Federal Home Loan Bank advances and commercial bank portfolio composition
This paper considers the role of Federal Home Loan Bank (FHLB) advances in stabilizing their commercial bank members' residential mortgage lending activities. Our theoretical model shows that using mortgage-related membership criteria or requiring mortgage-related collateral does not ensure that FHLB advances will be put to use for stabilizing members' financing of housing. Using panel vector autoregression (VAR) techniques, we estimate recent dynamic responses of U.S. bank portfolios to FHLB advance shocks, bank lending shocks, and macroeconomic shocks. Our empirical findings suggest that FHLB advances are just as likely to fund other types of bank credit as to fund single-family mortgages.
AUTHORS: Frame, W. Scott; Hancock, Diana; Passmore, Wayne
Market discipline in banking reconsidered: the roles of funding manager decisions and deposit insurance reform
We find that the risk-sensitivity of bank holding company subordinated debt spreads at issuance increased with regulatory reforms that were designed to reduce conjectural government guarantees, but declined somewhat with subsequent reforms that were aimed in part at reducing regulatory forbearance. In addition, we test and find evidence for a straightforward form of "market discipline:" The extent to which bond issuance penalizes relatively risky banks. Evidence for such discipline only appears in the periods after conjectural government guarantees were reduced.
AUTHORS: Hancock, Diana; Kwast, Myron L.; Covitz, Daniel M.
The Federal Reserve's portfolio and its effects on mortgage markets
We provide an empirical analysis of the effects of the Federal Reserve's asset holdings on MBS yields and mortgage rates. We argue that understanding the particulars of the U.S. mortgage markets, particularly the linkages between the secondary and primary mortgage markets, is important. We find evidence that the Federal Reserve's portfolio holdings influence mortgage markets, through both a "portfolio balancing channel" and an "excess reserves" channel. These two channels can work in opposite directions and their magnitudes are difficult to estimate, but on net, larger Federal Reserve's portfolio holdings seem to have placed a significant downward influence on MBS yields and mortgage rates.
AUTHORS: Passmore, Wayne; Hancock, Diana
The competitive effects of risk-based bank capital regulation: an example from U.S. mortgage markets
Basel II bank capital regulations are designed to be substantially more risk sensitive than the current regulations. In the United States, only the largest banks would be required to adopt Basel II; other depositories could choose to adopt such standards or to remain under the Basel I capital standards. We consider possible effects of this two-pronged or "bifurcated" approach on the market for residential mortgages. Specifically, we analyze whether those institutions that adopt Basel II will enjoy lower costs than nonadopters and whether they have an incentive to retain mortgages in their own portfolios. We find that (1) despite the large differences in regulatory capital requirements between adopters and nonadopters, it is unlikely that there will be any measurable effect of Basel II implementation on most mortgage rates and, consequently, any direct impact on the competition between adopters and nonadopters for originating or holding residential mortgages; (2) the most significant competitive impact may be felt among mortgage securitizers; and (3) adopters might have increased profits from some mortgages relative to nonadopters because they will capture some of the deadweight losses that occur under the current regulatory regime, but nonadopters would likely retain their market shares.
AUTHORS: Passmore, Wayne; Lehnert, Andreas; Hancock, Diana; Sherlund, Shane M.
An analysis of government guarantees and the functioning of asset-backed securities markets
Mortgage securitization has been tried several times in the United States and each time it has failed amid a credit bust. In what is now a familiar recurring history, during the credit boom, underwriting standards are violated and guarantees are inadequately funded; subsequently, defaults increase and investors in mortgage-backed securities attempt to dump their investments. ; We focus on a specific market failure associated with asset-backed securitization and propose a tailored government remedy. Our analysis of loan market equilibriums shows that the additional liquidity provided by securitization may (or may not) lower primary loan rates, but such liquidity comes at a cost. More specifically, if guarantee-sensitive investors doubt the credit quality of asset-backed bonds, significant risk premiums can develop. If a financial crisis ensues, securitization can disappear from the market entirely, leaving banks that originate just the highest quality loans as the only source of credit. This abrupt increase in lending standards can tighten credit, exacerbate asset price declines, and impinge on economic growth. ; We argue that an institutional structure for stemming "runs," analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in Fannie Mae and Freddie Mac. Hence, the provision of federally-backed catastrophic insurance could provide a rationale for restructuring the housing-related GSEs towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.
