nep-ban New Economics Papers
on Banking
Issue of 2018‒09‒10
twenty-six papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. The Performance of Financial Institutions: Modeling, Evidence, and Some Policy Implications By Joseph P. Hughes; Loretta J. Mester
  2. Capital Requirements in a Quantitative Model of Banking Industry Dynamics By Pablo D'Erasmo; Dean Corbae
  3. The Geographic Flow of Bank Funding and Access to Credit: Branch Networks and Local-Market Competition By Aguirregabiria, Victor; Clark, Robert; Wang, Hui
  4. Foreign Expansion, Competition and Bank Risk By Ester Faia; Sebastien Laffitte; Gianmarco Ottaviano
  5. Macroeconomic implications of shadow banks: A DSGE analysis By Bora Durdu; Molin Zhong
  6. Borrower-Specific and Institutional Factors Leading to the Forced or Voluntary Exit of Microfinance Borrowers By Cesar Escalante; Hofner Rusiana
  7. Testing the Quiet Life Hypothesis in the African Banking Industry By Asongu, Simplice; Odhiambo, Nicholas
  8. Repo market functioning: The role of capital regulation By Kotidis, Antonis; Van Horen, Neeltje
  9. Design of Macro-prudential Stress Tests By Dmitry Orlov; Andy Skrzypacz; Pavel Zryumov
  10. Where are the economies of scale in Canadian banking? By McKeown, Robert
  11. Costs, size and returns to scale among Canadian and U.S. commercial banks By McKeown, Robert
  12. Private Money Creation, Liquidity Crises, and Government Intervention By Benigno, Pierpaolo; Robatto, Roberto
  13. How Do Banks Interact with Fintechs? Forms of Alliances and their Impact on Bank Value By Lars Hornuf; Milan F. Klus; Todor S. Lohwasser; Armin Schwienbacher
  14. Dynamic Bank Capital Regulation in Equilibrium By Douglas Gale; Andrea Gamba; Marcella Lucchetta
  15. La correlazione tra PD ed LGD nell’analisi del rischio di credito/The correlation between probability of default and loss given default in the credit risk analysis By Franco Varetto
  16. Diversification benefits under multivariate second order regular variation By Das, Bikramjit; Kratz, Marie
  17. A General Equilibrium Theory of Capital Structure By Douglas Gale; Piero Gottardi
  18. Risk Management and Regulation By Tobias Adrian
  19. Shadow Banking and Market-Based Finance By Tobias Adrian; Bradley Jones
  20. Monitoring Bank Failures in a Data-Rich Environment By Jean Armand Gnagne; Kevin Moran
  21. A Model of Endogenous Debt Maturity with Heterogeneous Beliefs By Matthew Darst; Ehraz Refayet
  22. ALM and Credit Risk By Edward Bace
  23. Villains or Scapegoats? The Role of Subprime Borrowers in Driving the U.S. Housing Boom By Conklin, James; Frame, W. Scott; Gerardi, Kristopher S.; Liu, Haoyang
  24. The Incentive Channel of Capital Market Interventions By Michael Lee; Daniel Neuhann
  25. Data Lessons on Bank Behavior By Juliane Begenau; Jeremy Majerovitz; Saki Bigio
  26. Diversification and Systemic Bank Runs By Xuewen Liu

  1. By: Joseph P. Hughes (Rutgers University); Loretta J. Mester (Federal Reserve Bank of Cleveland)
    Abstract: The unique capital structure of commercial banking – funding production with demandable debt that participates in the economy’s payments system – affects various aspects of banking. It shapes commercial banks’ comparative advantage in providing financial products and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to operate and explicit and implicit federal guarantees of bank liabilities to reduce the probability of bank runs. These aspects of banking affect a bank’s choice of risk versus expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect their valuable charters from episodes of financial distress, and they also have an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. These are contrasting incentives tied to bank size. Measuring bank performance and its relationship to size requires untangling cost and profit from decisions about risk versus expected return because both cost and profit are functions of endogenous risk-taking. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of commercial banking cost that ignore endogenous risk-taking find little evidence of scale economies at the largest banks, while those that control for this risk-taking find large scale economies at the largest banks – evidence with important implications for regulation.
