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

Banking

Does the Structure of Banking Markets Affect Economic Growth? Evidence from U.S. State Banking Markets

This paper examines the impacts of banking market structure and regulation on economic growth using new data on banking market concentration and manufacturing industry-level growth rates for U.S. states during 1899-1929—a period when the manufacturing sector was expanding rapidly and restrictive branching laws segmented the U.S. banking system geographically. Unlike studies of developing and developed countries today, we find that banking market concentration generally had a positive impact on manufacturing sector growth in the early twentieth century United States, with a somewhat stronger impact on industries with smaller establishments, lower rates of incorporation, and less reliance on bond markets (and, hence, relatively more reliance on banks). Because regulations affecting bank entry varied considerably across states and the industrial organization of the U.S. banking system differs markedly from those of other countries, we consider the impact of other aspects of banking market structure and policy on growth. Even after controlling for differences in the prevalence of branch banking, deposit insurance, and other aspects of policy and market structure, we find that market concentration boosted industrial growth.

Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks

The number of commercial banks in the United States has fallen by more than 50 percent since 1984. This consolidation of the U.S. banking industry and the accompanying large increase in average (and median) bank size have prompted concerns about the effects of consolidation and increasing bank size on market competition and on the number of banks that regulators deem “too–big–to–fail.” Agency problems and perverse incentives created by government policies are often cited as reasons why many banks have pursued acquisitions and growth, though bankers often point to economies of scale. This paper presents new estimates of ray-scale and expansion-path scale economies for U.S. banks based on non-parametric local-linear estimation of a model of bank costs. Unlike prior studies that use models with restrictive parametric assumptions or limited samples, our methodology is fully non-parametric and we estimate returns to scale for all U.S. banks over the period 1984–2006. Our estimates indicate that as recently as 2006, most U.S. banks faced increasing returns to scale, suggesting that scale economies are a plausible (but not necessarily only) reason for the growth in average bank size and that the tendency toward increasing scale is likely to continue unless checked by government intervention.

U.S. Commercial Bank Lending through 2008:Q4: New Evidence from Gross Credit Flows

What was hiding behind the aggregate commercial bank loans through the end of 2008? We use balance sheet data for every insured U.S. commercial bank from 1999:Q1 to 2008:Q4 to construct credit expansion and credit contraction series and provide new evidence on changes in lending. Until 2008:Q3 net credit growth was not dissimilar to the 1980 and 2001 recessions. However, between the third and fourth quarter credit contraction grew larger than credit expansion across all types of loans and for the largest banks. With the inclusion of 2008:Q4 data our series most resemble the intensification of the Savings and Loan crisis. <p><a href=\"/econ/contessi/2009_011_appendix.pdf\" class=\"icon-pdf\">Appendix</a></p>

The Evolution of Cost-Productivity and Efficiency Among U.S. Credit Unions

Advances in information-processing technology have significantly eroded the advantages of small scale and proximity to customers that traditionally enabled community banks and other small-scale lenders to thrive. Nonetheless, U.S. credit unions have experienced increasing membership and market share, though consolidation has reduced the number of credit unions and increased their average size. We investigate the evolution of the efficiency and productivity of U.S. credit unions between 1989 and 2006 using a new methodology that benchmarks the performance of individual firms against an estimated order-α quantile lying “near” the efficient frontier. We construct a cost analog of the widely-used Malmquist productivity index, and decompose the index to estimate changes in cost and scale efficiency, and changes in technology, that explain changes in cost-productivity. We find that cost-productivity fell on average across all credit unions but especially among smaller credit unions. Smaller credit unions confronted an unfavorable shift in technology that increased the minimum cost required to produce given amounts of output. In addition, all but the largest credit unions became less scale efficient over time.

Are Credit Unions Too Small?

U.S. credit unions serve 93 million members, hold 10 percent of U.S. savings deposits, and make 13.2 percent of all non-revolving consumer loans. Since 1985, the share of U.S. depository institution assets held by credit unions has nearly doubled, and the average (inflation-adjusted) size of credit unions has increased over 600 percent. We use a non-parametric local-linear estimator to estimate a cost relationship for credit unions and derive estimates of ray-scale and expansion-path scale economies. We employ a dimension-reduction technique to reduce estimation error, and bootstrap methods for inference. We find substantial evidence of increasing returns to scale across the range of sizes observed among credit unions, suggesting that further industry consolidation and growth in the average size of credit unions are likely.

