Research Exchange: October 2024

Selected Outside Research

Bank Geographic Diversification and Funding Stability

This study investigates, using branch-level deposit data, how geographic diversification of U.S. banks' branch networks affects their funding stability. The analysis finds that banks with a more diversified funding base experience reduced volatility in deposit growth over time, especially for demand deposits. In turn, the more stable funding allows banks to shift from more expensive time deposits to demand deposits, contributing to lower overall funding costs. The analysis also demonstrates that these advantages from funding stability translate into increased small business lending, which enhances local economic activity. An important takeaway is that the increasing geographic diversification of U.S. banks due to banking industry consolidation has improved banks' funding stability and fostered liquidity creation.

Bank Geographic Diversification and Funding Stability | BIS.org

The Effect of Student Loan Payment Burdens and Nonfinancial Frictions on Borrower Outcomes

Rising student loan debt and worries over borrowers' ability to meet the monthly payment obligations have led to growing reliance on "income-driven repayment" (IDR) plans, which are designed to prevent default via income-scaled payment schedules. This paper explores the effects of IDR implementation by tracking the comparative repayment performance of first-time IDR applicants over time using administrative data. The analysis indicates that borrowers with zero initial payment obligations have significantly reduced delinquency and default rates. However, these short-term benefits diminish over longer intervals as some borrowers become less engaged with loan servicers, leading to increased long run delinquency risks. The findings highlight the complexity of borrower behavior and suggest that both financial constraints as well as administrative and behavioral frictions, such as inattention to loan obligations, are critical factors affecting student loan repayment outcomes.

The Effect of Student Loan Payment Burdens and Nonfinancial Frictions on Borrower Outcomes | FRB of Philadelphia

Perceived Political Bias of the Federal Reserve

Little is known about public perceptions of the Fed's political independence or political bias, though these perceptions may affect the Fed's credibility and in turn the effectiveness of its monetary policy. Seeking to fill this gap, this study examines findings from a survey of a politically representative sample of U.S. consumers inquiring how perceptions of the U.S. Federal Reserve's political stance impact macroeconomic expectations and public trust. Views on the Fed's political alignment vary, with most consumers seeing the Fed as biased towards the opposing party relative to their own. The minority who see the Fed as aligned with their own political leanings tend to report more positive macroeconomic outlooks, express greater trust in the institution and place more weight on the Fed's communication of inflation expectations.

Perceived Political Bias of the Federal Reserve | BFI

Bank Capital and the Growth of Private Credit

Lending by nonbank financial intermediaries to the corporate sector has grown to become a major source of corporate financing in recent years, but the reasons for this growth are not well understood. This paper presents new evidence on the factors driving the expansion of private credit derived from an analysis of business development companies, which are closed-end funds that provide a significant share of nonbank loans to middle market firms. The analysis finds that BDCs are very well capitalized, which the study argues is inconsistent with the notion that bank loans are being displaced by private credit due to high regulatory capital charges applied to bank loans. Rather, the evidence suggests that it is more financially attractive for large banks to hold senior claims on middle market loans in the form of credit facilities provided to BDCs, as compared to direct middle market lending. This is because "loans to BDCs and other nonbank financial intermediaries get relatively favorable capital treatment, enabling banks to exploit their low-cost funding" and because these facilities "are relatively large and thus less costly to originate, underwrite, and service than a portfolio of middle-market loans."

Bank Capital and the Growth of Private Credit | Harvard Kennedy School

Liquidity Stress Tests for Banks: Range of Practices and Possible Developments

Financial regulators use liquidity stress tests to assess banking sector vulnerabilities to funding and market liquidity risks, particularly under rapid funding outflow or asset devaluation scenarios. This paper reviews the range of approaches used by regulators and the major challenges they face in conducting liquidity stress tests. Authorities employ a mix of bank-specific and sector-wide methodologies. The more complex approaches capture potential contagion effects across individual institutions and the interdependent relationship between the bank and nonbank financial institution sectors. Stress testing challenges include data limitations and appropriately modeling the complexities of banks' management responses, cross-firm and cross-sector interactions and contagion risks. The paper also identifies key stress test assumptions, such as around "price declines, liability outflow rates, and the accounting treatment of high-quality liquid assets and exposure concentrations" that may merit refinement. For instance, the discussion highlights how, as technology and depositor behaviors shift, assumptions around high-quality liquid assets (HQLA) and intragroup funding may need to be reconsidered.

Liquidity Stress Tests for Banks - Range of Practices and Possible Developments | BIS.org

Capital Requirements in Pillar 1 or Pillar 2: Does It Matter for Market Discipline?

This paper examines how financial markets respond to the Basel regulatory capital requirements, and the comparative responsiveness to Basel Pillar 1 versus Pillar 2 requirements, with particular attention to the pricing of bank credit default swaps (CDS) in the EU. The analysis examines the factors driving CDS spreads and finds significant relationship to regulatory capital ratios. The analysis also indicates that spreads "react more to changes in capital requirements if implemented via direct adjustments to Pillar 1 risk weights than imposed as a percentage of Risk-Weighted Assets (RWAs) under Pillar 2." In addition, the paper analyzes a "quasi-natural experiment" based on a 2018 event in which "the Swedish supervisory authority changed the implementation approach of a risk weight floor on Swedish mortgages by shifting it from Pillar 2 to Pillar 1 while keeping total capital requirements stable." The analysis shows a significant effect of this purely technical modification on banks' capital holdings, consistent with a market discipline effect. The paper concludes that "risks are more disciplined by markets if they are reflected in regulatory capital ratios via RWAs"; that is, in Pillar 1 requirements.