    Keywords: bank, efficiency, risk, cost, profit
    JEL: D20 D21 G21
    Date: 2018–09–07
  2. By: Pablo D'Erasmo (FRB Philadelphia); Dean Corbae (University of Wisconsin)
    Abstract: We develop a model of banking industry dynamics to study the quantitative impact of capital requirements on bank risk taking, commercial bank failure, and market structure. We propose a market structure where big banks with market power interact with small, competitive fringe banks. Banks face idiosyncratic funding shocks as well as aggregate shocks to the fraction of performing loans in their portfolio. A nontrivial size distribution of banks arises out of endogenous entry and exit, as well as banks' buffer stock of net worth. We test the model using business cycle properties and the bank lending channel across banks of different sizes. We then conduct a series of counterfactuals (including countercyclical requirements and size contingent (e.g. SIFI) requirements). We find that regulatory policies can have an important impact on market structure itself.
    Date: 2018
  3. By: Aguirregabiria, Victor; Clark, Robert; Wang, Hui
    Abstract: This paper studies the integration of deposit and loan markets, which may be constrained by the geographic dispersion of depositors, borrowers, and banks. This dispersion results in problems of asymmetric information, monitoring and transaction costs, which in turn may prevent deposits from owing from areas of low demand for loans to areas of high demand. We provide systematic evidence on the extent to which deposits and loans are geographically imbalanced, and develop a methodology for investigating the contribution of (i) branch networks, (ii) local market power, and (iii) economies of scope to this imbalance using data at the bank-county- year level from the US banking industry for 1998-2010. Our results are based on the construction of an index which measures the geographic imbalance of deposits and loans, and the estimation of a structural model of bank oligopoly competition for deposits and loans in multiple geographic markets. The estimated model shows that a bank's total deposits have a significant effect on the bank's market shares in loan markets. We also find evidence of significant economies of scope between deposits and loans at the local level. Counterfactual experiments show that multi-state branch networks contribute significantly to the geographic ow of credit but benefit especially larger/richer counties. Local market power has a very substantial negative effect on the ow of credit to smaller/poorer counties.
    Keywords: Demand and Price Analysis, Financial Economics
    Date: 2017–11
  4. By: Ester Faia; Sebastien Laffitte; Gianmarco Ottaviano
    Abstract: Using a novel dataset on the 15 European banks classified as G-SIBs from 2005 to 2014, we find that the impact of foreign expansion on risk is always negative and significant for most individual and systemic risk metrics. In the case of individual metrics, we also find that foreign expansion affects risk through a competition channel as the estimated impact of openings differs between host countries that are more or less competitive than the source country. The systemic risk metrics also decline with respect to expansion, though results for the competition channel are more mixed, suggesting that systemic risk is more likely to be affected by country or business models characteristics that go beyond and above the differential intensity of competition between source and host markets. Empirical results can be rationalized through a simple model with oligopolistic/oligopsonistic banks and endogenous assets/liabilities risk.
    Keywords: banks risk-taking, systemic risk, geographical expansion, gravity, diversification, competition, regulatory arbitrage
    JEL: G21 G32 L13
    Date: 2018–08
  5. By: Bora Durdu (Federal Reserve Board); Molin Zhong (Federal Reserve Board)
    Abstract: Shadow banks have played an increasing role in the intermediation of credit as well as transmission of shocks to the rest of the economy over the last two decades. We examine the implications of these banks using a medium-scale DSGE model in which shadow banks differ from commercial banks in two aspects. First, shadow banks do not face capital requirements. Second, these banks do not receive deposit insurance from the government. Using the model, we highlight that shadow banks can mitigate the effects of an increase in capital requirements. A one percentage point increase in capital requirements leads to an annualized decline from 0.75% to around 0.05% in commercial bank default rates in the longer run. These declines in default rates are achieved with modest declines in economic activity; the change in capital requirement leads to a short-run decline in GDP of 0.6%, a long-run decline of 0.2%, and a total lending decline of 0.9%.
