Knowledge that Transforms

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This study examines how geographically diversified banks adjust lending practices in response to abnormal hot temperatures, a proxy for climate risk, and finds that these banks reduce small farm lending by 2–3 percent more than geographically constrained banks after a standard deviation increase in abnormal temperatures. Geographically diversified banks demonstrate proactive portfolio risk management by prioritizing credit in core markets and reallocating funds away from high-risk non-core regions, leaving lending gaps in affected counties. These findings highlight the importance of geographic diversification in building climate resiliency for banks while reducing the total credit available to farmers in a region.

Recent studies provide strong evidence that credit default swap (CDS) markets play a leading role in information intermediation. This paper proposes a model to rationalize the information transmission mechanism between the CDS and equity markets. In our model, informed traders with an informational advantage obtained from monitoring credit markets engage in capital structure arbitrage and trade strategically to exploit mispricings between individual stocks and CDS. In line with our model’s prediction, our empirical results provide evidence of a contemporaneous channel transmitting structural CDS shocks to equities. A positive shock to CDS decreases stock returns contemporaneously and over the long run. This credit-to-equity channel dominates the reverse transmission channel from stocks to CDS. Robustness tests confirm the role of the CDS market as a preferred venue for informed trading, independently of credit rating events or business sectors.

In standard banking models a demand for liquidity arises because investors want to take precautions against sudden consumption needs. It has long been taken for granted that banks’ maturity transformation is because they insure against such risk, exposing them to crises and justifying bank regulation. We show that if a demand for liquidity arises additionally for another important reason, their co-existence substantially alters equilibrium outcomes. Specifically, we introduce investors who want to preserve flexibility in case better investment opportunities arrive later. We show that (1) there is no maturity transformation if the funding liquidity of new investment opportunities is not sufficiently limited, (2) equilibria in models that consider only a single reason for liquidity demand are not necessarily robust, (3) an equilibrium in pure strategies in the depositing game may not exist at all.

Firms’ currency exposure can lead to financial distress and macroeconomic instability. Over-the-counter (OTC) derivatives provided by financial institutions are the primary risk management tool for nonfinancial firms. However, the role of financial institutions in providing these derivatives remains underexplored in the literature. Using novel loan and derivatives microdata, we examine how lending relationships influence access to foreign exchange (FX) OTC derivatives. We find that firms are more likely to trade derivatives with their lending relationship banks than with other banks, with a stronger preference for their main lender. These effects are more pronounced for small firms and first-time derivatives users, highlighting how lending relationships reduce informational and search costs, thereby facilitating access to hedging. Additionally, derivatives prices are lower when traded with the firms’ main lender and lenders providing loans in foreign currency, indicating that banks encourage hedging to reduce risks in their loan portfolios.

We present a model of the maturity of a bank’s uninsured debt. The bank borrows to invest in a long-term asset with endogenous and nonverifiable risk. This moral hazard problem leads to excessive risk-taking. Short-term debt may have a disciplining effect on risk-taking, but it may lead to overborrowing and/or inefficient liquidation. We characterize the conditions under which short- and long-term debt are feasible, and show circumstances where only short-term debt is feasible and where short-term debt dominates long-term debt when both are feasible. The results are consistent with some features of the period preceding the 2007-2009 global financial crisis.

We examine whether U.S. banks whose uninsured deposits were subject to greater risk of loss prior to the March 2023 banking crisis used institutional mechanisms to expand their deposit insurance or accessed government funding after the crisis. We construct a bank-level measure of pre-crisis uninsured depositor risk incorporating financial statements, unrealized security losses, and estimates of unrealized loan losses that predicts a bank’s post-crisis loss of uninsured deposits. We find that riskier small and midsize banks tended to utilize reciprocal, sweep, and brokered deposits, but not listing service deposits, to attract more insured deposits. Riskier small and midsize banks temporarily accessed FHLB advances while only risky midsize banks borrowed from the Discount Window. Risk did not predict banks’ use of Fed BTFP funding. Riskier banks, particularly small and midsize ones, paid relatively higher interest rates on many types of deposits.