Which Dealers Borrowed from the Fed’s Lender-of-Last-Resort Facilities?
During the 2007-08 financial crisis, the Fed established lending facilities designed to improve market functioning by providing liquidity to nondepository financial institutions—the first lending targeted to this group since the 1930s. What was the financial condition of the dealers that borrowed from these facilities? Were they healthy institutions behaving opportunistically or were they genuinely distressed? In published research, we find that dealers in a weaker financial condition were more likely to participate than healthier ones and tended to borrow more. Our findings reinforce the ...
Measuring systemic risk
We present a simple model of systemic risk and show how each financial institution?s contribution to systemic risk can be measured and priced. An institution?s contribution, denoted systemic expected shortfall (SES), is its propensity to be undercapitalized when the system as a whole is undercapitalized, which increases in its leverage, volatility, correlation, and tail-dependence. Institutions internalize their externality if they are ?taxed? based on their SES. Through several examples, we demonstrate empirically the ability of components of SES to predict emerging systemic risk during the ...
How Does Zombie Credit Affect Inflation? Lessons from Europe
Even after the unprecedented stimulus by central banks in Europe following the global financial crisis, Europe’s economic growth and inflation have remained depressed, consistently undershooting projections. In a striking resemblance to Japan’s “lost decades,” the European economy has been recently characterized by persistently low interest rates and the provision of cheap bank credit to impaired firms, or “zombie credit.” In this post, based on a recent staff report, we propose a “zombie credit channel” that links the rise of zombie credit to dis-inflationary pressures.
Are banks passive liquidity backstops? deposit rates and flows during the 2007-2009 crisis
Can banks maintain their advantage as liquidity providers when they are heavily exposed to a financial crisis? The standard argument - that banks can - hinges on deposit inflows that are seeking a safe haven and provide banks with a natural hedge to fund drawn credit lines and other commitments. We shed new light on this issue by studying the behavior of bank deposit rates and inflows during the 2007-09 crisis. Our results indicate that the role of the banking system as a stabilizing liquidity insurer is not one of the passive recipient, but of an active seeker, of deposits. We find that ...
The Making of Fallen Angels—and What QE and Credit Rating Agencies Have to Do with It
Riskier firms typically borrow at higher rates than safer firms because investors require compensation for taking on more risk. However, since 2009 this relationship has been turned on its head in the massive BBB corporate bond market, with risky BBB-rated firms borrowing at lower rates than their safer BBB-rated peers. The resulting risk materialized in an unprecedented wave of “fallen angels” (or firms downgraded below the BBB investment-grade threshold) at the onset of the COVID-19 pandemic. In this post, based on a related Staff Report, we claim that this anomaly has been driven by a ...
Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting
Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient ?pet? projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank ...
Systemic risk and deposit insurance premiums
Professor Viral Acharya of the London Business School and New York University collaborates with New York Fed economists Joo Santos and Tanju Yorulmazer to analyze various ways to incorporate systemic risk into deposit insurance premiums. Presented at "Central Bank Liquidity Tools and Perspectives on Regulatory Reform" a conference sponsored by the Federal Reserve Bank of New York, February 19-20, 2009.
The effects of focus and diversification on bank risk and return: evidence from individual bank loan portfolios
We study empirically the effect of focus (specialization) vs. diversification on the return and the risk of banks using data from 105 Italian banks over the period 1993?1999. Specifically, we analyze the tradeoffs between (loan portfolio) focus and diversification using a unique data set that is able to identify individual bank loan exposures to different industries, to different sectors, and to different geographical regions. Our results are consistent with a theory that predicts a deterioration in bank monitoring quality at high levels of risk and a deterioration in bank monitoring quality ...
Dealer financial conditions and lender-of-last resort facilities
We examine the financial conditions of dealers that participated in two of the Federal Reserve?s lender-of-last-resort (LOLR) facilities--the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF)--that provided liquidity against a range of assets during 2008-09. Dealers with lower equity returns and greater leverage prior to borrowing from the facilities were more likely to participate in the programs, borrow more, and--in the case of the TSLF--at higher bidding rates. Dealers with less liquid collateral on their balance sheets before the facilities were ...
Cash holdings and bank compensation
The experience of the 2007-09 financial crisis has prompted much consideration of the link between the structure of compensation in financial firms and excessive risk taking by their employees. A key concern has been that compensation design rewards managers for pursuing risky strategies but fails to exact penalties for decision making that leads to bank failures, financial system disruption, government bailouts, and taxpayer losses. As a way to better align management's interests with those of other stakeholders such as creditors and taxpayers, the authors propose a cash holding requirement ...