    Date: 2018
  6. By: Cesar Escalante (University of Georgia); Hofner Rusiana (University of Georgia)
    Abstract: Microfinance borrowers tend to have no properties to offer as loan security (collateral) as they are poor and low-income, and thus would constitute a considerable risk to lenders once they default. MFIs, therefore, have to device a system to ensure that loan defaults are as low as possible in order to maintain their financial sustainability, without which they would resort to higher interest rates that would only defeat the original intent of their microfinance lending philosophy.This paper seeks to identify factors that affect the voluntary exits or forced eviction of Philippine borrowers from microfinance lending networks focusing on indicators that are (a)internal to the borrowers? personal circumstances and business operating environments; and(b)those that capture the microfinance institutions? loan delivery operations. The analysis will analyze data compiled by the Social Enterprise Development Partnerships, Inc. (SEDPI) on micro-insurance borrowers in the Philippines from 2000 to 2010. Econometric analysis will employ Heckman selection techniques to determine significant determinants of either the forced eviction or the voluntary exit of MFI borrowers. Two versions of the Heckman equation system will be developed. The first version defines the selection equation to select MFI borrower observations who were forced to leave the program (FORCED=1; VOLUNTARY=0) for the outcome equation that identifies significant factors behind such MFI action. The second version?s selection equation focuses on the voluntary borrower exits (VOLUNTARY=1; FORCED=0) so that the outcome equation will determine significant factors behind such borrowers? decisions. Explanatory variables will capture personal, business, Centre-related, and macroeconomic factors. Expected results will shed light on how sudden changes in personal circumstances of certain borrowers (physical and economic), business viability issues (often associated with macroeconomic conditions), and institutional factors affecting borrower servicing and other borrower-lender relationship issues may lead to either the MFIs? decision to evict certain borrowers or individual borrowers voluntarily deciding to exit from the MFI lending system. This study offers important implications on achieving a proper balance of financial sustainability and social outreach goals of microfinance operations. This balancing of goals has been a difficult challenge for most MFIs globally. The Philippine microfinance experience may help shed light on possible remedies to this elusive balancing goal.
    Keywords: microfinance, forced exit, voluntary exit, financial sustainability, loan repayment, loan delivery
    JEL: D19 G21 L26
    Date: 2018–07
  7. By: Asongu, Simplice; Odhiambo, Nicholas
    Abstract: The Quiet Life Hypothesis (QLH) is the pursuit of less efficiency by firms. In this study, we assess if powerful banks in the African banking industry are increasing financial access. The QLH is therefore consistent with the pursuit of financial intermediation inefficiency by large banks. To investigate the hypothesis, we first estimate the Lerner index. Then, using Two Stage Least Squares, we assess the effect of the Lerner index on financial access proxied by loan price and loan quantity. The empirical evidence is based on a panel of 162 banks from 42 African countries for the period 2001-2011. The findings support the QLH, although quiet life is driven by the below-median Lerner index sub-sample. Policy implications are discussed.
    Keywords: Financial access; Bank performance; Africa
    JEL: D40 G20 G29 L10 O55
    Date: 2018–01
  8. By: Kotidis, Antonis; Van Horen, Neeltje
    Abstract: This paper shows that the leverage ratio affects repo intermediation for banks and non-bank financial institutions. We exploit a novel regulatory change in the UK to identify an exogenous intensification of the leverage ratio and combine this with supervisory transaction-level data capturing the near-universe of gilt repo trading. Studying adjustments at the dealer-client level and controlling for demand and confounding factors, we find that dealers subject to a more binding leverage ratio reduced liquidity in the repo market. This affected their small but not their large clients. We further document a reduction in frequency of transactions and a worsening of repo pricing, but no adjustment in haircuts or maturities. Finally, we find evidence of market resilience, based on existing, rather than new repo relationships, with foreign, non-constrained dealers stepping in. Overall, our findings help shed light on the impact of Basel III capital regulation on repo markets.
