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Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critial comment.


The (Unintended?) Consequences of the Largest Liquidity Injection Ever

We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank's three-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This "collateral trade" effect is large, as banks purchased short-term bonds equivalent to 10.6% of amounts outstanding. The steepening of peripheral sovereign yield curves after the policy announcement is consistent with the equilibrium effects of the collateral trade.

The Persistence of Financial Distress

Using recently available proprietary panel data, we show that while many (35%) US consumers experience financial distress at some point in the life cycle, most of the events of financial distress are primarily concentrated in a much smaller proportion of consumers in persistent trouble. Roughly 10% of consumers are distressed for more than a quarter of the life cycle, and less than 10% of borrowers account for half of all distress events. These facts can be largely accounted for in a straightforward extension of a workhorse model of defaultable debt that accommodates a simple form of heterogeneity in time preference but not otherwise.

Banking on the Boom, Tripped by the Bust: Banks and the World War I Agricultural Price Shock

Bank lending booms and asset price booms are often intertwined. Although a fundamental shock might trigger an asset boom, aggressive lending can push asset prices higher, leading to more lending, and so on. Such a dynamic seems to have characterized the agricultural land boom surrounding World War I. This paper examines i) how banks responded to the asset price boom and how they were affected by the bust; ii) how various banking regulations and policies influenced those effects; and iii) how bank lending contributed to rising farm land values in the boom, and how bank closures contributed to falling prices in the bust. We find that rising crop prices encouraged bank entry and balance sheet expansion in agriculture counties. State deposit insurance systems amplified the impact of rising crop prices on the size and risk of bank portfolios, while higher minimum capital requirements dampened the effects. Further, increases in county farm land values and mortgage debt were correlated with the number of local banks ex ante and increases in bank loans during the boom. When farm land prices collapsed, banks that had responded most aggressively to the asset boom had a higher probability of closing, while counties with more bank closures experienced larger declines in land prices than can be explained by falling crop prices alone.

Bank panics and scale economies

A bank panic is an expectation-driven redemption event that results in a self-fulfilling prophecy of losses on demand deposits. From the standpoint of theory in the tradition of Diamond and Dybvig (1983) and Green and Lin (2003), it is surprisingly difficult to generate bank panic equilibria if one allows for a plausible degree of contractual flexibility. A common assumption employed in the standard banking model is that returns are linear in the scale of investment. Instead, we assume the existence of a fixed investment cost, so that a higher risk-adjusted rate of return is available only if investment exceeds a minimum scale requirement. With this simple and empirically-plausible modification to the standard model, we find that bank panic equilibria emerge easily and naturally, even under highly flexible contractual arrangements. While bank panics can be eliminated through an appropriate policy, it is not always desirable to do so. We use our model to examine a number of issues, including the likely effectiveness of recent financial market regulations. Our model also lends some support for the claim that low-interest rate policy induces a “reach-for-yield” phenomenon resulting in a more panic-prone financial system.

A Survey of the Empirical Literature on U.S. Unconventional Monetary Policy

This paper reviews and critically evaluates the empirical literature on the effects of U.S. unconventional monetary policy on both financial markets and the real economy. In order to understand how such policies could work, we also briefly review the literature on the theory of such policies. We show that event studies provide very strong evidence that U.S. unconventional policy announcements have strongly influenced international bond yields, exchange rates, and equity prices in the desired manner. In addition, such studies indicate that such policies curtailed market perceptions of extreme events. Calibrated modeling and vector autoregressive (VAR) exercises strongly suggest that these policies significantly improved macroeconomic outcomes, raising U.S. GDP and CPI, through these changes in asset prices. Both event studies and VARs imply positive international spillovers of such policies.

Near-Money Premiums, Monetary Policy, and the Integration of Money Markets: Lessons from Deregulation

The 1960s and 1970s witnessed rapid growth in the markets for new money market instruments, such as negotiable certificates of deposit (CDs) and Eurodollar deposits, as banks and investors sought ways around various regulations affecting funding markets. In this paper, we investigate the impacts of the deregulation and integration of the money markets. We find that the pricing and volume of negotiable CDs and Eurodollars issued were influenced by the availability of other short-term safe assets, especially Treasury bills. Banks appear to have issued these money market instruments as substitutes for other types of funding. The integration of money markets and ability of banks to raise funds using a greater variety of substitutable instruments has implications for monetary policy. We find that, when deregulation reduced money market segmentation, larger open market operations were required to produce a given change in the federal funds rate, but that the pass through of changes in the funds rate to other market rates was also greater.

