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Working Paper
Investigating output cycles under two alternative financial systems
Different financial systems vary in the way they contribute to the process of resource allocation in the economy and in the risk-sharing pattern that they bring about. It would therefore be plausible to expect different financial systems to differ in the way they affect real economic activity. I hereby provide a theoretic framework for the comparison and analysis of output cycles under two alternative financial systems: an equity-based financial system (EFS), in which a mutual fund functions as a financial intermediary, versus a debt-based financial system (DFS), in which a bank plays that ...
Working Paper
Community bank performance in the presence of county economic shocks
A potentially troubling characteristic of the U.S. banking industry is the geographic concentration of many community banks* offices and operations. If geographic concentration of operations exposes banks to local market risk, we should observe a widespread decline in their financial performance following adverse economic shocks. By analyzing the performance of a sample of geographically concentrated U.S. community banks exposed to severe unemployment shocks in the 1990s, we find that banks are not particularly sensitive to local economic deterioration. Indeed, performance at banks in ...
Working Paper
The Financial Modernization Act: evolution or revolution?
The Gramm-Leach-Bliley Act (GLBA) removed the barriers that separated commercial banking from investment banking, merchant banking, and insurance activities. Did this legislation revolutionize the financial services industry by allowing Financial Holding Companies (FHCs) to exploit revenue efficiencies and cost economies, or did it merely formalize an evolutionary process of deregulation that was already well underway? Our evidence refutes the notion that the GLBA was a revolutionary event, at least in the short run. Using a combination of market and accounting data, we find that, to date, ...
Working Paper
Gains from financial integration in the European union: evidence for new and old members
We estimate potential welfare gains from financial integration and corresponding better insurance against country-specific shocks to output (risk sharing) for the twenty-five European Union countries. Using theoretical utility-based measures we express the gains from risk sharing as the utility equivalent of a permanent increase in consumption. We report positive potential welfare gains for all the EU countries if they move toward full risk sharing. Ten country-members who joined the Union in 2004 have more volatile or counter-cyclical consumption and output and would obtain much higher ...
Working Paper
Understanding the subprime mortgage crisis
We analyze the subprime mortgage crisis: an unusually large fraction of subprime mortgages originated in 2006 being delinquent or in foreclosure only months later. We utilize a loan-level database, covering about half of all US subprime mortgages, and identify two major causes. First, over the past five years, high loan-to-value borrowers increasingly became high-risk borrowers, in terms of elevated delinquency and foreclosure rates. Lenders were aware of this and adjusted mortgage rates accordingly over time. Second, the below-average house price appreciation in 2006-2007 further contributed ...
Working Paper
What does the Federal Reserve’s economic value model tell us about interest rate risk at U.S. community banks?
The savings and loan crisis of the 1980s revealed the vulnerability of some depository institutions to changes in interest rates. Since that episode, U.S. bank supervisors have placed more emphasis on monitoring the interest rate risk of commercial banks. One outcome developed by economists at the Federal Reserve Board of Governors was a duration-based Economic Value Model (EVM) designed to estimate the interest rate sensitivity of banks. ; We test whether measures derived from the Fed?s EVM are correlated with the interest rate sensitivity of U.S. community banks. The answer to this question ...
Working Paper
Relationship loans and regulatory capital: why fair-value accounting is inappropriate for bank loans
Banks have been required to report many securities and all derivatives at fair values under U.S. GAAP rules for many years. Soon, International Accounting Standards will provide some banks with a ?fair-value option? for loans, also. A similar movement toward applying fair values to loans may occur in the U.S. in the near future, too. ; This paper argues that fair-value accounting is inappropriate for banks? relationship loans from the standpoint of safety-and-soundness supervision?that is, for the purposes of calculating a bank?s regulatory capital. The argument is straightforward, although ...
Working Paper
The future of small banks
This paper is a report to the Banking Supervision and Regulation Division on research that I conducted on the future of small banks while working in the Division as a Visiting Scholar. In this paper, small banks are identified as those with total assets less than $1 billion. Small banks have an important role in financing economic activity in the U.S., through their loans to small businesses. In addition, the Banking Supervision and Regulation Division of the St. Louis Fed has a vital interest in the future of small banks because most of the staff in this Division are involved in supervising ...
Working Paper
Consumer-finance myths and other obstacles to financial literacy
The consumer-finance market for middle and upper-income households in the United States is characterized by a wide range of choices, both in terms of financial-services providers and the specific products and services available.1 Prices generally are determined in competitive markets. Consumer-protection regulation is extensive. Why then is there so much dissatisfaction with the U.S. consumer-finance market, even for prime-quality customers? ; This paper focuses not on inadequate choices, inadequate competition or regulation, but on the difficulty many middle and upper-income households ...
Working Paper
Monetary policy actions and the incentive to invest
The ability of monetary policy actions to affect the private sector's incentive to invest in fixed capital is hotly debated. Whereas a downward shift in the yield curve increases the present value of expected cash flows and should spur investment, lower short-term interest rates make delay more desirable. These influences work against each other so the net effect of stimulative monetary policy actions could go either way. This article outlines a simple investment decision rule that captures both effects of changing interest rates. It also clarifies why monetary policy actions that shift the ...