    Keywords: Capital regulation; leverage ratio; non-bank financial institutions; repo market
    JEL: G10 G21 G23
    Date: 2018–07
  9. By: Dmitry Orlov (University of Rochester); Andy Skrzypacz (Stanford Graduate School of Business); Pavel Zryumov (University of Rochester)
    Abstract: We study the design of macro-prudential stress tests and capital requirements. The tests provide information about correlation in banks portfolios. The regulator chooses contingent capital requirements that create a liquidity buffer in case of a fire sale. The optimal stress test discloses information partially: when systemic risk is low, capital requirements reflect full information; when systemic risk is high, the regulator pools information and requires all banks to hold precautionary liquidity. With heterogeneous banks, weak banks determine the level of transparency and strong banks are often required to hold excess capital when systemic risk is high. Moreover, dynamic disclosure and capital adjustments can improve welfare.
    Date: 2018
  10. By: McKeown, Robert
    Abstract: Using a new data set from the Office of the Superintendent of Financial Institutions, I conduct an in-depth study on cost efficiency and returns to scale (RTS) in Canadian banking. I estimate a transcendental log cost function for the six largest Canadian commercial banks which account for approximately 90% of chartered bank assets over the 1996-2011 sample period. The minimal amount of firm entry and exit simplifies many difficulties in the analysis, and the panel dynamic ordinary least squares estimator (PDOLS) provides less biased results than the fixed-effect OLS. Departing from previous studies in banking, I calculate whether the estimated cost function satisfies the microeconomic properties of a monotonicity and price concavity. To my knowledge, this is the first paper to find evidence of constant RTS among the Canadian banks. The result is robust to a number of different asset and price specifications. Furthermore, there is little evidence to suggest cost inefficiencies among the large Canadian banks. This is true whether the Greene (2005) true fixed effects ML estimator is estimated or a distribution-free approach is measured. Combining these two results, the large Canadian banks managed costs efficiently and minimized costs from 1996 to 2011.
    Keywords: Financial Economics, International Development
    Date: 2017–04
  11. By: McKeown, Robert
    Abstract: I compare returns to scale in the U.S. and Canadian banking system from 1996 to 2015. I estimate a parametric trans-log cost function and, for robustness, an inputoriented distance function. I do this in a way that is commensurate with the limitations of these models. Among the ten largest commercial banks, I find evidence for small but statistically significant increasing returns to scale (RTS). This reflects the descriptive data that offers little evidence for extremely large scale economies. Comparatively, I find constant RTS for the Canadian banks. They paid fewer costs per asset, particularly lower labour costs and legal penalties. Comparing income statement items, I find that, despite higher firm concentration in Canada, the U.S. banks had higher net interest margin rate, paid a lower rate of interest on funds, and had higher credit losses per financial assets. If the U.S. banking system is more competitive, this questions whether an increase in bank competition will create a net positive outcome for society.
    Keywords: Financial Economics
    Date: 2017–04
  12. By: Benigno, Pierpaolo; Robatto, Roberto
    Abstract: We study the joint supply of public and private liquidity when financial intermediaries issue both riskless and risky debt and the economy is vulnerable to liquidity crises. Government interventions in the form of asset purchases and deposit insurance are equivalent (in the sense that they sustain the same equilibrium allocations), increase welfare, and, if fiscal capacity is sufficiently large, eliminate liquidity crises. In contrast, restricting intermediaries to invest in low-risk projects always eliminates liquidity crises but reduces welfare. Under some conditions, deposit insurance gives rise to an equilibrium in which intermediaries that issue insured debt (i.e., traditional banks) coexist with others that issue uninsured debt (i.e., shadow banks), despite the two being ex ante identical.
    Date: 2018–07
  13. By: Lars Hornuf; Milan F. Klus; Todor S. Lohwasser; Armin Schwienbacher
    Abstract: The increasing pervasiveness of technology-driven firms that offer banking services has led to a growing pressure on traditional banks to modernize their core business activities. Banks attempt to confront the challenges of digitalization by cooperating with financial technology firms (fintechs) in various forms. In this paper, we investigate the factors that drive banks to form alliances with fintechs. Furthermore, we analyze whether such bank-fintech alliances affect the market valuation of banks. We provide descriptive evidence on the different forms of alliances occurring in practice. Using hand-collected data covering the largest banks from Canada, France, Germany, and the United Kingdom, we show that banks are significantly more likely to form alliances with fintechs when they pursue a well-defined digital strategy and/or employ a Chief Digital Officer. We evidence that markets react more strongly if digital banks rather than traditional banks announce a bank-fintech alliance. Finally, we find that alliances are most often characterized by a product-related collaboration between the bank and the fintech and that banks most often cooperate with fintechs providing payment services.
