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Economic Research

Liberty Street Economics
Liquidity Effects of Post-Crisis Regulatory Reform
Post-crisis reforms to improve the capital and liquidity positions of regulated institutions provide incentives for banks to change both the structure of their own balance sheets and how they interact with customers and other market participants. This post provides an overview of three recent New York Fed staff reports that study the impact of post-crisis regulation on the willingness and ability of regulated firms to participate in U.S. over-the-counter markets.
By Nina Boyarchenko and Or Shachar
Did Banks Subject to LCR Reduce Liquidity Creation?
A lesson from the financial crisis is that banks need a liquidity cushion to cover unexpected cash outflows. To mitigate this risk, regulators implemented the liquidity coverage ratio (LCR), mandating that banks hold a buffer of liquid assets. Our bloggers find that a side effect of the regulation, however, is a reduction in liquidity creation by banks subject to LCR.
By Daniel Roberts, Asani Sarkar, and Or Shachar
Leverage Rule Arbitrage
Using difference-in-difference analysis, our bloggers find that after the supplementary leverage ratio (SLR) rule was imposed on the very largest U.S. banks, those banks shifted their portfolio toward riskier (risk-weighted) assets and higher-yielding securities compared with large banks not subject to the rule. Despite increased asset risk, overall bank risk did not increase, suggesting the higher capital required under the new rule offset the risk shifting.
By Dong Beom Choi, Michael Holcomb, and Donald P. Morgan
What Happens When Regulatory Capital Is Marked to Market?
There is little agreement about the right way to measure bank regulatory capital requirements. A key debate is the extent to which capital ratios should be based on current market values rather than historical “accrual” values of assets and liabilities. Our bloggers highlight findings from their staff report in which they investigate the effects of a recent change that, for some banks, ties regulatory capital directly to the market value of their securities portfolio.
By Andreas Fuster and James Vickery
Why Do Banks Target ROE?
Nonfinancial corporations focus on growth in their earnings per share to benchmark their performance. Banks used to follow a similar practice, but began to emphasize return on equity (ROE) in the late 1970s. Our bloggers outline findings from their recent staff report that argues banks had an incentive to make this change when increased competition eroded the values of their charters, and the incentive to change was magnified by risk-insensitive deposit insurance.
By George Pennacchi and João A. C. Santos
Recent Publications
Review of New York Fed Studies on the Effects of Post-Crisis Banking Reforms
In 2017, the Federal Reserve Bank of New York Fed launched a project to assess the effects of regulatory reforms that affected banks following the financial crisis of 2007-08. This article reviews the resulting twelve studies, which analyzed the effects of the reforms on the cost of bank equity capital, on bank profitability and risk, and on liquidity. Most of the findings aligned with theoretical predictions or results of earlier studies of the reforms. However, some studies produced results which contrast with evidence in the academic literature.
Richard K. Crump and João A. C. Santos, Economic Policy Review Volume 24 Number 2, October 2018
Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability before and during the Great Depression
Prior to the Great Depression, regulators imposed double liability on bank shareholders to ensure financial stability and protect depositors. Under this rule, shareholders of failing banks lost their initial investment and had to pay up to the par value of the stock in order to compensate depositors. The authors find no evidence that the rule reduced bank risk prior to the Great Depression, but do find evidence that double-liability banks were less susceptible to runs during the Great Depression. These results suggest that the protection afforded depositors by the rule may have weakened market discipline and undermined the effectiveness of double liability as a regulatory tool for reducing Bank risk.
By Haelim Anderson, Daniel Barth, and Dong Beom Choi, Staff Report 869, October 2018
Financial Frictions, Real Estate Collateral, and Small Firm Activity in Europe
Smaller and younger firms are “opaque” from the perspective of lenders and often face difficulties in accessing finance. Typically, such firms overcome such informational asymmetries by pledging collateral, which enhances their borrowing capacity. Residential real estate constitutes a common source of entrepreneurial collateral and, as a corollary, the value of real estate drives small firm activity and entrepreneurship. However, the authors document significant heterogeneity in the correlation between small firm activity and changes in the value of residential real estate across different countries in Europe.
By Ryan N. Banerjee and Kristian S. Blickle, Staff Report 868, October 2018
Relative Pricing and Risk Premia in Equity Volatility Markets
This paper provides empirical evidence that volatility markets are integrated through the time-varying term-structure of variance risk premia. These risk premia predict the returns from selling volatility for different horizons, maturities, and products--including variance swaps, straddles, and VIX futures. In addition, the paper derives a closed form-relationship between the prices of variance swaps and VIX futures. Although tightly linked, VIX futures exhibit deviations of varying significance from the no-arbitrage prices and bounds implied by the variance swap market. The author examines these pricing errors and their relationship to VIX futures return predictability.
By Peter Van Tassel, Staff Report 867, September 2018
New York Fed Releases New Issue of the Economic Policy Review
The Federal Reserve Bank of New York has published a new issue of its Economic Policy Review, a policy-oriented journal focused on macroeconomic, banking, and financial market topics. The issue contains two articles, each of which had previously been posted as forthcoming articles. The first, “The Political Origins of Section 13(3) of the Federal Reserve Act,” explores why Congress chose to endow the central bank with the authority to provide loans to nonbank financial institutions. The second, “Tracking and Stress-Testing U.S. Household Leverage,” analyzes household leverage—the ratio of housing debt to housing values—over time and across states and regions, using a unique new data set.
Global Trends in Interest Rates
The world real interest rate for safe and liquid assets fluctuated close to 2 percent for more than a century, but has dropped significantly over the past three decades. This decline has been common among advanced economies, as trends in real interest rates have converged over this period. The downturn was driven primarily by an increase in the premium that international investors are willing to pay to hold safe and liquid assets and by lower global economic growth.
By Marco Del Negro, Domenico Giannone, Marc P. Giannoni, and Andrea Tambalotti, Staff Report 866, September 2018
What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices
This paper analyzes the effects of the lower bound for interest rates on the distributions of expectations for future inflation and interest rates. We study a stylized New Keynesian model where the policy instrument is subject to a lower bound to motivate the empirical analysis. Two equilibria emerge: In the “target equilibrium,” policy is unconstrained most or all of the time, whereas in the “liquidity trap equilibrium,” policy is mostly or always constrained. We use options data on future interest rates and inflation to study whether the decrease in the natural rate of interest leads to forecast densities consistent with the theoretical model. We develop a lower bound indicator that captures the effects of the lower bound on the distribution of interest rates. Qualitatively, we find that the evidence is largely consistent with the theoretical predictions in the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. Quantitatively, while the lower bound has a sizable effect on the distribution of future interest rates, its impact on forecast densities for inflation is relatively modest.
By Thomas M. Mertens and John C. Williams, Staff Report 865, August 2018