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In a previous post, we argued that double liability for bank owners might not limit their risk taking, despite the extra “skin in the game,” if it also weakens depositor discipline of banks. This post, drawing on our recent working paper, looks at the interplay of those opposing forces in the late 1920s when bank liability differed across states. We find that double liability may have reduced the outflow of deposits during the crisis, but wasn’t successful in mitigating bank risk during the boom.
Banks traditionally provide loans that are funded mostly by deposits and thereby create liquidity, which benefits the economy. However, since the loans are typically long-term and illiquid, whereas the deposits are short-term and liquid, this creation of liquidity entails risk for the bank because of the possibility that depositors may “run” (that is, withdraw their deposits on short notice). To mitigate this risk, regulators implemented the liquidity coverage ratio (LCR) following the financial crisis of 2007-08, mandating banks to hold a buffer of liquid assets. A side effect of the regulation, however, is a reduction in liquidity creation by banks subject to LCR, as we find in our recent paper.
Dong Beom Choi, Michael Holcomb, and Donald P. Morgan
Classic arbitrage involves the same asset selling at different prices; the leverage rule arbitrage we study here involves assets of different risk levels requiring the same amount of capital. The supplementary leverage ratio (SLR) rule, finalized by U.S. regulators in September 2014, requires a minimum ratio of capital to assets at the largest U.S. banks. The floor is higher for more systemically important banks, but not for banks with riskier assets. That non-risk-based aspect of SLR was intentional, since the leverage limit was meant to backstop (“supplement”) risk-based capital rules in case banks underestimate their asset risk and overstate their capital strength. As policymakers have noted and bankers have warned, if the leverage rule is the binding capital requirement, banks can “arbitrage” the rule by selling safer assets and replacing them with riskier, higher-yielding ones. The findings of our recent staff report are consistent with those concerns.
Minimum equity capital requirements are a key part of bank regulation. But there is little agreement about the right way to measure regulatory capital. One of the key debates is the extent to which capital ratios should be based on current market values rather than historical “accrual” values of assets and liabilities. In a new research paper, we investigate the effects of a recent regulatory change that ties regulatory capital directly to the market value of the securities portfolio for some banks.
Nonfinancial corporations focus on the growth in earnings per share (EPS) to benchmark their performance. Banks used to follow a similar practice, but starting in the late 1970s they began to emphasize return on equity (ROE) instead. In this blog post, we outline findings from our recent staff report, which argues that banks had an incentive to make this change when their charter values eroded owing to increased competition, and the incentive to change was magnified by risk-insensitive deposit insurance.
Andreas Fuster, Matthew Plosser, and James Vickery
The Consumer Financial Protection Bureau (CFPB), created in 2011, is a key element of post-crisis U.S. financial regulation, as well as the subject of intense debate. While some have praised the agency, citing the benefits of consumer financial protection, others argue that its activities involve high compliance costs, increase uncertainty and legal risk, and ultimately reduce the availability of financial services for consumers. We present new evidence on whether the CFPB’s supervisory and enforcement activities have significantly affected the supply of mortgage credit, or had other effects on bank risk-taking and profitability.
Banks contend that equity capital is expensive and that an increase in capital requirements will adversely impact bank services, including the volume and cost of mortgages and corporate loans. For example, JPMorgan CEO Jamie Dimon said in 2017 that “It is clear that the banks have too much capital…and more of that capital can be safely used to finance the economy.” In a recent staff report, we compare the different treatments of short-term credit commitments under the Basel I and Basel II Accords to assess the effect of capital regulation on banks’ cost of capital.
Anna Kovner, Peter Van Tassel, and Brandon Zborowski
In response to the financial crisis nearly a decade ago, a number of regulations were passed to improve the safety and soundness of the financial system. In this post and our related staff report, we provide a new perspective on the effect of these regulations by estimating the cost of capital for banks over the past two decades. We find that, while banks’ cost of capital soared during the financial crisis, after the passage of the Dodd-Frank Act (DFA), banks experienced a greater decrease in their cost of capital than nonbanks and nonbank financial intermediaries (NBFI).
The financial crisis of 2007-08 exposed many limitations of the regulatory architecture of the U.S. financial system. In an attempt to mitigate these limitations, there has been a wave of regulatory reforms in the post-crisis period, especially in the banking sector. These include tighter bank capital and liquidity rules; new resolution procedures for failed banks; the creation of a stand-alone consumer protection agency; greater transparency in money market funds; and a move to central clearing of derivatives, among other measures. As these reforms have been finalized and implemented, a healthy debate has emerged in the policy and academic communities over the degree to which they have achieved their intended goals and the extent of any unintended consequences that might have arisen in the process.
Better understanding of financial intermediation is critical to the efforts of the New York Fed to promote financial stability and economic growth. In pursuit of this mission, the New York Fed recently hosted the thirteenth annual Federal Reserve Bank of New York–New York University Stern School of Business Conference on Financial Intermediation. At this conference, a range of authors were invited to discuss their research in this area. In this post, we present some of the discussion and findings from the conference.
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.
The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.
The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
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