Effects of Credit Supply on Unemployment and Inequality

The Great Recession, which was preceded by the financial crisis, resulted in higher unemployment and inequality. We propose a simple model where firms producing varieties face labor-market frictions and credit constraints. In the model, tighter credit leads to lower output, lower number of vacancies, and higher directed-search unemployment. Where workers are more productive at higher levels of firm output, lower credit supply increases firm capital intensity, raises inequality by increasing the rental of capital relative to the wage, and has an ambiguous effect on welfare. At initial high levels of labor share in total costs tighter credit lowers welfare. This pattern reverses during an expansionary phase caused by higher credit availability.

Did the Founding of the Federal Reserve Affect the Vulnerability of the Interbank System to Contagion Risk?

As a result of legal restrictions on branch banking, an extensive interbank system developed in the United States during the nineteenth century to facilitate interregional payments and flows of liquidity and credit. Vast sums moved through the interbank system to meet seasonal and other demands, but the system also transmitted shocks during banking panics. The Federal Reserve was established in 1914 to reduce reliance on the interbank system and to correct other defects that caused banking system instability. Drawing on recent theoretical work on interbank networks, we examine how the Fed’s establishment affected the system’s resilience to solvency and liquidity shocks and whether those shocks might have been contagious. We find that the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquidity after the Fed’s founding.The industry’s response illustrates how the introduction of a lender of last resort can alter private behavior in ways that increase the likelihood that the lender will be needed.

Interbank Markets and Banking Crises: New Evidence on the Establishment and Impact of the Federal Reserve

This paper examines the impact of the Federal Reserve’s founding on seasonal pressures and contagion risk in the interbank system. Deposit flows among classes of banks were highly seasonal before 1914; amplitude and timing varied regionally. Panics interrupted normal flows as banks throughout the country sought funds from the central money markets simultaneously. Seasonal pressures and contagion risk in the system were lower by the 1920s, when the Fed provided seasonal liquidity and reserves. Panics returned in the 1930s, due in part to shocks from nonmember banks and because the Fed’s decentralized structure hampered a vigorous response to national crises.

The Evolution of Scale Economies in U.S. Banking

Continued consolidation of the U.S. banking industry and a general increase in the size of banks has prompted some policymakers to consider policies that discourage banks from getting larger, including explicit caps on bank size. However, limits on the size of banks could entail economic costs if they prevent banks from achieving economies of scale. This paper presents new estimates of returns to scale for U.S. banks based on nonparametric, local-linear estimation of bank cost, revenue and profit functions. We report estimates for both 2006 and 2015 to compare returns to scale some seven years after the financial crisis and five years after enactment of the Dodd-Frank Act with returns to scale before the crisis. We find that a high percentage of banks faced increasing returns to scale in cost in both years, including most of the 10 largest bank holding companies. And, while returns to scale in revenue and profit vary more across banks, we find evidence that the largest four banks operate under increasing returns to scale.

Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay

This review essay is intended as a critical review of Humpage (2015), and it expands on the issues raised in that volume. Federal Reserve Policy during the financial crisis, and in its aftermath are addressed, along with the relationship to historical experience in the U.S. and elsewhere in the world.

Banker Preferences, Interbank Connections, and the Enduring Structure of the Federal Reserve System

Established by a three person committee in 1914, the structure of the Federal Reserve System has remained essentially unchanged ever since, despite criticism at the time and over ensuing decades. This paper examines the original selection of cities for Reserve Banks and branches, and placement of district boundaries. We show that each aspect of the Fed’s structure reflected the preferences of national banks, including adjustments to district boundaries after 1914. Further, using newly-collected data on interbank connections, we find that banker preferences mirrored established correspondent relationships. The Federal Reserve was thus formed on top of the structure that it was largely meant to replace.

