Knowledge that Transforms

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.

We study the liquidity behavior of commercial banks in response to negative capital shocks. Using pre-Basel III data, U.S. banks with assets less than $1 billion treated (unregulated) liquidity and (regulated) capital as substitutes. Following exogenous shocks to their regulatory capital ratios, these banks shifted away from loans, loan commitments, and dividend payouts, actions that both repaired their capital ratios and enhanced their liquidity positions. We find little similar behavior at larger banks. We conclude that a minimum capital constraint naturally mitigates liquidity risk at community banks, justifying the exemption of these banks from the Basel III liquidity standards.

Interest rates in many advanced economies have been low for almost a decade now and are often expected to remain so. This creates challenges for banks. Using a sample of 3385 banks from 47 countries from 2005 to 2013, we find a one percentage point interest rate drop implies an 8 basis points lower net interest margin, with this effect greater (20 basis points) at low rates. Low rates also adversely affect bank profitability, but with more variation. And for each additional year of “low-for-long”, margins and profitability fall by another 9 and 6 basis points, respectively.

Before the 1930s Building and Loan Associations (B&Ls) were the leading residential mortgage leaders in the U.S. When severely distressed during the housing crisis of the 1930s, B&Ls frequently took years to liquidate. These delays in resolution resulted from the unique B&L contract that encouraged borrowing members to prolong dissolution and gave them shared control over the timing of liquidation. We estimate a hazard model of dissolution using a new dataset of New Jersey B&Ls and find that the probability of liquidation rose 37% when the share of non-borrowing members rose above two-thirds. The severe restriction on liquidity suffered by non-borrowers was instrumental to the rapid transition from the traditional B&L to the modern Savings & Loan industry during the 1930s housing crisis.

This paper considers optimal executive pay regulations for banks that are too-big-to-fail. Theoretically, we map the consequences of a series of commonly-used pay schemes, describing their relative optimality and ultimate societal consequences. We argue that in a world of too-big-to-fail policy, simple equity-linked remuneration schemes maximise shareholder value by incentivising executives to choose excessively risky projects at the expense of the taxpayer. We find that paying the executive partly in debt fails to mitigate the project choice distortion when debt markets are informed. By contrast, both clawback rules and linking pay to interest rates can incentivise the executive to make socially optimal risk choices, but only if they are accompanied by appropriate restrictions on the curvature of pay with respect to the bank’s market value. Pay curvature can be generated by tools such as equity options and promotion policy. The policy implication is that unless regulators can enforce restrictions on pay curvature, bank shareholders can undermine the effectiveness of these pay regulations.

In recent years, policymakers have generally relied on macroprudential policies to address financial stability concerns. However, our understanding of these policies and their efficacy is limited. In this paper, we construct a novel index of macroprudential policies in 57 advanced and emerging economies covering the period from 2000:Q1 to 2013:Q4, with tightenings and easings recorded separately. The effectiveness of these policies in curbing credit growth and house price appreciation is then assessed using a dynamic panel data model. The main findings of the paper are: (1) Macroprudential policies have been used far more actively after the global financial crisis in both advanced and emerging economies. (2) These policies have primarily targeted the housing sector, especially in the advanced economies. (3) Macroprudential policies are usually changed in tandem with bank reserve requirements, capital flow restrictions, and monetary policy. (4) Our analysis suggests that macroprudential tightening is associated with lower bank credit growth, housing credit growth, and house price appreciation. (5) Targeted policies – for example, those specifically intended to limit house price appreciation – seem to be more effective, especially in economies where bank finance is important.

We investigate how seasoned equity offerings (SEOs) by issuers with large customers affect both trading partners’ market values and the relationship's health. We hypothesize that SEOs reveal adverse information about an issuer's major customers and find that issuers and their large customers experience negative returns on SEO announcements. These results are more pronounced when customers have higher levels of information asymmetry and when customer-supplier relationships are particularly important. Large customers of issuers experience larger declines in post-SEO sales, operating performance, and credit ratings than large customers of non-issuers. Also, SEO issuer sales to large customers and relationship duration significantly decline.

Investment spending by US public firms is highly concentrated. The 100 largest spenders account for 60% of total capital expenditures and drive most of the variation in aggregate investment. This high concentration creates a disconnect between the average public firm and macroeconomic aggregates. For large firms, cash flow remains the primary driver of investment spending and has not declined in importance as it has for smaller public firms. The cash flowing to big spenders provides a better forecast of future investment opportunities than noisy proxies for Tobin's q even though these firms are not financially constrained. These results suggest that, at least for the largest spenders, it is unlikely that measurement error drives the significance of cash flow. Our results are also inconsistent with recent models that predict higher investment-cash flow sensitivity for small young growth firms and suggest that cash flow is still the most important determinant of macroeconomic fluctuations in investment spending.

Bank liquidity shortages associated with the growth of wholesale-funded credit intermediation has motivated the implementation of liquidity regulations. We analyze a dynamic stochastic general equilibrium model in which liquidity and capital regulations interact with the supply of risk-free assets. In the model, the endogenously time varying tightness of liquidity and capital constraints generates intermediaries’ leverage cycle, influencing the pricing of risk and the level of risk in the economy. Our analysis focuses on liquidity policies’ implications for households’ welfare. Within the context of our model, liquidity requirements are preferable to capital requirements, as tightening liquidity requirements lowers the likelihood of systemic distress without impairing consumption growth. In addition, we find that intermediate ranges of risk-free asset supply achieve higher welfare.

This paper sheds new light on the role bank executives played in the financial crisis. It examines whether they foresaw the poor performance of their own bank by analyzing their insider trading patterns. Insider trading during 2006 predicts stock returns during the crisis: a portfolio strategy based on insider trading information earns a risk-adjusted return of over 40% during the crisis. Further, banks with a high exposure to the housing market and banks with a low exposure exhibit different insider trading patterns starting in mid-2006, when US housing prices first decline: insiders of high-exposure banks are 20% more likely to sell stock than insiders of low-exposure banks. This pattern is more pronounced for CEOs than other insiders. However, insider trading patterns of high- and low-exposure banks do not differ before 2006. Replacing high-exposure banks by too-big-too-fail banks yields similar results. This evidence indicates that insiders of high-exposure and too-big-too-fail banks revised their assessment of their banks’ investments following the reversal in the housing market.