Capital Requirements in Pillar 1 or Pillar 2: Does it Matter for Market Discipline? | Europa.eu

Tracking Reserve Ampleness in Real Time Using Reserve Demand Elasticity

The ampleness of reserves is an important consideration for Federal Reserve policymakers in deciding when to slow and then stop quantitative tightening, as the Fed seeks to implement QT while ensuring that reserves remain sufficiently ample to effectively pursue monetary policy. That is, the quantity of reserves in the banking system must be large enough "such that everyday changes in reserves do not cause large variations in short-term rates." Therefore, gauging the ampleness of reserves has become a key issue for policymakers and researchers. This post reviews how the ampleness of reserves can be assessed using the Federal Reserve Bank of New York's new Reserve Demand Elasticity measure, which the Bank will be publishing monthly on its website.

Tracking Reserve Ampleness in Real Time Using Reserve Demand Elasticity | Liberty Street Economics

Dueling Intraday Demands on Reserves

This post examines the use of reserves held at Federal Reserve Banks for the settlement of interbank obligations, focusing on intraday flows of reserves over the two main settlement systems, Fedwire Funds and Fedwire Securities. The analysis demonstrates that "the mechanics of each settlement system result in starkly different intraday demands on reserves and differing sensitivities of those intraday demands to the total amount of reserves in the financial system." In particular, the analysis shows that the timing of payments over Fedwire Funds is sensitive to the overall level of total reserves in the system and therefore informative about banks' demand for reserves, while the intraday timing of settlements on Fedwire Securities is invariant to changes in the total amount of reserves in the system. The discussion may help inform the debate over total amount of reserves needed for efficient settlement, which is an important issue given that the Federal Reserve's current quantitative tightening policy stands to drain reserves from the system.

The Dueling Intraday Demands on Reserves | Liberty Street Economics

Assessment of Dealer Capacity to Intermediate in Treasury and Agency MBS Markets

This note assesses the current and future capacity of broker-dealers to support the functioning of the Treasury and agency MBS markets in the face of increases in Treasury issuance and continued Federal Reserve balance sheet normalization. The discussion focuses on two types of constraints that are most relevant for dealers' intermediation activities: the regulatory minimum supplementary leverage ratio (SLR) at the bank holding company level, and internal risk limits-specifically Value at Risk limits-at the trading-desk level for each dealer. The analysis finds that dealers' SLR constraints have become less binding as holding company Tier 1 capital generally grew more quickly than total leverage exposure. However, "dealers' risk-based constraints may have become more binding amid elevated interest rate volatility and increased dealer inventories of Treasury securities." One conclusion is that, although dealers' balance sheets are projected to expand, "the regulatory minimum SLR requirements would not limit dealers' intermediation activities" through the end of 2024 under normal market conditions. However, the analysis suggests that under stressed market conditions, "high market volatility could significantly increase the effect of internal risk-sensitive limits at fixed income trading desks and constrain dealers' ability to support market functioning by supplying liquidity."

Assessment of Dealer Capacity to Intermediate in Treasury and Agency MBS Markets | Federal Reserve

Chart of the Month

SRTs move the credit risks associated with a pool of assets from banks to investors through a financial guarantee or credit-linked notes while keeping the loans on banks' balance sheets. While SRTs are well-established in Europe and Canada, they were virtually nonexistent in the U.S. until recently. U.S. activity increased in 2023 and is expected to accelerate further, driven by two factors: regulatory agencies providing additional clarity on the permissibility of these instruments, and anticipated increases in bank capital requirements following the finalization of Basel III Endgame.

Featured BPI Research

Barr Raises the Right Questions, But Has He Already Decided on the Answers?

In a recent speech on liquidity regulation and discount window policy, Federal Reserve Vice Chair Michel Barr discussed how banks can promote financial stability and efficient monetary policy by treating reserve balances and reverse Treasury repos as substitutes and making use of the Fed's standing lending facilities. This note affirms the importance of engaging in an examination and debate of these issues, while also raising concerns that the Fed may be "making critical decisions about aspects of regulations without subjecting them to careful analysis informed by public debate." In particular, the post criticizes inconsistencies between the Vice Chair's call for self-insurance and the use of private liquidity channels by banks with the encouragement of reliance on the Fed's discount window.

Barr Raises the Right Questions, But Has He Already Decided on the Answers? | BPI

Survey Finds Compliance is Growing Demand on Bank Resources

BPI recently conducted a survey of its members gathering information on growth in regulatory compliance costs since 2016. The survey finds that banks are dedicating significantly more resources to regulatory compliance. From 2016 to 2023, employee hours dedicated to compliance with financial regulations and examiner mandates increased by 61%, despite aggregate employee hours only growing by 20% during the same period. C-suite and managing boards were also affected, exhibiting a 75% and 63% increase in time investment for compliance, respectively. Correspondingly, the portion of bank IT budgets designated for compliance grew by 40%.

Survey Finds Compliance is Growing Demand on Bank Resources | BPI

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