    Keywords: fintech, strategic alliance, entrepreneurial finance, financial institutions, banks
    JEL: G21 G23 G34 M13
    Date: 2018
  14. By: Douglas Gale (New York University); Andrea Gamba (University of Warwick); Marcella Lucchetta (Universita Ca' Foscari)
    Abstract: We study optimal bank regulation in an economy with aggregate uncertainty. Bank liabilities are used as “money” and hence earn lower returns than equity. In laissez faire equilibrium, banks maximize market value, trading off the funding advantage of debt against the risk of costly default. The capital structure is not socially optimal because external costs of distress are not internalized by the banks. The constrained efficient allocation is characterized as the solution to a planner’s problem. Efficient regulation is procyclical, but countercyclical relative to laissez faire. We show that simple leverage constraints can get the decentralized economy close to the constrained efficient outcome.
    Date: 2018
  15. By: Franco Varetto (CNR-IRCRES, National Research Council, Research Institute on Sustainable Economic Growth, via Real Collegio 30, Moncalieri (TO) – Italy and The Munk School of Global Affairs, University of Toronto, 315 Bloor Street West, Toronto, ON, M5S 0A7 Canada)
    Abstract: The international regulation on banking developed by Basel Committee on Banking Supervision has set a simplified link between default probabilities and loss given default, avoiding to introduce the correlation. The scientific literature ha proposed many models that try to improve the Basel framework. This article examines the most important models proposed in the literature and apply two of them to aggregate data from the Bank of Italy.
    Keywords: Default probability, loss given default, correlation, credit risk, credit portfolio model, credit VaR
    JEL: G21 G28 G33 C18
    Date: 2017–12
  16. By: Das, Bikramjit (Singapore University of Technology and Design); Kratz, Marie (ESSEC Research Center, ESSEC Business School)
    Abstract: We analyze risk diversification in a portfolio of heavy-tailed risk factors under the assumption of second order multivariate regular variation. Asymptotic limits for a measure of diversification benefit are obtained when considering, for instance, the value-at-risk . The asymptotic limits are computed in a few examples exhibiting a variety of different assumptions made on marginal or joint distributions. This study ties up existing related results available in the literature under a broader umbrella.
    Keywords: asymptotic theory; diversification benefit; heavy tail; risk concentration; second order regular variation; value-at-risk
    JEL: C02
    Date: 2017–04
  17. By: Douglas Gale (New York University); Piero Gottardi (European University Institute)
    Abstract: We develop a general equilibrium theory of the capital structures of banks and firms. The liquidity services of bank deposits make deposits a "cheaper" source of funding than equity. Banks pass on part of this funding advantage in the form of lower interest rates to firms that borrow from them. Firms and banks choose their capital structures to balance the benefits of debt financing against the risk of costly default. An increase in the equity of a firm makes its debt less risky and that in turn reduces the risk of the banks who lend to the firm. Hence there is some substitutability between firm and bank equity. We find that firms have a comparative advantage in providing a buffer against systemic shocks, whereas banks have a comparative advantage in providing a buffer against idiosyncratic shocks.
    Date: 2018
  18. By: Tobias Adrian
    Abstract: The evolution of risk management has resulted from the interplay of financial crises, risk management practices, and regulatory actions. In the 1970s, research lay the intellectual foundations for the risk management practices that were systematically implemented in the 1980s as bond trading revolutionized Wall Street. Quants developed dynamic hedging, Value-at-Risk, and credit risk models based on the insights of financial economics. In parallel, the Basel I framework created a level playing field among banks across countries. Following the 1987 stock market crash, the near failure of Salomon Brothers, and the failure of Drexel Burnham Lambert, in 1996 the Basel Committee on Banking Supervision published the Market Risk Amendment to the Basel I Capital Accord; the amendment went into effect in 1998. It led to a migration of bank risk management practices toward market risk regulations. The framework was further developed in the Basel II Accord, which, however, from the very beginning, was labeled as being procyclical due to the reliance of capital requirements on contemporaneous volatility estimates. Indeed, the failure to measure and manage risk adequately can be viewed as a key contributor to the 2008 global financial crisis. Subsequent innovations in risk management practices have been dominated by regulatory innovations, including capital and liquidity stress testing, macroprudential surcharges, resolution regimes, and countercyclical capital requirements.
