FROM OUR SHOP: Highlights of Research Conducted by The Clearing House

Over the past year, the research department has released 14 research notes and 26 blog posts. Here are brief synopses of the most recent research. The full library of TCH research can be found here.

New Research Estimates Credit Allocation Encouraged by CCAR Stress Tests
The Capital Allocation Inherent in the Federal Reserve’s Capital Stress Test attempts to determine which bank customers are being favored or disadvantaged by post-crisis regulatory rules – the Federal Reserve’s Comprehensive Capital Adequacy Review (CCAR) stress test. Specifically, the research derives the capital requirements for each category of bank asset classes in CCAR. The results show that the Federal Reserve’s CCAR stress test is imposing dramatically higher capital requirements on certain asset classes – most notably, small-business loans and residential mortgages – than Basel standardized models and banks’ internal models that are approved by the Federal Reserve.

Recognizing the Value of the Central Bank as a Liquidity Backstop
This paper argues that a critical missing element of the internationally agreed upon bank liquidity condition metric, the liquidity coverage ratio (LCR), is recognition of the liquidity support available to a commercial bank from the central bank. The paper describes a way that central banks can adjust their lending and deposit-taking operations so that banks get, for a fee, recognition of their borrowing capacity. Likely inadvertently, such arrangements effectively already exist at the ECB, BoE, and BoJ. If the Federal Reserve were to adopt the proposed facilities, it would enhance economic growth, make the financial system safer, and raise money for taxpayers.

Bank Capitalization and Loan Growth
In this note, we show that the positive relationship between bank capitalization and the growth of lending is driven by the amount of capital in excess of capital requirements, an amount that we refer to as the “capital surplus.” That is, our results show that banks with a higher capital surplus tend to lend more. In contrast, we find that an increase in capital requirements leads to a decrease in loan growth. This note analyzes the impact of changes in capital requirements on bank lending using data covering only the period when Basel I requirements were still in place.

The Clearing House Bank Conditions Index
The Clearing House has created a new index that provides a quantitative assessment of the resiliency of the U.S. banking sector. The index is constructed using a wide range of indicators that are commonly used to characterize the condition of the banking sector. Specifically, The Clearing House Bank Conditions Index (TCHBCI) synthesizes data on 23 banking indicators, grouped into six categories: capital, liquidity, risk taking, asset quality, interconnectedness, and profitability. The choice of the variables included in each category follows a large academic literature on banking crises.

Why Have Banks’ Market-to-Book Ratios Declined? 
The note shows that most of the decline in price-to-tangible book value (P/TBV) of equity in the post-crisis period is driven by the fall in banks’ profitability as measured by the return on tangible common equity (ROTCE). This TCH note also shows that both the decline in P/TBV and ROTCE is particularly pronounced for banks with more than $10 billion in total consolidated assets. The note then explores possible explanations for this finding, including the role of major changes in regulatory policies.

Liquidity and Leverage Regulation, Money Market Structure, and the Federal Reserve’s Monetary Policy Framework in the Longer Run 
The note demonstrates that recent changes in bank regulation will have foreseeable and material consequences for the structure of, and pricing in, money markets. We also show that new bank regulations will constrain the FOMC’s choices for its longer-run monetary policy framework.

Liquidity Regulations, the Neutral Real Federal Funds Rate, and the Money Premium 
TCH provides evidence that tighter liquidity regulations may have several significant unintended consequences that could reduce the ability of the Federal Reserve to provide stimulus to the economy and promote reliance on the shadow banking sector.

Research from Around the Industry: Academics, Think Tanks, and Regulators

Capital

BoE Working Paper: “Specialization in mortgage risk under Basel II”
(Bennetton, Eckley, Garbarino, Kirwin & Latsi)
Since Basel II was introduced in 2008, two approaches to calculating bank capital requirements have co-existed: lenders’ internal models and a less risk-sensitive standardized approach. Using a unique data set covering 7 million U.K. mortgages for 2005–2015, the authors find that the differences between these approaches cause lenders to specialize. This leads to systemic concentration of high-risk mortgages in lenders with less-sophisticated risk management.

