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Robust capital regulation

Banks? leverage choices represent a delicate balancing act. Credit discipline argues for more leverage, while balance-sheet opacity and ease of asset substitution argue for less. Meanwhile, regulatory safety nets promote ex post financial stability, but also create perverse incentives for banks to engage in correlated asset choices and to hold little equity capital. As a way to cope with these distorted incentives, we outline a two-tier capital framework for banks. The first tier is a regular core capital requirement that helps deter excessive risk-taking incentives. The second tier, a novel ...
Staff Reports , Paper 490

Report
"Beggar-thy-neighbor" or "beggar-thyself"? the income effect of exchange rate fluctuations

This paper analyzes the impact of exchange rate fluctuations when they are only partially passed through to consumer prices. We show that an exchange rate depreciation does not necessarily have a beggar-thy-neighbor effect and may in fact have an opposite, or beggar-thyself, effect. The direction of the welfare effect depends on who owns the firms importing goods from producers and selling them to consumers, an issue that has not been explored in the earlier literature
Staff Reports , Paper 112

Report
Markov switching in disaggregate unemployment rates

We develop a dynamic factor model with Markov switching to examine secular and business cycle fluctuations in U.S. unemployment rates. We extract the common dynamics among unemployment rates disaggregated for seven age groups. The framework allows analysis of the contribution of demographic factors to secular changes in unemployment rates. In addition, it allows examination of the separate contribution of changes due to asymmetric business cycle fluctuations. We find strong evidence in favor of the common factor and of the switching between high and low unemployment rate regimes. We also find ...
Staff Reports , Paper 132

Report
Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying

This paper explores the ability of theoretically based asset pricing models such as the CAPM and the consumption CAPM-referred to jointly as the (C)CAPM - to explain the cross-section of average stock returns. Unlike many previous empirical tests of the (C)CAPM, we specify the pricing kernel as a conditional linear factor model, as would be expected if risk premia vary over time. Central to our approach is the use of a conditioning variable which proxies for fluctuations in the log consumption-aggregate wealth ratio and is likely to be important for summarizing conditional expectations of ...
Staff Reports , Paper 93

Report
Specialization in Banking

Using highly detailed data on the loan portfolios of large U.S. banks, we document that these banks "specialize" by concentrating their lending disproportionately into one industry. This specialization improves a bank’s industry-specific knowledge and allows it to offer generous loan terms to borrowers, especially to firms with access to alternate sources of funding and during periods of greater nonbank lending. Superior industry-specific knowledge is further reflected in better loan and, ultimately, bank performance. Banks concentrate more on their primary industry in times of instability ...
Staff Reports , Paper 967

Report
Identifying shocks via time-varying volatility

An n-variable structural vector auto-regression (SVAR) can be identified (up to shock order) from the evolution of the residual covariance across time if the structural shocks exhibit heteroskedasticity (Rigobon (2003), Sentana and Fiorentini (2001)). However, the path of residual covariances can only be recovered from the data under specific parametric assumptions on the variance process. I propose a new identification argument that identifies the SVAR up to shock orderings using the autocovariance structure of second moments of the residuals, implied by an arbitrary stochastic process for ...
Staff Reports , Paper 871

Report
Stabilizing expectations under monetary and fiscal policy coordination

This paper analyzes how the formation of expectations constrains monetary and fiscal policy design. Economic agents have imperfect knowledge about the economic environment and the policy regime in place. Households and firms learn about the policy regime using historical data. Regime uncertainty substantially narrows, relative to a rational expectations analysis of the model, the menu of policies consistent with expectations stabilization. When agents are learning about the policy regime, there is greater need for policy coordination: the specific choice of monetary policy limits the set of ...
Staff Reports , Paper 343

Report
Informational contagion in the laboratory

We study the informational channel of financial contagion in the laboratory. In our experiment, two markets with correlated fundamentals open sequentially. In both markets, subjects receive private information. Subjects in the market opening second also observe the history of trades and prices in the first market. We find that although in both markets private information is only imperfectly aggregated, subjects are able to make correct inferences based on the public information coming from the market that opens first. As a result, we observe financial contagion in the laboratory: Indeed, the ...
Staff Reports , Paper 715

Report
Cyber Risk and the U.S. Financial System: A Pre-Mortem Analysis

We model how a cyber attack may be amplified through the U.S. financial system, focusing on the wholesale payments network. We estimate that the impairment of any of the five most active U.S. banks will result in significant spillovers to other banks, with 38 percent of the network affected on average. The impact varies and can be larger on particular days and geographies. When banks respond to uncertainty by liquidity hoarding, the potential impact in forgone payment activity is dramatic, reaching more than 2.5 times daily GDP. In a reverse stress test, interruptions originating from banks ...
Staff Reports , Paper 909

Report
A study of competing designs for a liquidity-saving mechanism

We study two designs for a liquidity-saving mechanism (LSM), a queuing arrangement used with an interbank settlement system. We consider an environment where banks are subjected to liquidity shocks. Banks must make the decision to send, queue, or delay their payments after observing a noisy signal of the shock. With a balance-reactive LSM, banks can set a balance threshold below which payments are not released from the queue. Banks can choose their threshold such that the release of a payment from the queue is conditional on the liquidity shock. With a receipt-reactive LSM, a payment is ...
Staff Reports , Paper 336

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