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Series:Working Paper Series, Issues in Financial Regulation  Bank:Federal Reserve Bank of Chicago 

Working Paper
\\"Peso problem\\" explanations for term structure anomalies
We examine the empirical evidence on the expectation hypothesis of the term structure of interest rates in the United States, the United Kingdom, and Germany using the Campbell-Shiller (1991) regressions and a vector-autoregressive methodology. We argue that anomalies in the U.S. term structure, documented by Campbell and Shiller (1991), may be due to a generalized peso problem in which a high-interest rate regime occurred less frequently in the sample of U.S. data than was rationally anticipated. We formalize this idea as a regime-switching model of short-term interest rates estimated with data from seven countries. Technically, this model extends recent research on regime-switching models with state-dependent transitions to a cross-sectional setting. Use of the small sample distributions generated by regime-switching model for inference considerably weakens the evidence against the expectations hypothesis, but it remains somewhat implausible that our data-generating process produced the U.S. data. However, a model that combines moderate time-variation in term premiums with peso-problem effects is largely consistent with term-structure data from the U.S., U.K., and Germany.
AUTHORS: Bekaert, Geert; Marshall, David A.; Hodrick, Robert J.
DATE: 1997

Working Paper
Bank capital standards for market risk: a welfare analysis
We develop a model of commodity money and use it to analyze the following two questions motivated by issues in monetary history: What are the conditions under which Gresham's Law holds? And, what are the mechanics of a debasement (lowering the metallic content of coins)? The model contains light and heavy coins, imperfect information, and prices determined via bilateral bargaining. There are equilibria with neither, both, or only one type of coin in circulation. When both circulate, coins may trade by weight or by tale. We discuss the extent to which Gresham's Law holds in the various cases. Following a debasement, the quantity of reminting depends on the incentives oered by the sovereign. Equilibria exist with positive seigniorage and a mixture of old and new coins in circulation.
AUTHORS: Marshall, David A.; Venkataraman, Subu
DATE: 1997

Working Paper
The role of the financial services industry in the local economy
AUTHORS: Evanoff, Douglas D.; Israilevich, Philip R.; Graham R. Schindler
DATE: 1997

Working Paper
Bank failures, systemic risk, and bank regulation
AUTHORS: Kaufman, George G.
DATE: 1996

Working Paper
On biases in tests of the expectations hypothesis of the term structure of interest rates
We document extreme bias and dispersion in the small sample distributions of five standard regression tests of the expectations hypothesis of the term structure of interest rates. These biases derive from the extreme persistence in short interest rates. We derive approximate analytic expressions for these biases, and we characterize the small-sample distributions of these test statistics under a simple first-order autoregressive data generating process for the short rate. The biases are also present when the short rate is modeled with a more realistic regime-switching process. The differences between the small-sample distributions of test statistics and the asymptotic distributions partially reconcile the different inferences drawn when alternative tests are used to evaluate the expectations hypothesis. In general, the test statistics reject the expectations hypothesis more strongly and uniformly when they are evaluated using the small-sample distributions, as compared to the asymptotic distributions.
AUTHORS: Bekaert, Geert; Hodrick, Robert J.; Marshall, David A.
DATE: 1996

Working Paper
The equity premium puzzle and the risk-free rate puzzle at long horizons
The failure of consumption based asset pricing models to match the stochastic properties of the equity premium and the risk-free rate has been attributed by some authors to frictions, transaction costs or durability. However, such frictions would primarily affect the higher frequency data components: consumption-based pricing models that concentrate on long-horizon returns should be more successful. ; We consider three consumption-based models of the asset-pricing kernel: time-separable utility, and the models of Abel (1990) and Constantinides (1990). We estimate a vector ARCH model that includes the pricing kernel and the equity return, and use the fitted model to assess the model's implications for the equity premium and for the risk-free rate. We find that time-separable preferences fail at all horizons, and none of the models perform well at the quarterly horizon. When consumption is measured as nondurables plus services, the Abel and the Constantinides models show modest improvements at the one- and two-year horizon. However, when consumption is measured either as expenditures on nondurables or as total consumption purchases, versions the Abel and the Constantinides match the mean and the variance of the observed equity premium at the two-year horizon, capture a good deal of the time-variation of the equity premium in post-war data, and have more success matching the first and second moments of the observed risk-free rate. A major unresolved issue is to understand why the measured consumption services series perform so poorly in these models.
AUTHORS: Marshall, David A.; Kent Daniel
DATE: 1996

Working Paper
Strategic responses to bank regulation: evidence from HMDA data
The intent of fair lending regulation is to encourage loans in low income areas and insure that loan decisions are based on economic criteria instead of noneconomic borrower characteristics. We evaluate situations in which banks may find it in their self interest to respond to regulation in a strategic manner intended to improve public relations and appease regulators rather than to adhere to the true spirit of the regulation. We find some evidence consistent with such behavior.
AUTHORS: Segal, Lewis M.; Evanoff, Douglas D.
DATE: 1996

Working Paper
Deposit insurance, bank capital structures and the demand for liquidity
This paper provides an economic explanation for the extraordinary and historically unprecedented accumulation of liquid assets by the banking system in the aftermath of the Great Depression. At the end of the decade (1938 to 1939) the banking system held over 35 percent of their assets in non-interest bearing cash. Why are these holdings so high and why didn't we observe the same phenomenon in Canada? My theory is that, contrary to what happened in Canada, U.S. banks came out of the Depression severely undercapitalized and they did not immediately replenish the capital account because, at the time, it would have been extremely expensive to do so. In order to calm depositors' fears, bank managers increased the share of liquid assets in their portfolios to reduce their risk exposure on the asset side. In order to shed some light into this observation I construct a banking model that generates some empirically testable implications. The model generates a negative correlation between the equity-to-assets ratio and the liquidity ratio. Using aggregate time-series data (1929-1940), I find that this prediction is borne out in the data. The banking system held a higher share of liquid assets during periods of more severe undercapitalization. With Call Report data (1985Q1-1989Q4) on over 10,000 U.S. banks, I test the cross-sectional implications of the model. I perform a pooled time-series, cross-section, fixed-effects regression across different asset size classes and find evidence of the negative correlation suggested by the model. In fact the banks with higher shares of liquidity were the ones with more precarious capital positions. I also do a theoretical experiment on the optimal design of deposit insurance policies. I derive six propositions characterizing bank risk-taking and portfolio composition under three different deposit insurance arrangements: (i) Fixed-rate (FDIC type), (ii) Actuarially fair, and, Bank-neutral. Banks would never hold actuarially fair deposit insurance voluntarily and there is a moral hazard problem with fixed-rate deposit insurance. Bank-neutral deposit insurance eliminates the moral hazard incentive and allows implementation without coercion. It has an imbedded subsidy given by the FDIC but with good countercyclical properties.
AUTHORS: Ramos, Alberto M.
DATE: 1996

Working Paper
Bank fragility: perception and historical evidence
AUTHORS: Kaufman, George G.
DATE: 1996

Working Paper
How should financial institutions and markets be structured? Analysis and options for financial system design
AUTHORS: Kroszner, Randall S.; Kaufman, George G.
DATE: 1996

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