible, it must be thought of as an integral part of the ongoing oversight of financial institutions by regulators, and not as simply a set of mechanisms that are kept for troubled times.”

Armour, John (2014), “Making Bank Resolution Credible,” February 11.

Value of Large Banks

Banks Still Have Incentives to Continue Growing (February). In a paper entitled Are U.S. Commercial Banks Too Big?, Diego Restrepo et al – using data from U.S. commercial banks from 2001-2010 – find that almost all small and medium size banks and the majority of the biggest U.S. commercial banks enjoy scale economies and still have incentives to continue growing.

Restrepo, Diego, Subal Kumbhakar and Kai Sun (2013), “Are U.S. Commercial Banks Too Big?” Documentos de trabajo Economía y Finanzas, 13-14, February 2.

Supervisory Oversight

and Examination

OCC Auditor Report on OCC Examination Process Says Remove Examiners from Big Banks (December). The OCC released a report, prepared by a team of international regulators at Comptroller Thomas Curry’s request, that offers recommendations around broad areas including mission, vision, and strategic goals; risk identification; ratings systems staffing; the scope and consistency of supervisory strategies; and enterprise governance. The report offers a specific recommendation to “move examination teams and subject matter experts from individual bank locations to shared OCC offices in the field.”

Office of the Comptroller of the Currency (2013), “An international Review of OCC’s Supervision of Large and Midsize Institutions: Recommendations to Improve Supervisory Effectiveness,” December 4.

Debit Interchange

Kansas City Fed Economist Finds Free Checking Affected By Interchange Fees (December)

Richard Sullivan, a senior economist at the Kansas City Fed, examines how banks’ business models responded to the regulatory cap on debit interchange fees. The paper finds that, as the regulation of interchange fees for debit card payments eliminated roughly $8 billion of revenue at regulated banks, many of these banks did away with free checking to provide for the loss. However, as many regulated banks eliminated free checking, many exempt banks, particularly larger exempt banks, provided for the servicing shortfall by adding free checking. On a net basis, the number of banks offering free checking accounts rose from 19.4% of all checking account balances in 2011 to 21.6% in 2012, thus implying welfare gains for consumers, particularly in regions with high levels of competition among banks.

Sullivan, Richard (Forthcoming), “The Impact of Debit Card Regulation on Checking Account Fees,” Federal Reserve Bank of Kansas City Economic Review (Forthcoming).

Stress Testing

FRBNY Economists Evaluate CLASS Model (February). In a paper entitled The Capital and Loss Assessment Under Stress Scenarios Model, three FRBNY economists provide a comprehensive review of the CLASS model, including a detailed description of the model approach, regression equations data, and results of model projections. The CLASS model is a “top‐down” model of the U.S. commercial banking industry that generates projections of commercial bank and bank holding company income and capital under two macroeconomic scenarios. The projections cover each of the 200 largest domestic banking institutions and are based on a set of 22 regression models of components of bank income, expense and loan performance, combined with assumptions about provisioning, dividends, asset growth and other factors. Similar to models produced by some other central banks, the goal of the CLASS model is to produce system‐wide estimates and distributions of net income and capital. The model is designed to complement the bottom-up supervisory approaches to model bank revenues and expenses that are used for CCAR and DFAST and European stress tests. The authors use this framework to calculate a projected industry capital gap relative to a target ratio at different points in time under a common stressful macroeconomic scenario. They find that this estimated capital gap began rising four years before the financial crisis and peaked at the end of 2008. The gap has since fallen sharply and is now significantly below pre-crisis levels.

Hirtle, Beverly, Anna Kovner, James Vickery and Meru Bhanot (2014), “The Capital and Loss Assessment under Stress Scenarios (CLASS) Model,” Federal Reserve Bank of New York Staff Report, (663), (February).

Liquidity

Committed Liquidity Facility – A New Tool To Mitigate LCR Side Effects (January). In a BIS Working Paper entitled On the Economics of Committed Liquidity Facilities, economists Morten Bech and Todd Keister study the effects of the new Basel III liquidity regulations in jurisdictions with a limited supply of high-quality liquid assets. The study shows that introducing a liquidity coverage ratio in such settings can have significant negative consequences, thus leading to a large liquidity premium. A central bank can mitigate this, they argue, by adding a committed liquidity facility and providing, for an up-front fee, contractual committed liquidity lines that count toward a bank’s stock of liquid assets.

Bech, Morten and Todd Keister (2014), “On the economics of committed liquidity facilities,” Bank for International Settlements Working Papers, (439), (January).

