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Highlights of Research Conducted by The Clearing House
Over the second quarter, the research department has released two research notes and nine blog posts. Here are brief synopses of the most recent research. The full library of TCH research can be found here.
Are the Supervisory Bank Stress Tests Constraining the Supply of Credit to Small Businesses?
This note finds that the U.S. stress tests are constraining the availability of small business loans secured by nonfarm nonresidential properties, which account for approximately half of small business loans on the books of all banks.
Capital Requirements in Supervisory Stress Tests and their Adverse Impact on Small Business Lending
This paper estimates the implicit capital requirements in the U.S. supervisory stress tests. Our results show that stress tests are imposing dramatically higher capital requirements on certain asset classes – most notably, small business loans and residential mortgages – than bank internal models and Basel standardized models.In addition, the paper identifies the impact of supervisory stress tests on the availability of credit to small businesses by analyzing differences in small business loan growth at banks subject to stress tests versus those that are not.
FED Paper: An Empirical Economic Assessment of the Costs and Benefits of Bank Capital in the US
(Firestone, Lorenc & Ranish)
The authors evaluate the economic costs and benefits of bank capital in the U.S., accounting for the impact of liquidity and resolution-related regulations on the probability of a crisis. Analysis reveals that increases in the banks’ cost of funding are transferred to borrowers, thus hindering economic output. They find that levels of bank capital between 13% and 26% maximize net benefits.
IMF Working Paper: Back to the Future: The Nature of Regulatory Capital Requirements
(Chami et al.)
This paper compares regulatory capital requirements under the Dodd-Frank Act with those under the proposed Financial CHOICE Act. They find that most banks would not qualify for the 10% leverage ratio option unless they add considerable amounts of capital. However, most large banks are actually very close to the proposed leverage threshold and are more likely to gain from this regulatory relief. The paper also indicates that banks are likely to increase risk-taking while trying to qualify for the “off-ramp” option.
FRB Cleveland Working Paper: The Optimal Response of Bank Capital Requirements to Credit and Risk in a Model with Financial Spillovers
This paper studies optimal bank capital requirements in an economy where bank losses have financial spillovers. The spillovers amplify the effects of shocks, making the banking system and the economy less stable. The spillovers increase with banks’ financial distortions, which in turn increase with banks’ credit risk. Higher capital requirements dampen the current supply of banks’ credit, but mitigate banks’ future financial distortions. Thus, this paper argues that capital requirements should be raised in response to both an expansion of banks’ credit supply and an increase in expected credit losses. They should be lowered close to one-to-one in response to an increase in realized bank losses.
BoE Staff Working Paper: The Economic Cost of Capital: A VECM Approach for Estimating and Testing the Banking Sector’s Response to Changes in Capital Ratios
(de-Ramon & Straughan)
The paper conducts an econometric analysis on the long- and short-run implications of the Basel III/CRD IV reforms on U.K. banking activity. The paper finds that in response to an increase in capital requirements, banks increase credit spreads to nonfinancial corporate borrowers before households in order to reduce exposures to riskier borrowers with shorter maturity to maximize the reduction in risk-weighted assets. Over the long run, banks increase lending spreads across both sectors to recover the increase in funding costs.
Liquidity and Lending
BIS Working Paper: The Shifting Drivers of Global Liquidity
(Avdjiev, Gambacorta, Goldberg & Schiaffi)
The post-crisis period has seen a considerable shift in the composition and drivers of international bank lending and international bond issuance, the two main components of global liquidity. The paper analyses the shifting sensitivities of both types of flows since the crisis to drivers including: U.S. monetary policy, global risk conditions, changes in country composition of lending banking systems, and changes in the behaviors of creditors involved in international financial flows.
(Santioni, Schiantarelli & Strahan)
This paper shows that in Italy, firms in business groups have been more likely to survive the challenging environment following the global financial crisis and the euro crisis compared to unaffiliated firms. Better performance stems from access to an internal capital market; actual internal capital transfers increase during the crisis, and these transfers move funds from cash-rich to cash-poor firms and also to those with more favorable investment opportunities. The paper’s results highlight the benefits of internal capital markets when external capital markets are tight or distressed.
(Jagtiani & Lemieux)
The authors explore advantages and disadvantages of loans made by the Lending Club versus those originated through traditional banking. The authors find that the use of alternative information has allowed borrowers that would traditionally be classified as subprime to get better loan grades and therefore lower credit costs from the Lending Club. In addition to penetrating more underserved areas, consumers pay smaller spreads on loans with the same risk of default through the Lending Club. The findings imply that FinTech can provide wider access to credit at a lower cost due the differences in the way these lending channels are regulated and suggest that banks could benefit partnering with FinTech for access to alternative data sources and big data.
(Acharya, Berger & Roman)
While the U.S. bank stress tests aim to improve financial system stability, they may also affect bank credit supply. Testing a number of hypotheses, the paper’s results are consistent with the Risk Management Hypothesis, under which stress-tested banks reduce credit supply – particularly to relatively risky borrowers – to decrease their credit risk. The findings do not support the Moral Hazard Hypothesis, in which these banks expand credit supply – particularly to relatively risky borrowers that pay high spreads – increasing their risk.
