Bank Policy Institute
10/07/2024 | Press release | Distributed by Public on 10/07/2024 10:44
Research Exchange: September 2024
Selected Outside Research
Unrealized Asset Loss, Liquidity Risk from Uninsured Deposit Outflows and Bank Runs: Evidence from the 2023 Banking Stress
The Spring 2023 banking crisis was characterized by an accumulation of unrealized asset losses, loss of depositor confidence and a heavy reliance on uninsured deposit funding. This paper analyzes these factors and explores mechanisms that could mitigate the risk of depositor runs using an "in-depth, mark-to-market methodology." The analysis finds a total unrealized asset loss of $1.6 trillion for the entirety of the U.S. banking system. In addition, the paper presents a scenario analysis that indicates that during the crisis period, only 20 out of 4,844 banks faced impairment risk under a 50% uninsured deposit withdrawal scenario. Moreover, the three banks that failed during that period were not among these 20, implying that their failure resulted from liquidity shortfalls during bank runs as opposed to a lack of fair-valued assets. The analysis also suggests that the failure to liquidate assets, specifically for Silicon Valley Bank, originated from an inability to pledge collateral swiftly enough through the Fed's discount window. The paper suggests potential avenues for improvement through prepositioning collateral at the Fed's discount window.
The Impact of the Fundamental Review of the Trading Book: Evaluation on a Stylized Portfolio
This study examines changes to market risk capital requirements for banks and their trading activities due to combining the Fundamental Review of the Trading Book with the internal models approach to calibrating these requirements. The analysis evaluates the impact of the FRTB on a stylized trading portfolio and demonstrates that it leads to substantially higher capital requirements, especially for portfolios heavily weighted with bonds. It finds that capital requirements may rise by up to 101% compared to the current regime, specifically for bond-heavy portfolios. These effects of the FRTB occur through the shift from measuring portfolio tail risk with value-at-risk to expected shortfall, the incorporation of liquidity horizons to account for varying asset liquidity and limitations on portfolio diversification benefits. The findings suggest that trading portfolios may require significant adjustment to comply with the FRTB's stringent requirements.
The Impact of the Fundamental Review of the Trading Book: Evaluation on a Stylized Portfolio | SSRN
Industrial Composition of Syndicated Loans and Banks' Climate Commitments
Within the past two decades, many banks have joined global initiatives aimed at mitigating climate change through more environmentally friendly asset portfolios. Utilizing loan-level information, this paper delves into whether banks' climate commitments, or lack thereof, have influenced the emission exposures of their syndicated loan portfolios. They find that all banks reduced their exposure to high-emission sectors over the past eight years. In general, however, banks with climate commitments did not significantly differ from those without such commitments. A notable exception was banks that had been early signers of the "Principles for Responsible Investments"-which a priori had lower exposures to these sectors. Thus, the study concludes that "banks reduced their exposure to climate transition risks on average, but voluntary climate commitments did not contribute to syndicated loan reallocation away from highly-emitting sectors.
Industrial Composition of Syndicated Loans and Banks' Climate Commitments | NBER
Credit Scores: Performance and Equity
Credit scores play a critical role in banks' consumer lending decisions in the United States, but data for evaluating their performance is not readily available. This paper evaluates a widely used credit score in the U.S. credit market by benchmarking it against a machine learning model for predicting consumer default. The study finds significant borrower misclassification, such that the machine learning model exhibited notable improvements in predictive accuracy, especially for young, low-income and minority populations. As a result, these groups experienced improved credit standings. The findings suggest that "improving credit scoring performance could lead to more equitable access to credit."
Credit Scores: Performance and Equity | NBER
Why Do Some Troubled Banks Fail Instead of Merge?
The majority of troubled banks do not fail; rather, they are monitored by the FDIC and encouraged to resolve their issues, often via mergers. This paper compares the qualities of struggling banks that survive through mergers with those that ultimately fail, utilizing a sample of failed and merged banks from 2001-2019. The analysis finds that banks that fail tend to exhibit poorer management of market risk and non-real estate credit risk, decreasing their attractiveness as merger targets. Additionally, it indicates that the merged institution had better management of funding and labor costs. The paper concludes that strong cost and risk management, combined with effective leadership, can make distressed banks more viable candidates for mergers, ultimately avoiding costly failures and reducing financial burdens on the FDIC's insurance fund.
Why Do Some Troubled Banks Fail Instead of Merge? | SSRN
The Real Effects of Current Expected Credit Loss Provision on Banks' Small Business Lending
With the introduction of the Current Expected Credit Loss (CECL) model and its elevated requirements for pertinent counterparty credit risk information, questions related to information acquisition costs arise, along with potential implications for banks' lending decisions. This study examines the effect of CECL on banks' small business lending, which can be informationally intensive. The analysis indicates that CECL may have led banks to significantly reduce their loan originations for small businesses at locations that are relatively far from bank branches, especially for loans under $100,000. The finding is attributed to higher information costs and the need for acquiring "'soft' information through interactions with borrowers and the local community." No similar patterns are observed for mortgage loans or small business loan purchases, which require less intensive information processes.
