Tailoring Bank Regulations
Policy Update article: Tailoring Bank Regulations
Low Interest Rates and Bank Profits
The Fed?s December 2015 decision to raise interest rates after an unprecedented seven-year stasis offers a chance to assess the link between interest rates and bank profitability. A key determinant of a bank?s profitability is its net interest margin (NIM)?the gap between an institution?s interest income and interest expense, typically normalized by the average size of its interest-earning assets. The aggregate NIM for the largest U.S. banks reached historic lows in the fourth quarter of 2015, coinciding with the ?low for long? interest rate environment in place since the financial crisis. ...
Resolving \\"Too Big to Fail\\"
Many market participants believe that large financial institutions enjoy an implicit guarantee that the government will step in to rescue them from potential failure. These ?Too Big to Fail? (TBTF) issues became particularly salient during the 2008 crisis. From the government?s perspective, rescuing these financial institutions can be important to avoid harm to the financial system. The bailouts also artificially lower the risk borne by investors and the financing costs of big banks. The Dodd-Frank Act attempts to remove the incentive for governments to bail out banks in the first place by ...
Did Banks Subject to LCR Reduce Liquidity Creation?
Banks traditionally provide loans that are funded mostly by deposits and thereby create liquidity, which benefits the economy. However, since the loans are typically long-term and illiquid, whereas the deposits are short-term and liquid, this creation of liquidity entails risk for the bank because of the possibility that depositors may ?run? (that is, withdraw their deposits on short notice). To mitigate this risk, regulators implemented the liquidity coverage ratio (LCR) following the financial crisis of 2007-08, mandating banks to hold a buffer of liquid assets. A side effect ofthe ...
Bank Liquidity Creation, Systemic Risk, and Basel Liquidity Regulations
We find that banks subject to the Liquidity Coverage Ratio (LCR banks) create less liquidity per dollar of assets in the post-LCR period than non-LCR banks by, in part, lending less. However, we also find that LCR banks are more resilient as they contribute less to fire-sale risk, relative to non-LCR banks. We estimate the net after-tax benefits from reduced lending and fire-sale risk to be about 1.4 percent of assets in 2013:Q2-2014 for large banks. Our findings, which we show are unlikely to result from capital regulations, highlight the trade-off between lower liquidity creation and ...
Gates, fees, and preemptive runs
We build a model of a financial intermediary, in the tradition of Diamond and Dybvig (1983), and show that allowing the intermediary to impose redemption fees or gates in a crisis?a form of suspension of convertibility?can lead to preemptive runs. In our model, a fraction of investors (depositors) can become informed in advance about a shock to the return on the intermediary?s assets. Later, the informed investors learn the realization of the shock and choose their redemption behavior based on this information. We prove two results: First, there are situations in which informed investors ...
Banks' incentives and the quality of internal risk models
This paper investigates the incentives for banks to bias their internally generated risk estimates. We are able to estimate bank biases at the credit level by comparing bank-generated risk estimates within loan syndicates. The biases are positively correlated with measures of regulatory capital, even in the presence of bank fixed effects, consistent with an effort by low-capital banks to improve regulatory ratios. At the portfolio level, the difference in borrower probability of default is as large as 100 basis points, which can improve the typical loan portfolio?s Tier 1 capital ratio by as ...
Why do banks target ROE?
Historically, nonfinancial corporations relied on performance targets linked to their EPS. Up until the 1970s, banks also appeared to follow a similar practice, but since then they have favored ROE. Equity investors seem to be aware of these differences because EPS growth is better at explaining nonfinancials? stock market value while ROE is better at explaining banks? market values. In this paper we present a model of a bank with fixed-rate deposit insurance that faces increasing competition that erodes its charter value. When under these conditions the bank chooses its capital to maximize ...
Cyber Risk and the U.S. Financial System: A Pre-Mortem Analysis
We model how a cyber attack may be amplified through the U.S. financial system, focusing on the wholesale payments network. We estimate that the impairment of any of the five most active U.S. banks will result in significant spillovers to other banks, with 38 percent of the network affected on average. The impact varies and can be larger on particular days and in geographies with concentrated banking markets. When banks respond to uncertainty by liquidity hoarding, the potential impact in forgone payment activity is dramatic, reaching more than 2.5 times daily GDP. In a reverse stress test, ...
New Estimates of the Lerner Index of Market Power for U.S. Banks
The Lerner index is widely used to assess firms' market power. However, estimation and interpretation present several challenges, especially for banks, which tend to produce multiple outputs and operate with considerable inefficiency. We estimate Lerner indices for U.S. banks for 2001-18 using nonparametric estimators of the underlying cost and profit functions, controlling for inefficiency, and incorporating banks' off-balance-sheet activities. We find that mis-specification of cost or profit functional forms can seriously bias Lerner index estimates, as can failure to account for ...