The Loan Structure And Housing Tenure Decisions In An Equilibrium Model Of Mortgage Choice

The objective of this paper is to understand how loan structure affects (i) the borrower’s selection of a mortgage contract and (ii) the aggregate economy. We develop a quantitative equilibrium theory of mortgage choice where households can choose from a menu of long-term (nominal) mortgage loans. The model accounts for observed patterns in housing consumption, ownership, and portfolio allocations. We find that the loan structure is a quantitatively significant factor in a household’s housing finance decision. The model suggests that the mortgage structure preferred by a household is dependent on age and income and that loan products with low initial payments offer an alternative to mortgages with no downpayment. These effects are more important when inflation is low. The presence of inflation reduces the real value of the mortgage payment and the outstanding loan overtime reducing mobility. Changes in the structure of mortgages have implications for risk sharing.

The Dynamic Interaction of Order Flows and the CAD/USD Exchange Rate

We explore the relationship between disaggregated trading flows, the Canada/U.S. dollar (CAD/USD) market and U.S. macroeconomic announcements with a novel data set of unprecedented breadth and length. Foreign financial trading flows appear to demand liquidity, contemporaneously driving the CAD/USD while commercial trading flows seem to be price sensitive, providing liquidity in response to exchange rate movements. Despite strong contemporaneous correlations with trading flows, exchange rate returns are generally not predictable, except for some intriguing success at long horizons. This failure contrasts with much, but not all, previous research on the topic. While two types of CAD trading flows and the CAD/USD appear to be cointegrated, such structure is probably spurious. There appear to be structural breaks in the order-flow-exchange rate VECM systems in 1994-1996 and 1998-1999. <a href="http://research.stlouisfed.org/econ/cneely/Data_Appendix_The_Dynamic_Interaction.pdf">Data Appendix</a>.

Lending to Uncreditworthy Borrowers

We study optimal lending behavior under adverse selection in environments with hetero- geneous borrowers— specifically, where the borrower’s reservation payoffs (outside options) increase with quality (creditworthiness). Our results show that factors affecting credit sup- ply can also affect lending standards either directly through lending costs or indirectly through borrower reservation payoffs. Lending to uncreditworthy borrowers can be pre- vented by lowering reservation payoffs, by raising lending costs, or both. Lenders seeking to attract creditworthy borrowers with high reservation payoffs would have to lower rates and, consequently, increase collateral requirements on offers that screen out uncreditworthy types. This leads to higher screening costs, thereby increasing the profitability of offers that pool uncreditworthy borrowers— a veritable lowering of credit standards. In addition, equilibria in a competition version of the model can also explain the phenomenon of “cream-skimming” by outside (foreign) lenders. Surprisingly, we find that the presence of an informed rival actually aids “cream-skimming” behavior.

Affiliated Mutual Funds and Analyst Optimism

Prior studies have shown that investment banking affiliations place pressure on analysts to produce optimistic recommendations on the investment bank’s stock-clients. Our analysis of a large sample of recommendations issued from 1995 through 2003 indicates that a mutual fund affiliation also affects analysts’ research. That is, analysts are likely to look favorably at stocks held by the affiliated mutual funds. Controlling for a variety of factors including the investment banking affiliation, we find that the greater the portfolio weight of a stock for the affiliated mutual funds, the more optimistic the analyst rating becomes when compared to the consensus. Reputation partly restrains the optimism of analyst recommendations. In fact, the presence of other institutional investors as shareholders of the recommended stocks curbs analyst optimism. Nevertheless, from 1999 through 2001, star analysts report the most optimism when they recommend stocks in the portfolios of affiliated mutual funds.

Currency Design in the United States and Abroad

Despite the increasing use of electronic payments, currency retains an important role in the payment system of every country. In this article, the authors compare and contrast tradeoffs among currency design features, including those primarily intended to deter counterfeiting and ones to improve usability by the visually impaired. The authors conclude that periodic changes in the design of currency are an important aspect of counterfeit deterrence, and that currency designers worldwide generally have been successful in efforts to deter counterfeiting. At the same time, currency designers have sought to be sensitive to the needs of the visually impaired. Although tradeoffs among goals sometimes have forced compromises, new technologies promise banknotes both more difficult to counterfeit and more accessible to the visually impaired. U.S. banknotes are special because, among the world’s currencies, they are the banknotes most widely used outside their country of issue.