Interdealer Price Dispersion and Intermediary Capacity
Intermediation capacity in bond markets varies across dealers, which can impair the efficient reallocation of credit risk and reduce the risk-bearing capacity of the dealer sector overall. The paper investigates how these differences in intermediation capacity and associated impairment of efficient reallocation result in greater interdealer price dispersion, lower bond prices and an increase in effective market-level risk aversion. The analysis suggests that such price dispersion explains discrepancies between bond spread and fair value spreads, and much of the variation in bond yield spreads and returns. A key takeaway is that interdealer frictions play a critical role in determining intermediary bond pricing and their risk-bearing capacity.
Interdealer Price Dispersion and Intermediary Capacity | NBER
Determinants of Recent CRE Distress: Implications for the Banking Sector
Rising market interest rates and structural shifts in the demand for commercial space have triggered concerns about banks' exposure to CRE loan default risk. This paper uses confidential loan-level data on bank CRE portfolios to investigate the factors associated with CRE loan delinquency and the extent to which portfolio composition determines the degree of CRE loss exposure across banks. The analysis identifies higher loan-to-value ratios, larger property sizes and an increased share of employee remote work in a locality as key determinants of bank exposure to CRE loan losses, particularly for office loans. In addition, the analysis finds that observable portfolio characteristics can explain most of the variation in loan performance across banks. A key takeaway is that smaller banks, which have relatively high concentrations of CRE loans, have experienced comparatively modest delinquency rates, primarily because of their low holdings of large-sized office loans.
The Interaction of Bank Leverage, Interest Rate Risk and Runnable Funding
This study introduces a measure called lower friction liquidity (LFL) ratio, which assesses a bank's ability to meet liquidity needs using highly liquid, available-for-sale (AFS) securities, without breaching its tier 1 capital ratio requirement, in the event of deposit outflows. This measure, along with a measure of market-adjusted tier 1 equity ratio that accounts for unrealized fair value losses on a bank's securities and loans, is applied to analyze "the build-up of fragilities in the banking system" that led to three major bank failures in 2023 (Silicon Valley Bank, Signature Bank and First Republic Bank.) The analysis finds that "in the year leading up to the failure of SVB, banks with lower LFL ratios shed more cash than their peers and retained fewer AFS securities, despite a comparable build in uninsured deposits." Following the failure of SVB, these banks had worse stock price returns than their peers, suggesting that prior to that event, markets had overlooked this buildup of vulnerability. The analysis suggests that better liquidity management, capital buffers and access to liquidity facilities - providing balance sheet flexibility - could mitigate the risk of future bank runs and contagion.
Chart of the Month
As shown in the top panel, the combination of period-end dealer balance sheet compression and the settlement of Treasury coupon securities drove repo rates substantially higher over the days around the end of the third quarter. As shown in the middle panel, the use of the Fed's overnight reverse repo facility rose as money funds needed an alternative place to invest. At the same time, borrowing from the Fed's standing repo facility picked up as some bank or primary dealer turned to the Fed for repo financing. As shown in the bottom panel, the tightness cannot be attributable to a shortage of reserve balances as reserves have not declined over the past few years.
Featured BPI Research
Adjusting Regulatory Thresholds for Economic Growth
Banking regulations need periodic updates to account for economic growth and inflation. Without adjustments, static thresholds may impose stricter rules on banks due to normal economic expansion rather than increased risk. In the post, BPI recommends indexing key thresholds to economic growth, particularly for the GSIB Surcharge and bank tailoring indicators. This would ensure regulations remain proportional to actual systemic risk. For instance, GSIB Surcharge coefficients haven't changed since 2015 and should be adjusted for economic growth. Failing to adjust for growth could lead to overly strict capital and liquidity requirements, potentially hindering bank lending and economic growth.
Adjusting Regulatory Thresholds for Economic Growth
How U.S. Regulation is Reducing Foreign Bank Participation in Capital Markets
Post-crisis U.S. regulatory changes have reduced foreign bank (FBO) involvement in U.S. capital markets. New rules on Intermediate Holding Companies and stress testing have increased FBOs' capital requirements. These changes make it harder for FBOs to use capital efficiently and discourage investment in U.S. subsidiaries. The stress testing framework particularly affects FBOs due to their reliance on trading income. As a result, FBOs have reduced participation in capital markets. Regulators should review these rules' combined impact, adjust stress tests for FBO business models, and reconsider operational risk calculations in upcoming Basel III changes.
How U.S. Regulation is Reducing Foreign Bank Participation in Capital Markets
How the Federal Reserve Got So Huge, and Why and How It Can Shrink
This article by BPI's Bill Nelson, which originated as a BPI Working Paper, has been published in the September 2024 issue of Southern Economic Journal, with this abstract: "Following the collapse of Lehman Brothers in September 2008, the Federal Reserve underwent a significant shift in how it implemented monetary policy, transitioning to an excessive-reserves framework that it had deemed too radical and rejected just months prior. This shift involved borrowing excessive reserves from banks, deviating from its traditional method of borrowing only the amount banks needed to meet reserve requirements and address clearing needs. Despite initial intentions to revert to the necessary-reserves framework, subsequent developments, including three rounds of quantitative easing, led to the permanent adoption of the excessive-reserves approach in January 2019 by the Federal Open Market Committee (FOMC). This decision was a mistake. The framework has not yielded the purported benefits, such as simpler policy implementation, and has required the Fed to be vastly larger than originally anticipated. Advocates of the excessive-reserves approach argue it aligns with the Friedman rule, but alternatives like a voluntary-reserve-requirement regime could achieve similar outcomes without the drawbacks."
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