OFR Working Paper: “Do Higher Capital Standards Always Reduce Bank Risk? The Impact of the Basel Leverage Ratio on the U.S. Triparty Repo Market”
(Allahrakha, Cetina & Munyan, 2016)
This paper examines the impact of the supplementary leverage ratio (SLR) on repo market activity. The paper concludes that the SLR has given incentives to broker-dealer affiliates of bank holding companies to decrease their repo borrowing, but at the same time to increase the use of repo backed by riskier collateral. The paper also finds increased participation of non-bank affiliated broker dealers in the triparty repo market, suggesting that risks maybe shifting to nonregulated entities.

BIS Working Paper: “Adding It All Up: The Macroeconomic Impact of Basel III and Outstanding Reform Issues”
(Fender & Lewrick, 2016)
This BIS working paper presents a very simple conceptual framework to assess the macroeconomic impact of the core Basel III reforms. Results suggest that Basel III is expected to generate nontrivial macroeconomic net benefits even after taking into account changes in bank behavior. In particular, the paper estimates net economic benefits in the range of about 0.5% to 2.0% of GDP per year.

FRB Working PapeR: “Are Basel’s Capital Surcharges for Global Systemically Important Banks Too Small?”
(Passmore & von Hafften)
This paper poses that the current capital surcharges for global systemically important banks (G-SIBs) are too low for three reasons: the current Method 1 GSIB calibration underestimates the probability that a GSIB can fail; does not take into account the impact of short-term funding on the probability of failure; and excludes too many banks from being subject to a GSIB surcharge. The authors estimate that the current Method GSIB surcharges should be between 225 and 525 basis points higher for G-SIBs that are not reliant on short-term funding and even higher for G-SIBs that are.

Liquidity

FRB NY Staff Report: “Market Liquidity after the Financial Crisis”
(Adrian, Fleming, Shachar & Vogt, 2016)
After the crisis, regulations were implemented in tandem with major changes in dealers’ business models; in particular, deleveraging occurred during the same time that dealers’ balance sheets shrank, the introduction of electronic trading, and the evolving liquidity demands of large asset managers. This paper seeks to identify which of these changes caused the decline in market liquidity. Overall, the authors find that liquidity is within historical norms and has not declined significantly since the crisis. The bulk of their evidence comes from a review of several market liquidity metrics from the U.S. Treasury and corporate bond markets (bid-ask spreads, quantity of treasury securities traded as a measure of depth, trade size, Kyle’s lambda or price impact, Treasury yield curve error, Treasury/RefCorp Spread), as well as three case studies.

FRBNY Working Paper: “Trends in Credit Market Arbitrage”
(Boyarchenko, Gupta, Steele & Yen)
This FRBNY working paper examines recent trends in arbitrage-based measures of liquidity in corporate bond and credit default swap (CDS) markets and evaluates potential explanations for the deterioration in these measures that occurred between the middle of 2015 and early 2016. In particular, both the CDS-bond basis and the CDX-CDS basis have been increasing since January 2015, suggesting that liquidity of the cash bond market relative to the CDS market, as well as the CDS market relative to the CDX market, has been deteriorating. Three potential explanations for these recent changes are: greater idiosyncratic risk at the firm level, increase in long positions by asset managers, and post-crisis regulatory changes, which reduce the attractiveness of arbitrage trades. The paper also elaborates on the mechanics of the CDS-bond arbitrage trade, finding that executing the trades is now costlier largely due to the extra capital required as a result of the supplementary leverage ratio.

FRB Working Paper: “The Volcker Rule and Market-Making in Times of Stress”
(Bao, O’Hara & Zhou)
Focusing on investment downgrades as stress events that drive the selling of corporate bonds, the authors find that the illiquidity of stressed bonds has increased after the Volcker Rule. Dealers regulated by the rule have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity. Even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations.