Social Learning and Monetary Policy Rules

We analyze the effects of social learning in a widely-studied monetary policy context. Social learning might be viewed as more descriptive of actual learning behavior in complex market economies. Ideas about how best to forecast the economy’s state vector are initially heterogeneous. Agents can copy better forecasting techniques and discard those techniques which are less successful. We seek to understand whether the economy will converge to a rational expectations equilibrium under this more realistic learning dynamic. A key result from the literature in the version of the model we study is that the Taylor Principle governs both the uniqueness and the expectational stability of the rational expectations equilibrium when all agents learn homogeneously using recursive algorithms. We find that the Taylor Principle is not necessary for convergence in a social learning context. We also contribute to the use of genetic algorithm learning in stochastic environments.

Strategic Online-Banking Adoption

In this paper we study the determinants of banks' decision to adopt a transactional web-site for their customers. Using a panel of commercial banks in the United States for the period 2003- 2006, we show that although bank-specific characteristics are important determinants of banks' adoption decisions, competition also plays a prominent role. The extent of competition is related to the geographical overlap of banks in different markets and their relative market share in terms of deposits. In particular, banks adopt earlier in markets where their competitors have already adopted. In order to construct the different local markets, this paper is one of the first that makes use of the geographic market definitions delimited by the Cassidi R Database compiled at the Federal Reserve Bank of St. Louis.

Foreign Entry and Bank Competition

Foreign entry and bank competition are modeled as the interaction between asymmetrically informed principals: the entrant uses collateral as a screening device to contest the incumbent's informational advantage. Both better information ex ante and stronger legal protection ex post are shown to facilitate the entry of low-cost outside competitors into credit markets. The entrant's success in gaining borrowers of higher quality by offering cheaper loans increases with its efficiency (cost) advantage. This paper accounts for evidence suggesting that foreign banks tend to lend more to large firms thereby neglecting small and medium enterprises. The results also explain why this observed "bias" is stronger in emerging markets.

The Termination of Subprime Hybrid and Fixed Rate Mortgages

Adjustable rate and hybrid loans have been a large and important component of subprime lending in the mortgage market. While maintaining the familiar 30-year term the typical adjustable rate loan in subprime is designed as a hybrid of fixed and adjustable characteristics. In its most prevalent form, the first two years are typically fixed and the remaining 28 years adjustable. Perhaps not surprisingly, using a competing risks proportional hazard framework that also accounts for unobserved heterogeneity, hybrid loans are sensitive to rising interest rates and tend to temporarily terminate at much higher rates when the loan transforms into an adjustable rate. However, these terminations are dominated by prepayments not defaults.

Robust Non-parametric Quantile Estimation of Efficiency and Productivity Change in U.S. Commercial Banking, 1985-2004

This paper describes a non-parametric, unconditional, hyperbolic quantile estimator that unlike traditional non-parametric frontier estimators is both robust to data outliers and has a root-n convergence rate. We use this estimator to examine changes in the efficiency and productivity of U.S. banks between 1985 and 2004. We find that larger banks experienced larger efficiency and productivity gains than small banks, consistent with the presumption that recent changes in regulation and information technology have favored larger banks.

Why Do Analysts Continue to Provide Favorable Coverage for Seasoned Stocks?

Research has documented that the first report an investment bank affiliated analyst issues on a newly listed stock tends to be favorable. Our analysis of 16,824 relationships between analyst teams and established listed companies during 1995-2003 indicates that analyst coverage decisions of seasoned stocks are influenced by their affiliations with investment banks and mutual funds. Controlling for market returns, stock characteristics, and a variety of performance indicators, we find analysts are more likely to issue favorable reports when the stock is held by affiliated mutual funds. The more invested by affiliated mutual funds, the more optimistic the analyst rating compared to the consensus.

Central Bank Intervention With Limited Arbitrage,

Shleifer and Vishny (1997) pointed out some of the practical and theoretical problems associated with assuming that rational risk-arbitrage would quickly drive asset prices back to long-run equilibrium. In particular, they showed that the possibility that asset price disequilibrium would worsen, before being corrected, tends to limit rational speculators. Uniquely, Shleifer and Vishny (1997) showed that “performance-based asset management” would tend to reduce risk-arbitrage when it is needed most, when asset prices are furthest from equilibrium. We analyze a generalized Shleifer and Vishny (1997) model for central bank intervention. We show that increasing availability of arbitrage capital has a pronounced effect on the dynamic intervention strategy of the central bank. Intervention is reduced during periods of moderate misalignment and amplified at times of extreme misalignment. This pattern is consistent with empirical observation.