Preventing Bank Runs

Diamond and Dybvig (1983) is commonly understood as providing a formal rationale for the existence of bank-run equilibria. It has never been clear, however, whether bank-run equilibria in this framework are a natural byproduct of the economic environment or an artifact of suboptimal contractual arrangements. In the class of direct mechanisms, Peck and Shell (2003) demonstrate that bank-run equilibria can exist under an optimal contractual arrangement. The difficulty of preventing runs within this class of mechanism is that banks cannot identify whether withdrawals are being driven by psychology or by fundamentals. Our solution to this problem is an indirect mechanism with the following two properties. First, it provides depositors an incentive to communicate whether they believe a run is on or not. Second, the mechanism threatens a suspension of convertibility conditional on what is revealed in these communications. Together, these two properties can eliminate the prospect of bank-run equilibria in the Diamond-Dybvig environment.

Labor Market Upheaval, Default Regulations, and Consumer Debt

In 2005, reforms made formal personal bankruptcy much more costly. Shortly after, the US began to experience its most severe recession in seventy years, and while personal bankruptcy rates rose, they rose only modestly given the severity of the rise in unemployment. By contrast, informal default through delinquency rose sharply. In the subsequent recovery, households have been widely viewed as "deleveraging" (Mian and Su2011, Krugman and Eggertson 2012) via the largest reduction of unsecured debt seen in the past three decades. We measure the relative roles of recent bankruptcy reform and labor market risk in accounting for consumer debt and default over the Great Recession. Our results suggest that bankruptcy reform likely prevented a substantial increase in formal bankruptcy lings, but had only limited effect on informal default from delinquencies, and that changes in job-finding rates were central to both.

Understanding the Accumulation of Bank and Thrift Reserves during the U.S. Financial Crisis

The level of aggregate excess reserves held by U.S. depository institutions increased significantly at the peak of the 2007-09 financial crisis. Although the amount of aggregate reserves is deter- mined almost entirely by the policy initiatives of the central bank that act on the asset side of its balance sheet, the motivations of individual banks in accumulating reserves differ and respond to the impact of changes in the economic environment on individual institutions. We undertake a systematic analysis of this massive accumulation of excess reserves using bank-level data for more than 7,000 commercial banks and almost 1,000 savings institutions during the U.S. financial crisis. We propose a testable stochastic model of reserves determination when interest is paid on reserves, which we estimate using bank-level data and censored regression methods. We find evidence primarily of a precautionary motive for reserves accumulation with some notable heterogeneity in the response of reserves accumulation to external and internal factors of the largest banks com- pared with smaller banks. We combine propensity score matching and a difference-in-differences approach to determine whether the beneficiaries of the Capital Purchase Program of the Troubled Asset Relief Program accumulated less cash, including reserves, than non-beneficiaries. Contrary to anecdotal evidence, we find that banks that participated in the program accumulated less cash, including reserves, than nonparticipants in the initial quarters after the capital injection.

Investment and Bilateral Insurance

Private information may limit insurance possibilities when a few agents form a partnership to pool idiosyncratic risk. We show that these insurance possibilities can improve if the partnership's income depends on capital accumulation and production, because cheating distorts investment. As agents' weights in the partnership increase, they are more affected by the investment distortion, and their incentives to misreport under the full information allocation are reduced. In the long run, either one of the partners is driven to immiseration, or both partners' lifetime utilities are approximately equal. The second case is only possible with capital accumulation. The theory's testable implications are in line with empirical evidence on the organization of small-business partnerships.

Bankruptcy and Delinquency in a Model of Unsecured Debt

This paper documents and interprets a fact central to the dynamics of informal consumer debt default: delinquency does not mean a persistent cessation of payment. In particular, we observe that for individuals 60 to 90 days late on payments, (i) 85% make payments during the next quarter to avoid getting into severe delinquency, and (ii) 40% reduce their debt (either because they made payments or received debt forgiveness). To understand these facts, we develop a theoretically and institutionally plausible model of debt delinquency and bankruptcy. Our model reproduces the dynamics of delinquency and suggests an interpretation of the data in which lenders frequently (in roughly 40% of cases) reset loan terms for delinquent borrowers, typically offering partial debt forgiveness, rather than a blanket imposition of the “penalty rates” most unsecured credit contracts specify.

Why Doesn't Technology Flow from Rich to Poor Countries?

What is the role of a country’s financial system in determining technology adoption? To examine this, a dynamic contract model is embedded into a general equilibrium setting with competitive intermediation. The terms of finance are dictated by an intermediary’s ability to monitor and control a firm’s cash flow, in conjunction with the structure of the technology that the firm adopts. It is not always profitable to finance promising technologies. A quantitative illustration is presented where financial frictions induce entrepreneurs in India and Mexico to adopt less-promising ventures than in the United States, despite lower input prices.

