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Working Paper
Measuring capital adequacy supervisory stress tests in a Basel world
The United States is now committed to using two relatively sophisticated approaches to measuring capital adequacy: Basel III and stress tests. This paper shows how stress testing could mitigate weaknesses in the way Basel III measures credit and interest rate risk, the way it measures bank capital, and the way it creates countercyclical capital buffers. However, this paper also emphasizes the extent to which stress tests add value will depend upon the exercise of supervisor discretion in the design of stress scenarios. Whether supervisors will use this discretion more effectively than they ...
Working Paper
Debt, hedging, and human capital
This paper provides a theory of debt and hedging based on human capital. We distinguish human capital from physical capital in two ways: (1) human capital is inalienable and can exercise a one-sided option to leave the firm, and (2) human capital is not perfectly replaceable. We show that a firm may reach the first best solution while issuing debt or equity to outsiders provided that either the insiders receive a senior claim or that the firm hedges. We then show that, given asymmetric information concerning costs, the only viable solution has the firm issuing debt to outsiders and hedging.
Journal Article
So Far, So Good: Government Insurance of Financial Sector Tail Risk
The US government has intervened to provide extraordinary support 16 times from 1970 to 2020 with the goal of preventing or mitigating (or both) the cost of financial instability to the financial sector and the real economy. This article discusses the motivation for such support, reviewing the instances where support was provided, along with one case where it was expected but not provided. The article then discusses the moral hazard and fiscal risks posed by the government's insurance of the tail risk along with ways to reduce the government's risk exposure.
Working Paper
Is Stricter Regulation of Incentive Compensation the Missing Piece?
Although a number of steps have been taken to reduce the risk of financial stability, some significant weaknesses remain. This paper examines whether stricter regulation of incentive compensation is the missing piece needed to reduce risk to acceptable levels. Unfortunately, this review of the literatures on the relationship of risk to bank chief operating officer and bank employee compensation suggest both have some potential but that significant concerns remain in both cases. At this point, we cannot confidently say that compensation regulation is the missing piece.
Journal Article
Bank loan-loss accounting: a review of theoretical and empirical evidence
The philosophy underlying a bank's accounting for loan losses might have a material effect on the net income the firm reports to investors, which is a concern for securities regulators. A bank's loan-loss accounting philosophy might also significantly affect its ability to absorb unexpected future losses, which is a concern for bank supervisors. For example, a bank that follows a conservative loan-loss philosophy (maintains a higher loan-loss allowance) may be better able to absorb unexpected losses but also may have more freedom to manage reported earnings. This article focuses on the extent ...
Working Paper
Subordinated debt and bank capital reform
In recent years there has been a growing realization that there are significant problems with the current bank risk-based capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the existing capital requirements. They have become so good at avoiding the intent of capital regulation that the regulations have essentially ceased to be a safety and soundness issue for supervisors and have become more a compliance issue. There is also a growing realization that bank regulation must more effectively incorporate market discipline to ...
Banks' Accumulated Credit Losses in the First Quarter
The aggregate allowance for credit losses (ACL) at a set of large banks increased by 65 percent in the first quarter of 2020.1 The increase was due in approximately equal parts to two developments. First, the banks increased their ACL on January 1 to conform to a change in the method of estimating credit losses, from the incurred loss model to current expected credit loss (CECL). Second, the banks increased their ACL to cover an increase in expected credit losses. The magnitude of the ACL increase—commonly referred to as a "build"—at each bank depends on a variety of factors, but banks ...
Working Paper
Managing the risk of loans with basis risk: sell, hedge, or do nothing?
Individual loans contain a bundle of risks including credit risk and interest rate risk. This paper focuses on the general issue of banks? management of these various risks in a model with costly loan monitoring and convex taxes. The results suggest that if the hedge is not subject to basis risk, then hedging dominates a strategy of ?do nothing.? Whether hedging dominates loan sales depends on whether it induces reduced monitoring, the net benefit of monitoring, and the reduced tax burden of eliminating all risk via selling. If the hedge is subject to basis risk, then a ?do nothing? strategy ...
Journal Article
Taking note of the deposit insurance fund: a plan for the FDIC to issue capital notes
In the United States the risk that a financial breakdown could lead to a taxpayer bailout of the deposit insurance fund has been cited to justify current regulatory controls on what activities may be affiliated with banks. Despite some regulatory changes in the 1990s to protect taxpayers from future debacles, however, widespread failures could still expose taxpayers to losses. ; This article proposes a new way to monitor the deposit insurance fund by having the FDIC issue capital notes. Because the interest paid on the notes would be suspended if the fund required a loan from the Treasury or ...