    Keywords: Stock exchanges;Capital movements;Financial risk;Risk management;
    Date: 2018–08–01
  19. By: Tobias Adrian; Bradley Jones
    Abstract: Variants of nonbank credit intermediation differ greatly. We provide a conceptual framework to help distinguish various characteristics—structural features, economic motivations, and risk implications—associated with different forms of nonbank credit intermediation. Anchored by this framework, we take stock of the evolution of shadow banking and the extent of its transformation into market-based finance since the global financial crisis. In light of the substantial regulatory and supervisory responses of recent years, we highlight key areas of progress while drawing attention to elements where work still needs to be done. Case studies of policy challenges arising in different jurisdictions are also discussed. While many of the amplification forces that were at play during the global financial crisis have diminished, the post-crisis reform agenda is not yet complete, and policy makers must remain attentive to new challenges looming on the horizon.
    Keywords: Bank credit;Financial intermediation;Nonbank financial institution supervision;Stock exchanges;
    Date: 2018–08–01
  20. By: Jean Armand Gnagne; Kevin Moran
    Abstract: This paper develops a monitoring and forecasting model for the aggregate monthly number of commercial bank failures in the U.S. We extract key sectoral predictors from the large set of macroeconomic variables proposed by McCracken and Ng (2016) and incorporate them in a hurdle negative binomial model to predict the number of monthly commercial bank failures. We uncover a strong and robust relationship between the predictor synthesizing housing industry variables and bank failures. This relationship suggests the existence of a link between developments in the housing sector and the vulnerability of commercial banks to non-performing loans increases and asset deterioration. We assess different specifications
    Keywords: Financial Regulation, Financial Crises, Factors Models, Diffusion Index Models
    JEL: E60 F37 G01
    Date: 2018
  21. By: Matthew Darst (Board of Governors of the Federal Reserv); Ehraz Refayet (Office of the Comptroller of the Currency, U.S. Treasury)
    Abstract: This paper studies optimal debt maturity when firms issue non-contingent claims and investors disagree about repayment probabilities. The optimal debt maturity choice is a mix of long- and short-term debt securities. Multiple maturity issuances allow firms to best leverage scarce collateral by intertemporally catering risky promises to investors most willing to hold risk. Heterogeneous investors directly contrasts theories of debt predicated on agency costs and liquidity risk and provide a novel explanation for why large and mature companies typically issue debt with multiple maturities. Lastly, we show that non-financial covenants aimed at preventing debt dilution do not affect real outcomes because they simply reallocate collateral from short-term to long-term debt holders.
    Date: 2018
  22. By: Edward Bace (Middlesex University)
    Abstract: Credit risk is the main risk exposure of the vast majority of banks in any country. It represents a primary risk to the balance sheet. In a financial institution, credit risk management must be the responsibility of the Asset and Liability Committee (ALCO). The recommended operating model is that ALCO has effective authority to monitor, and ultimately approve, all operational aspects that impact the balance sheet.Individual business lines will manage their respective credit risks under the direction of the credit risk committee which also sets the firm-wide policy. Management of credit exposure (at the balance sheet level) is frequently undertaken by the treasury or ALM department, through use of credit derivatives, for example.The nature of ALCO oversight is technical: capital, liquidity, market and non-traded market and other cash flow impacts on the balance sheet. Given this core aspect of ALCO?s role, the need arises to establish a technical sub-committee of ALCO, perhaps called The Balance Sheet Management Committee (BSMCO), chaired by the Treasurer, to review the balance sheet and escalates issues where necessary to ALCO. Membership of BSMCO is at one level below the senior executives (CEO, CFO, CRO) with the exception of the Treasurer.The other recommended technical sub-committee of ALCO is the Product Pricing Committee / Deposit Pricing Committee (PPCO/DPCO). This is a smaller committee whose remit is to ensure that, based on the recommended model, all pricing decisions are made by ALCO. Products in question would be customer deposit products, perhaps extended to customer asset products if deemed necessary. PPCO (or DPCO) has delegated authority to approve specific changes to standard rates for one-off transactions.Given its importance to the balance sheet, ALCO can only undertake its mission effectively if it has final authority on credit risk exposure and credit risk appetite. This means the overall policy of the Credit Risk Committee must fall to ALCO review.ALCO is responsible for through-the-cycle sustainability of the balance sheet. Since credit risk exposure is the main negative impact potential on the balance sheet, ALCO must have oversight of it. This does not mean day-to-day running and minutiae of credit risk origination. It means approval of policies, monitoring of exposure and approval authority on significant transactions and any policy changes. This research presents such recommendations for effective implementations of a bank ALM process.