Loan Regulation and Child Labor in Rural India

We study the impact of loan regulation in rural India on child labor with an overlapping-generations model of formal and informal lending, human capital accumulation, adverse selection, and differentiated risk types. Specifically, we build a model economy that replicates the current outcome with a loan rate cap and no lender discrimination by risk using a survey of rural lenders. Households borrow primarily from informal moneylenders and use child labor. Removing the rate cap and allowing lender discrimination markedly increases capital use, eliminates child labor, and improves welfare of all household types.

Federal Reserve Lending to Troubled Banks During the Financial Crisis, 2007-10

Numerous commentaries have questioned both the legality and appropriateness of Federal Reserve lending to banks during the recent financial crisis. This article addresses two questions motivated by such commentary: 1) Did the Federal Reserve violate either the letter or spirit of the law by lending to undercapitalized banks? 2) Did Federal Reserve credit constitute a large fraction of the deposit liabilities of failed banks during their last year prior to failure? The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) imposed limits on the number of days that the Federal Reserve may lend to undercapitalized or critically undercapitalized depository institutions. We find no evidence that the Federal Reserve ever exceeded statutory limits during the recent financial crisis, recession and recovery periods. In most cases, the number of days that Federal Reserve credit was extended to an undercapitalized or critically undercapitalized depository institution was appreciably less than the number of days permitted under law. Furthermore, compared with patterns of Fed lending during 1985-90, we find that few banks that failed during 2008-10 borrowed from the Fed during their last year prior to failure, and only a few had outstanding Fed loans when they failed. Moreover, Federal Reserve loans averaged less than 1 percent of total deposit liabilities among nearly all banks that did borrow from the Fed during their last year. It is impossible to know whether the enactment of FDICIA explains differences in Federal Reserve lending practices during 2007-10 and the previous period of financial distress in the 1980s. However, it does seem clear that Federal Reserve lending to depository institutions during the recent episode was consistent with the Congressional intent of this legislation.

Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?

We use a regression discontinuity approach and present new institutional evidence to investigate whether affordable housing policies influenced the market for securitized subprime mortgages. We use merged loan-level data on non-prime mortgages with individual- and neighborhood-level data for California and Florida. We find no evidence that lenders increased subprime originations or altered loan pricing around the discrete eligibility cutoffs for the Government-Sponsored Enterprises'''' (GSEs) affordable housing goals or the Community Reinvestment Act. Although we find evidence that the GSEs bought significant quantities of subprime securities, our results indicate that these purchases were not directly related to affordable housing mandates.

Basel Accord and Financial Intermediation: The Impact of Policy

This paper studies loan activity in a context where banks must follow Basel Accord-type rules and acquire financing from households. Loan activity typically decreases when entrepreneurs’ investment returns decline, and we study which type of policy could revigorate an economy in a trough. We find that active monetary policy increases loan volume even when the economy is in good shape; introducing active capital requirement policy can be effective as well if it implies tightening of regulation in bad times. This is performed with an heterogeneous agent economy with occupational choice, financial intermediation and aggregate shocks to the distribution of entrepreneurial returns.

Credit Scoring and Loan Default

This paper introduces a measure of credit score performance that abstracts from the influence of "situational factors." Using this measure, we study the role and effectiveness of credit scoring that underlied subprime securities during the mortgage boom of 2000-2006. Parametric and nonparametric measures of credit score performance reveal different trends, especially on originations with low credit scores. The paper demonstrates an increasing trend of reliance on credit scoring not only as a measure of credit risk but also as a means to offset other riskier attributes of the origination. This reliance led to deterioration in loan performance even though average credit quality—as measured in terms of credit scores— actually improved over the years.

The Effect of Neighborhood Spillovers on Mortgage Selection

In this paper we analyze how spillovers in mortgage adoption affect mortgage product choice across neighborhoods and across borrowers of different racial or ethnic groups. We use loan-level data on subprime mortgages for metropolitan areas in California and Florida during 2004 and 2005, the peak years of the subprime mortgage boom. We identify an important and statistically significant effect of spillovers, both within and across groups, on the consumers\' choice of hybrid mortgage products that were popular during this period. In particular, we find that the group-specific spillover effects are strengthened by the group affiliation (race and ethnicity) of the borrower. The effects are particularly important among Hispanic and white borrowers, but not among black borrowers.