Future of Payments

Federal Reserve Payments Finds Check Payments Dwindling (December). The most recent edition of The 2013 Federal Reserve Payments Study, a triennial report from the Federal Reserve, examines noncash payment trends in the U.S. and finds that card payments now account for more than two-thirds of all noncash payments as the number of checks paid continues to decline. A more detailed publication describing the methodologies and data behind the report will be released this spring.

Federal Reserve System (2013), “The 2013 Federal Reserve Payments Study,” December 19.

Operational Risk

Operational Risk Difficult to Measure. A paper entitled Bank Capital for Operational Risk: A Tale of Fragility and Instability by Hal Scott of Harvard University et al. analyzes operational risk, one of the three risk types (market and credit risks are the other two) against which banks are required to hold regulatory capital. The paper notes that, while operational risk tends to be about 9-13% of the total risk pie, it is hardest to measure and model and the least understood. The authors make four policy suggestions on how to address operational risk: (i) target model fragility; (ii) relax the currently stringent link between model output and required regulatory capital; (iii) provide at least some capital relief for insurance, particularly given the rather modest percentage of insurance coverage for operational risk; and (iv) revise and expand upon the Basel II operational risk event type taxonomy.

Ames, Mark, Til Schuermann and Hal Scott (2014), “Bank Capital for Operational Risk: A Tale of Fragility and Instability,” February 10.

Cost of Funding Differential

Deposits Do Not Offer Banks A Sizable Cost of Funding Advantage. Do Deposit Rates Show Evidence of Too Big To Fail Effects?, an Oliver Wyman study funded by National Unrecovered Financial Services, analyzes a subset of financial firms perceived to receive a “Too Big to Fail” (TBTF) funding benefit. The authors assess the existing empirical evidence of whether market perceptions of TBTF status reduce funding costs for some institutions, and contribute to the research by updating one of the most cited studies on the subject by Stefan Jacewitz and Jonathan Pogach, which looks at deposit rates to uninsured accounts, with more recent, post crisis data from the 2010-2012 period. Looking at this more recent time period, the study finds that there is no evidence that large banks enjoy a sizable funding cost advantage on deposits that could be attributed to TBTF perceptions. This advantage, the study concludes, decreased to just 2 basis points by the end of 2012. Additionally, the study asserts that any findings of a funding cost advantage for large banks with regard to deposits, however small, likely are attributable to effects unrelated to TBTF perceptions.

Kumar, Aditi and John Lester (2014), “Do Deposit Rates Show Evidence of Too Big to Fail Effects?: An updated look at the empirical evidence through 2012 among US banks,” Oliver Wyman, (March).

EU Study: TBTF Costs Taxpayers €243 Billion (January). The European Parliament’s Green Party commissioned a study, which found that the implicit TBTF guarantee provided by the government amounted to a €234 billion cost to taxpayers. The €234 billion figure was derived by looking at eight academic and international studies focused on implicit subsidies.

The Greens/ EFA in the European Parliament (2014), “EU systemic banks capture huge amount of implicit subsidies,” January 27.

Dodd-Frank Unlikely to End TBTF (December). In The Financial Crisis of 2007-09: Why Did It Happen and What Did We Learn?, Washington University professor Anjan Thakor reviews the existing literature on the subprime crisis and the subsequent policy responses and concludes that because of its enormous complexity, Dodd-Frank is unlikely to eliminate the too-big-to-fail problem or help reduce systemic risk. Thakor believes more attention needs to focused not only on what should be done after a crisis arrives but also on what should be done ex ante to diminish its likelihood, and writes that the “web of complex regulations [under Dodd-Frank] and the even-richer set of circumventing actions by banks make effective regulation prohibitively expensive and thus more or less a practical impossibility.”

Thakor, Anjan (2013), “The Financial Crisis of 2007-09: Why Did It Happen and What Did We Learn?” (January).

Enforcement and Litigation

CCMR: Banks Paid $43.4 Billion in Fines in 2013 (January). The Committee for Capital Markets Regulation released data totaling the financial penalties imposed on financial institutions by the government in Q4 in 2013. According to the report, financial institutions paid $18.6 billion in that quarter and $43.4 billion for the year.

Committee on Capital Markets Regulation (2014), “Quarterly Financial Penalties Data,” January 27.

Emergency Lending Facilities

FRBNY Economist: Banks Willing to Pay Premium to Avoid Discount Window (January). Olivier Armantier of the Federal Reserve Bank of New York wrote an article in which he evaluated discount window lending during the last crisis. Armantier finds that banks could have lowered their interest expenses substantially during the financial crisis by borrowing from the discount window as opposed to from the Term Auction Facility but chose to pay this premium to avoid the market stigma attached to such borrowing.

Armantier, Olivier (2014), “Discount Window Stigma,” Federal Reserve Bank of New York Liberty Street Economics, January 13. •