The Duration of Foreclosures in the Subprime Mortgage Market: A Competing Risks Model with Mixing

This paper examines what happens to mortgages in the subprime mortgage market once foreclosure proceeding are initiated. A multinominial logit model that allows for the interdependence of the possible outcomes or risks (cure, partial cure, paid off, and real estate owned) through the correlation of associated unobserved heterogeneities is estimated. The results show that the duration of foreclosures is impacted by many factors including contemporaneous housing market conditions, the prior performance of the loan (prior delinquency), and the state-level legal environment.

Loan Servicer Heterogeneity and the Termination of Subprime Mortgages

After a mortgage is originated the borrower promises to make scheduled payments to repay the loan. These payments are sent to the loan servicer, who may be the original lender or some other firm. This firm collects the promised payments and distributes the cash flow (payments) to the appropriate investor/lender. A large data set (loan-level) of securitized subprime mortgages is used to examine if individual servicers are associated with systematic differences in mortgage performance (termination). While accounting for unobserved heterogeneity in a competing risk (default and prepay) proportional hazard framework, individual servicers are associated with substantial and economically meaningful impacts on loan termination.

Subprime Refinancing: Equity Extraction and Mortgage Termination

This paper examines the choice of borrowers to extract wealth from housing in the high-cost (subprime) segment of the mortgage market while refinancing and assesses the prepayment and default performance of these cash-out refinance loans relative to the rate refinance loans. Consistent with survey evidence the propensity to extract equity while refinancing is sensitive to interest rates on other forms of consumer debt. After the loan is originated, our results indicate that cash-out refinances perform differently from non cash-out refinances. For example, cash-outs are less likely to default or prepay, and the termination of cash-outs is more sensitive to changing interest rates and house prices.

Predatory Lending Laws and the Cost of Credit

Various states and other local jurisdictions have enacted laws intending to reduce predatory and abusive lending in the subprime mortgage market. These laws have created substantial geographic variation in the regulation of mortgage credit. This paper examines whether these laws are associated with a higher or lower cost of credit. Empirical results indicate that the laws are associated with at most a modest increase in cost. However, the impact depends on the product type. In particular, loans with fixed (adjustable) rates are associated a modest increase (decrease) in cost.

The Impact of Local Predatory Lending Laws on the Flow of Subprime Credit

Local authorities in North Carolina, and subsequently in at least 23 other states, have enacted laws intending to reduce predatory and abusive lending. While there is substantial variation in the laws, they typically extend the coverage of the Federal Home Ownership and Equity Protection Act (HOEPA) by including home purchase and open end mortgage credit, by lowering annual percentage rate (APR) and fees and points triggers, and by prohibiting or restricting the use of balloon payments and prepayment penalties. Empirical results show that the typical local predatory lending law tends to reduce rejections, while having little impact on the flow (application and origination) of credit. However, the strength of the law, measured by the extent of market coverage and the extent of prohibitions, can have strong impacts on both the flow of credit and rejections.

The Impact of Local Predatory Lending Laws

Local authorities in North Carolina, and subsequently in at least 23 other states, have enacted laws intending to reduce predatory and abusive lending. While there is substantial variation in the laws, they typically extend the coverage of the Federal Home Ownership and Equity Protection Act (HOEPA) by including home purchase and open-end mortgage credit, by lowering annual percentage rate (APR) and fees and points triggers, and by prohibiting or restricting the use of balloon payments and prepayment penalties. This paper provides a detailed summary of various local predatory lending laws that are effective as of the end of 2004. We also create an index that captures differences in the strength of the local laws along the two important dimensions of coverage and restrictions. In addition, our univariate results show that there is substantial heterogeneity in the observed market responses to the local laws.

A Dynamic Look at Subprime Loan Performance

This paper examines the implications of delinquency on the performance of subprime mortgages. Specifically, we examine whether delinquency has any predictive power of the future performance of a mortgage. Using a sample of subprime mortgages from the Loan performance database on securitized private-label pool collateral, we utilize a two-step estimation procedure to control for the endogeneity of delinquency in an estimation of default and prepayment probabilities. We find strong support for the "distressed prepayment" theory that very delinquent loans are more likely to prepay than to default and that the rate of increase of prepayment is substantially larger as delinquency intensity increases. Delinquency predominately leads to termination of a loan through prepayment while negative equity leads to termination through default.