FRB Working Paper: “Bond Market Intermediation and the Role of Repo”
(Huh & Infante)
This paper models the important role that repurchase agreements (repos) play in bond market intermediation. Repos allow dealers to finance their activities in order to fill client orders. Dealers pass on the higher intermediation cost of larger client orders to their clients in the form of higher bid-ask spreads. Although this method of intermediation is optimal, the use of repos significantly increases dealers’ balance sheets. The authors find that limiting one dealer’s balance sheet leverage, leaving all else equal, reduces the affected dealer’s market making abilities, and decreases market liquidity.

Resolution & TBTF

Philadelphia FRB: Banking Policy Review: Did Dodd-Frank End ‘Too Big to Fail’?
(Johnston, 2016)
This paper reviews recent academic literature on the too big to fail (TBTF) subsidy, or the funding advantages of the largest banks over small banks. A number of recent studies indicate that there is no evidence of a TBTF subsidy for large banks post-crisis, and that current funding costs accurately reflect bank risk. As a result, the Dodd-Frank Act may have ended TBTF, but the current low interest rate environment may make it difficult to disentangle a TBTF subsidy in the post-crisis period.

NBER Working Paper: “Are Larger Banks Valued More Highly?”
(Minton, Stulz & Taboada)
This paper investigates whether the value of large banks increases with the size of their assets using Tobin’s q and market-to-book as valuation measures. Many argue that because large banks receive subsidies from the regulatory safety net, their valuation increases with size. Instead, this paper finds no evidence that large banks are valued more highly; strong evidence that the value of large banks falls with size; and strong evidence of this negative relationship from 1987–2006, but not when the post-Dodd-Frank period is included in the sample. To explain the negative relationship between large bank valuation and size, the authors find that banks with more trading assets are worth less.

Macroprudential Policy and Other

FRB NY Liberty Street Economics Blog Post: “Money Market Funds and the New SEC Regulation”
(Chen, Cipriani, La Spada, Mulder & Shah)
Two principal amendments to Securities and Exchange Commission (SEC) rule 2a-7 were designed to reduce money market mutual funds’ (MMFs) susceptibility to runs. First, institutional prime and muni funds – but not retail or government funds – must compute their net asset values (NAVs) using market-based factors, as opposed to the fixed NAV. Second, prime and muni funds must adopt a system of gates and fees on redemptions. This post finds a large outflow from prime and muni funds to government funds, meaning that much of the industry is, in principle, vulnerable to runs. Yet, since the new regulations have resulted in a large shift of assets into relatively safe government funds, the SEC’s reforms have made runs on MMFs less likely and the industry itself more resilient.

FRB of Philadelphia Working Paper: “Market Discipline in the Secondary Bond Market: The Case of Systemically Important Banks”
(Elyasiani & Keegan)
This paper investigates the association between the yields on debt issued by U.S. systemically important banks (SIBs) and their idiosyncratic risk factors, macroeconomic factors, and bond features, in the secondary market. Although greater SIB risk levels are expected to increase debt yields, government safety nets complicate the market discipline mechanism. The paper finds that market discipline improved greatly during and after the crisis, despite generally accommodative fiscal and monetary policies. Thus, the results demonstrate that regulatory intervention and market discipline can work in tandem.

BIS Quarterly Review Feature: “The quest for speed in payments”
(Bech, Shimizu & Wong)
This feature looks at the diffusion of payments systems technology. It compares real-time gross settlement (RTGS) systems for wholesale payments with faster systems for retail payments (fast payments). RTGS systems emerged in the 1980s and were adopted over 30 years. Fast payments followed in the early 2000s. The diffusion of fast payments so far mirrors that of RTGS and is primed to take off. The next generation of payment systems, such as those based on distributed ledger technology, is still under development.

Prudential Policies and Their Impact on Credit in the United States
(Calem, Correa & Lee)
The authors analyze how two types of recently used prudential policies affected the supply of credit in the United States. First, the authors find that CCAR stress tests had a negative impact on the supply of mortgage credit – banks with worse capital positions were affected more negatively. Second, they analyze the impact of the 2013 Supervisory Guidance on Leveraged Lending and subsequent 2014 FAQ notice, which clarified expectations on the guidance. They find that the share of speculative-grade term-loan originations decreased notably at regulated banks after the FAQ notice.