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Report
Intermediary leverage cycles and financial stability
We present a theory of financial intermediary leverage cycles within a dynamic model of the macroeconomy. Intermediaries face risk-based funding constraints that give rise to procyclical leverage and a procyclical share of intermediated credit. The pricing of risk varies as a function of intermediary leverage, and asset return exposures to intermediary leverage shocks earn a positive risk premium. Relative to an economy with constant leverage, financial intermediaries generate higher consumption growth and lower consumption volatility in normal times, at the cost of endogenous systemic ...
Report
On the scale of financial intermediaries
This paper studies the economic scale of financial institutions. We show that banks and security broker-dealers actively smooth book equity by adjusting payouts. The smoothing of book equity is associated with procyclical book leverage and procyclical net payouts. In contrast, market leverage largely reflects movements in valuation levels as measured by book-to-market ratios. The 2008 crisis caused a structural break, after which the growth rates of the banking and dealer sectors have been subdued relative to pre-crisis levels. We draw conclusions for theories of financial intermediation and ...
Working Paper
Extrapolating Long-Maturity Bond Yields for Financial Risk Measurement
Insurance companies and pension funds have liabilities far into the future and typically well beyond the longest maturity bonds trading in fixed-income markets. Such long-lived liabilities still need to be discounted, and yield curve extrapolations based on the information in observed yields can be used. We use dynamic Nelson-Siegel (DNS) yield curve models for extrapolating risk-free yield curves for Switzerland, Canada, France, and the U.S. We find slight biases in extrapolated long bond yields of a few basis points. In addition, the DNS model allows the generation of useful financial risk ...
Working Paper
The Interplay Among Financial Regulations, Resilience, and Growth
Interconnectedness has been an important source of market failures, leading to the recent financial crisis. Large financial institutions tend to have similar exposures and thus exert externalities on each other through various mechanisms. Regulators have responded by putting more regulations in place with many layers of regulatory complexity, leading to ambiguity and market manipulation. Mispricing risk in complex models and arbitrage opportunities through regulatory loopholes have provided incentives for certain activities to become more concentrated in regulated entities and for other ...
Report
Regulation and risk shuffling in bank securities portfolios
Bank capital requirements are based on a mix of market values and book values. We investigate the effects of a policy change that ties regulatory capital to the market value of the ?available-for-sale" investment securities portfolio for some banking organizations. Our analysis is based on security-level data on individual bank portfolios matched to bond characteristics. We find little clear evidence that banks respond by reducing the riskiness of their securities portfolios, although there is some evidence of a greater use of derivatives to hedge securities exposures. Instead, banks respond ...
Report
Banks' incentives and the quality of internal risk models
This paper investigates the incentives for banks to bias their internally generated risk estimates. We are able to estimate bank biases at the credit level by comparing bank-generated risk estimates within loan syndicates. The biases are positively correlated with measures of regulatory capital, even in the presence of bank fixed effects, consistent with an effort by low-capital banks to improve regulatory ratios. At the portfolio level, the difference in borrower probability of default is as large as 100 basis points, which can improve the typical loan portfolio?s Tier 1 capital ratio by as ...
Report
The cost of bank regulatory capital
The Basel I Accord introduced a discontinuity in required capital for undrawn credit commitments. While banks had to set aside capital when they extended commitments with maturities in excess of one year, short-term commitments were not subject to a capital requirement. The Basel II Accord sought to reduce this discontinuity by extending capital standards to most short-term commitments. We use these differences in capital standards around the one-year maturity to infer the cost of bank regulatory capital. Our results show that following Basel I, undrawn fees and all-in-drawn credit spreads on ...
Report
Discussion of “Systemic Risk and the Solvency-Liquidity Nexus of Banks”
Pierret (2015) presents empirical analysis of the solvency-liquidity nexus for the banking system, documenting that a shock to the level of banks? solvency risk is followed by lower short-term debt. Conversely, higher short-term debt Granger-causes higher solvency risk. These results point toward a tight interaction between solvency and liquidity risk over time. My comments are threefold. First, I suggest improving the identification of shocks in Pierret?s vector autoregressive setup. Second, I caution against using the quantitative results as the basis for setting policy. Third, I recommend ...