Non-parametric, Unconditional Quantile Estimation for Efficiency Analysis with An Application to Federal Reserve Check Processing Operations

This paper examines the technical efficiency of U.S. Federal Reserve check processing offices over 1980–2003. We extend results from Park et al. (2000) and Daouia and Simar (2007) to develop an unconditional, hyperbolic, α-quantile estimator of efficiency. Our new estimator is fully non-parametric and robust with respect to outliers; when used to estimate distance to quantiles lying close to the full frontier, it is strongly consistent and converges at rate root-n, thus avoiding the curse of dimensionality that plagues data envelopment analysis (DEA) estimators. Our methods could be used by policymakers to compare inefficiency levels across offices or by managers of individual offices to identify peer offices.

A Specialized Inventory Problem in Banks: Optimizing Retail Sweeps

Deposits held at Federal Reserve Banks are an essential input to the business activity of most depository institutions in the United States. Managing these deposits is an important and complex inventory problem, for two reasons. First, Federal Reserve regulations require that depository institutions hold certain amounts of such deposits at the Federal Reserve Banks to satisfy statutory reserve requirements against customers' transaction accounts (demand deposits and other checkable deposits). Second, some inventory of such deposits is essential for banks to operate one of their core lines of business: furnishing payment services to households and firms. including wire transfers, ACH payments, and check clearing settlement. Because the Federal Reserve does not pay interest on such deposits used to satisfy statutory reserve requirements, banks seek to minimize their inventory of such deposits. In 1994, the banking industry introduced a new inventory management tool for such deposits, the retail deposit sweep program, which avoids the statutory requirement by reclassifying transaction deposits as savings deposits. In this analysis, we examine two algorithms for operating such sweeps programs within the limits of Federal Reserve regulations.

The Delinquency of Subprime Mortgages

This paper focuses on understanding the determinants of the performance of subprime mortgages. A growing body of literature recognizes the substantial lag between the time that a borrower stops making payments on a mortgage and the termination of the loan. The duration of this lag and the method by which the delinquency is ultimately terminated play a critical role in the costs borne by both borrower and lender. Using nested and multinomial logit, we find that delinquency and default are sensitive to current economic conditions and housing markets. Credit scores and loan characteristics also play important roles.

When For-Profits and Not-For-Profits Compete: Theory and Empirical Evidence from Retail Banking

We model competition in local deposit markets between for-profit and not-for-profit financial institutions. For-profit retail banks may offer a superior bundle of financial services, but not-for-profit (occupational) credit unions enjoy sponsor subsidies that allow them to capture a share of the local market. The model predicts that greater participation in credit unions in a given county will be associated with higher levels of retail-bank concentration. We find empirical evidence of this association. The ability of credit unions to affect local banking market structure supports the presumption of current banking antitrust analysis that retail banking markets remain local. We identify local economic factors that modulate the nature of competition between banks and credit unions, including income per capita and population density.

A Spatial Analysis of State Banking Regulation

We use a spatial model to investigate a state's choice of branch banking and interstate banking regimes as a function of the regime choices made by other states and other variables suggested in the literature. We extend the basic spatial econometric model by allowing spatial dependence to vary by geographic region. Our findings reveal that spatial effects have a large, statistically significant impact on state regulatory regime decisions. The importance of spatial correlation in the setting of state banking policies suggests the need to consider spatial effects in empirical models of state policies in general.

Can Feedback from the Jumbo-CD Market Improve Bank Surveillance?

We examine the value of jumbo certificate-of-deposit (CD) signals in bank surveillance. To do so, we first construct proxies for default premiums and deposit runoffs and then rank banks based on these risk proxies. Next, we rank banks based on the output of a logit model typical of the econometric models used in off-site surveillance. Finally, we compare jumbo-CD rankings and surveillance-model rankings as tools for predicting financial distress. Our comparisons include eight out-of-sample test windows during the 1990s. We find that rankings obtained from jumbo-CD data would not have improved on rankings obtained from conventional surveillance tools. More importantly, we find that jumbo-CD rankings would not have improved materially over random rankings of the sample banks. These findings validate current surveillance practices and, when viewed with other recent empirical tests, raise questions about the value of market signals in bank surveillance.


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