AUTHORS: Hancock, Diana; Passmore, Wayne
Why are bank profits so persistent: the roles of product market competition, informational opacity, and regional/macroeconomic shocks
We investigate how banking market competition, informational opacity, and sensitivity to shocks have changed over the last three decades by examining the persistence of firm-level rents. We develop propagation mechanisms with testable implications to isolate the sources of persistence. Our analysis suggests that different processes underlie persistent performance at the high and low ends of the distribution. Our tests suggest that impediments to competition and informational opacity continue to be strong determinants of performance; that the reduction in geographic regulatory restrictions had little effect on competitiveness; and that performance remains sensitive to regional/macroeconomic shocks. The findings also suggest reasons for the recent record profitability of the industry.
AUTHORS: Berger, Allen N.; Bonime, Seth D.; Covitz, Daniel M.; Hancock, Diana
Market discipline in banking reconsidered: the roles of deposit insurance reform, funding manager decisions and bond market liquidity
This paper demonstrates that the risk sensitivity of a banking organization's subordinated debt yield spreads may understate the potential for market discipline in some periods and overstate in others because such spreads contain liquidity premiums that are driven, in part, by the risk-sensitivity of funding manager decisions. Once such decisions are accounted for, new evidence is provided that indicates that subordinated debt spreads were sensitive to organization-specific risks in the mid-1980s, and that the risk- sensitivity of such spreads was about the same in the pre- and post-FDICIA periods. These results resolve some anomalies in the existing literature. In addition, it is argued that mandating the regular issuance of subordinated debt would, by reducing the endogeneity of liquidity premiums, improve the information content of both primary and secondary market debt spreads, thereby augmenting both direct and indirect market discipline.
AUTHORS: Covitz, Daniel M.; Hancock, Diana; Kwast, Myron L.
What does the yield on subordinated bank debt measure?
We provide evidence that a bank's subordinated debt yield spread is not, by itself, a sufficient measure of default risk. We use a model in which subordinated debt is held by investors with superior knowledge ("informed investor hypothesis"). First, we show that in theory the yield spread on subordinated debt must compensate investors for expected loss plus give them an incentive not to prefer senior debt. Second we present strong empirical evidence in favor of the informed investor hypothesis and of the existence of the incentive premium predicted by the model. Using data on the timing and pricing of public debt issues made by large U.S. banking organizations during the 1985-2002 period, we find that banks issue relatively more subordinated debt in good times, i.e. when informed investors have good news. Spreads at issuance (corrected for sample selection bias) react to (superior) private and to public information, in line with the comparative statics of the postulated incentive premium. Interestingly, as the model predicts, the influence of sophisticated investors' information on the subordinated yield spread became weaker after the introduction of prompt corrective action and depositor preference reforms, while the influence of public risk perception grew stronger. Finally, our model explains anomalies from the empirical literature on subordinated debt spreads and from market interviews (e.g. limited sensitivity to bank-specific risk and the "ballooning" of spreads in bad times). We conclude that a bank's subordinated yield spread conveys important information if interpreted together with its senior spread and with other banks' subordinated yield spreads.
AUTHORS: Hancock, Diana; Birchler, Urs W.
Bank efficiency derived from a profit function
AUTHORS: Hancock, Diana; Berger, Allen N.; Humphrey, David B.
The bank lending channel of monetary policy and its effect on mortgage lending
The bank lending channel of monetary policy suggests that banks play a special role in the transmission of monetary policy. We look for this special role by examining the business strategies of banks as it relates to mortgage funding and mortgage lending. "Traditional banks" have a large supply of excess core deposits and specialize in information-intensive lending to borrowers (which is proxied here using mortgage lending in subprime communities), whereas "market-based banks" are funded with managed liabilities and mainly lend to relatively easy-to-evaluate borrowers. We predict that only "transition banks" operating between these business strategies are likely to increase their loan rate spreads substantially in response to monetary tightening. To fund ongoing mortgage originations, these banks must substitute from core deposits to managed liabilities, which have a large external finance premium due to these banks' information-intensive lending. Consistent with this prediction, we find evidence of a bank lending channel only among transition banks - they significantly reduce mortgage lending in response to monetary contractions.
AUTHORS: Hancock, Diana; Black, Lamont K.; Passmore, Wayne