(Chen, Hanson & Stein)
Small business lending by the four largest U.S. banks fell sharply relative to other banks beginning in 2008 and remained depressed through 2014. This paper explores the consequences of this credit supply shock, finding that in high Top 4 counties, the aggregate flow of small business credit fell and interest rates rose from 2006 to 2010. In this period, fewer businesses expanded employment, the unemployment rate rose, and wages fell. Exploring how high Top 4 counties adjusted to this shock from 2010 to 2014, the authors find that the flow of small business credit has slowly recovered in affected counties, as smaller banks, non-bank finance companies, and online lenders have filled the void left by the Top 4 banks. However, loan interest rates remain elevated, suggesting that credit conditions are still tighter in these areas.
(Kang, Vitek, et al.)
Using event study and panel regression analyses, the authors present evidence that liquidity and macroprudential policy measures have small but regionally concentrated credit and output spillovers to cross-border banking activities worldwide while interventions focused on capital do not. Adjustments to the countercyclical capital buffer were also found to have the potential to generate spillovers affecting countries and their largest counterparties.
(Kim, Plosser & Santos)
The authors studied interagency guidance on leveraged lending and revealed that guidance was most effective on large, closely supervised banks that were given clear directives. This interagency guidance also triggered a migration of leveraged lending to nonbanks that have less-stringent lending policies. The authors concluded that non-banks increased their borrowing following the issuance of guidance to grow their leveraged lending. While this guidance reduced the leveraged lending activity of the banks, it is unclear whether it actually reduced the risk that these loans pose for greater financial stability.
(Altunbas, Binici & Gambacorta)
This paper investigates the effects of macroprudential policies on bank risk through a panel of banks operating in 61 advanced and emerging market economies. First, the authors find evidence suggesting that macroprudential tools have a significant impact on bank risk. Second, bank responses to changes in macroprudential tools differ depending on their specific balance sheet characteristics. In particular, smaller, weakly capitalized banks and those more dependent on wholesale funding react more strongly to changes in macroprudential tools. Third, controlling for bank-specific characteristics, macroprudential policies are more effective when tightened than when eased.
This paper examines whether the low interest rate environment that has prevailed since the Great Recession has compelled banks to reach for yield, focusing on a bank’s exposure to interest rate risk through the maturity mismatch between its assets and liabilities. It finds evidence that the banks that faced less enhanced regulation after the financial crisis took on assets with longer maturities or prepayment risk, while those banks designated as systematically important and thus subjected to expanded post-crisis regulations have substantially shortened the average maturity of their assets since the crisis. There is some evidence that greater maturity mismatch is slightly more associated with a higher net interest margin during the post-crisis years. After the taper tantrum in 2013, these two groups of banks also adjusted their securities holdings in different ways, consistent with the differential regulatory accounting treatment.
(Amiti, McGuire & Weinstein)
This paper addresses a question crucial to understanding international transmission of financial shocks: What is the role for supply and demand forces in determining movements in international banking flows? The authors find that during non-crisis years, bank flows are well-explained by a common global factor and a local demand factor. But during times of crisis, flows are affected by idiosyncratic supply shocks to a borrower country’s creditor banks. This has important implications for why standard models break down during crises.
Bank Regulation, Innovation & Other
(Athey, Catalini & Tucker)
“Notice and choice” has been a mainstay of policies designed to safeguard consumer privacy. Using field experiment data from the MIT digital currency experiment, this paper investigates distortions in consumer behavior when faced with notice and choice, which may limit the ability of consumers to safeguard privacy. First, the authors find that small incentives may explain the privacy paradox: While people say they care about privacy, they are willing to relinquish private data quite easily when given an incentive to do so. Second, small navigation costs have a tangible effect on how privacy-protective consumers’ choices are, often in sharp contrast with individual stated preferences. Third, the introduction of irrelevant but reassuring information about privacy protection makes consumers less likely to avoid surveillance, regardless of their stated privacy preferences.
This paper presents trends for regulators to consider as they move toward regulating new entrants into the FinTech industry. The author points out that encouraging entry, leveraging innovation, and shaping development of new systems might be the best way to solve the remaining challenges of financial regulation.
(Price, Wang & Wolman)
The authors use a data set of retail transactions at a national chain bank to examine the influence of location, day of the week, day of the month, and long-term trends on the consumer’s choice of transaction. Some highlights include the finding that as consumers’ payment behavior changed with transaction size, so did the dispersion of that behavior across locations; namely, the use of cash varied widely from location to location. The authors also note that the overall use of cash is declining in favor of debit or credit card transactions, especially for higher value transactions.
(Levine, Lin & Wang)
The authors use data from U.S. bank acquisitions from 1986 to 2014 to determine whether the predeal geographic reach of bank branches and subsidiaries have any effect on mergers or merger outcomes. They find that (1) banks with greater network overlap before a merger have an increased likelihood of merging in the future, and (2) there are higher cumulative abnormal returns to the acquirer, target, and combined banks. They also find that this network overlap is associated with larger labor cost reductions, managerial turnover, loan quality improvements, and revenue enhancements at target banks.
(Manuszak & Wozniak)
Following a regulation that capped debit card interchange fees in the U.S., this paper empirically investigates the link between interchange fees and granular deposit account prices. The authors’ results show that banks subject to the cap raised checking account prices by decreasing the availability of free accounts, raising monthly fees, and increasing minimum balance requirements, with different adjustments across account types. They also find that banks exempt from the cap adjusted prices as a competitive response to price changes made by regulated banks. Not accounting for such competitive responses underestimates the policy’s impact on the market, for both banks subject to the cap and those exempt from it.