    Keywords: Asset liability management, treasury, credit risk
    JEL: G21 G32
    Date: 2018–07
  23. By: Conklin, James (University of Georgia); Frame, W. Scott (Federal Reserve Bank of Atlanta); Gerardi, Kristopher S. (Federal Reserve Bank of Atlanta); Liu, Haoyang (Federal Reserve Bank of New York)
    Abstract: An expansion in mortgage credit to subprime borrowers is widely believed to have been a principal driver of the 2002–06 U.S. house price boom. Contrary to this belief, we show that the house price and subprime booms occurred in different places. Counties with the largest home price appreciation between 2002 and 2006 had the largest declines in the share of purchase mortgages to subprime borrowers. We also document that the expansion in speculative mortgage products and underwriting fraud was not concentrated among subprime borrowers.
    Keywords: mortgages; subprime; house prices; credit scores; housing boom
    JEL: D14 D18 D53 G21 G38
    Date: 2018–08–01
  24. By: Michael Lee (Federal Reserve Bank of New York); Daniel Neuhann (UT Austin, McCombs School of Business)
    Abstract: We develop a tractable dynamic model of collateralized lending in which the degree of adverse selection evolves endogenously due to moral hazard. We use this model to study how government interventions designed to boost liquidity in frozen markets af- fect private incentives to maintain high-quality assets. We show that small interventions can lead to “intervention traps” – expectations concerning future interventions destroy private incentives to improve the quality of collateral, which stunts recovery and war- rants continued market intervention – even when they restore market liquidity. Bigger interventions may lead to faster recoveries, and it may be efficient to continue to inter- vene even after market liquidity is restored. This runs counter to previous findings in static environments where it is optimal to keep interventions as small as possible, and to intervene only when markets are illiquid.
    Date: 2018
  25. By: Juliane Begenau (Stanford University); Jeremy Majerovitz (Stanford University); Saki Bigio (UCLA)
    Abstract: We investigate the behavior of bank balance sheet's in the United States during 2007-2015. The goal is to deepen the understanding of the behavior of banks. During this period, bank aggregate book-equity losses were entirely offset by equity issuances whereas market-value losses were catastrophic and never recovered. We find evidence that supports a theory where banks target market leverage, but where adjustments to a target are very gradual. We also find that, in contrast to the pre-crisis period, during the post-crisis banks relied more on retained earnings rather than on assets sales to adjust to a market leverage target. We present a heterogeneous-bank model that rationalizes these facts and can serve as a building block for future work.
    Date: 2018
  26. By: Xuewen Liu (HKUST)
    Abstract: Diversification through pooling and tranching securities was supposed to mitigate creditor runs in financial institutions by reducing their credit risk, yet many financial institutions holding diversified portfolios experienced creditor runs in the recent financial crisis of 2007-2009. We present a theoretical model to explain this puzzle. In our model, because financial institutions all hold similar (diversified) portfolios, their behavior in the asset market is clustered: they either sell their assets at the same time or collectively do not sell. Such clustering behavior reduces market liquidity after an adverse shock and increases the probability of a panic run by creditors. We show that diversification, while making the financial system more robust against small shocks, increases the possibility of a systemic crisis in the case of a larger shock; diversification, inducing stronger strategic complementarities across institutions, makes a self-fulfilling systemic crisis (multiple equilibria) more likely. Because individual institutions either over-diversify or under-diversity in the competitive equilibrium compared with the social optimum, there is room for regulation.
    Date: 2018

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