Differences in Subprime Loan Pricing Across Races and Neighborhoods

We investigate whether race and ethnicity influenced subprime loan pricing during 2005, the peak of the subprime mortgage expansion. We combine loan-level data on the performance of non-prime securitized mortgages with individual- and neighborhood- level data on racial and ethnic characteristics for metropolitan areas in California and Florida. Using a model of rate determination that accounts for predicted loan performance, we evaluate the differences in subprime mortgage rates in terms of racial and ethnic groups and neighborhood characteristics. We find evidence of adverse pricing for blacks and Hispanics. The evidence of adverse pricing is strongest for purchase mortgages and mortgages originated by non-depository institutions.

Did Doubling Reserve Requirements Cause the Recession of 1937-1938? A Microeconomic Approach

In 1936-37, the Federal Reserve doubled the reserve requirements imposed on member banks. Ever since, the question of whether the doubling of reserve requirements increased reserve demand and produced a contraction of money and credit, and thereby helped to cause the recession of 1937-1938, has been a matter of controversy. Using microeconomic data to gauge the fundamental reserve demands of Fed member banks, we find that despite being doubled, reserve requirements were not binding on bank reserve demand in 1936 and 1937, and therefore could not have produced a significant contraction in the money multiplier. To the extent that increases in reserve demand occurred from 1935 to 1937, they reflected fundamental changes in the determinants of reserve demand and not changes in reserve requirements.

The Promise and Performance of the Federal Reserve as Lender of Last Resort 1914-1933

This paper examines the origins and early performance of the Federal Reserve as lender of last resort. The Fed was established to overcome the problems of the National Banking era, in particular an “inelastic” currency and the absence of an effective lender of last resort. As conceived by Paul Warburg and Nelson Aldrich at Jekyll Island in 1910, the Fed’s discount window and bankers acceptance-purchase facilities were expected to solve the problems that had caused banking panics in the National Banking era. Banking panics returned with a vengeance in the 1930s, however, and we examine why the Fed failed to live up to the promise of its founders. Although many factors contributed to the Fed’s failures, we argue that the failure of the Federal Reserve Act to faithfully recreate the conditions that had enabled European central banks to perform effectively as lenders of last resort, or to reform the inherently unstable U.S. banking system, were crucial. The Fed’s failures led to numerous reforms in the mid-1930s, including expansion of the Fed’s lending authority and changes in the System’s structure, as well as changes that made the U.S. banking system less prone to banking panics. Finally, we consider lessons about the design of lender of last resort policies that might be drawn from the Fed’s early history.

Financing Development: The Role of Information Costs

To address how technological progress in financial intermediation affects the economy, a costly state verification framework is embedded into the standard growth model. The framework has two novel ingredients. First, firms differ in the risk/return combinations that they offer. Second, the efficacy of monitoring depends upon the amount of resources invested in the activity. A financial theory of firm size results. Undeserving firms are over financed, deserving ones under funded. Technological advance in intermediation leads to more capital accumulation and a redirection of funds away from unproductive firms toward productive ones. With continued progress, the economy approaches its first-best equilibrium.

Quantifying the Impact of Financial Development on Economic Development

How important is financial development for economic development? A costly state verification model of financial intermediation is presented to address this question. The model is calibrated to match facts about the U.S. economy, such as the intermediation spreads and the …firm-size distributions for 1974 and 2004. It is then used to study the international data using cross-country interest-rate spreads and per-capita GDPs. The analysis suggests a country like Uganda could increase its output by 116 percent if it could adopt the world’s best practice in the financial sector. Still, this amounts to only 29 percent of the gap between Uganda’s potential and actual output.

The IT revolution and the unsecured credit market

The information technology (IT) revolution coincided with the transformation of the U.S. unsecured credit market. From 1983 to 2004 households'''''''' unsecured borrowing increased rapidly and there was a even faster increase in the number of bankruptcy filings. To study the effect of information costs on debt and bankruptcy a risk of repu- diation model with asymmetric information and costly screening is introduced. When information costs are high, the design of contracts under private information prevents some households from borrowing with risk of default. As information costs drop, house- holds borrow more and the number of bankruptcy lings increase. A calibrated version of the model reproduces the main characteristics of the U.S. unsecured credit market in 1983 and 2004. Quantitative exercises suggest that the IT revolution may have played an important role in the transformation of the unsecured credit market.

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