Are banks really special? New evidence from the FDIC-induced failure of healthy banks

The FDIC used cross-guarantees to close thirty-eight subsidiaries of First RepublicBank Corporation in 1988 and eighteen subsidiaries of First City Bancorporation in 1992 when lead banks from each of these Texas-based bank holding companies were declared insolvent. I use this exogenous failure of otherwise healthy subsidiary banks as a natural experiment for studying the impact of bank failure on local-area real economic activity. I find that the closings of the subsidiaries were associated with a significant decline in bank lending that led to a permanent reduction in real county income of about 3 percent

Defaults and losses on commercial real estate bonds

We employ a unique data set of public commercial real estate (CRE) bonds issued during the Great Depression era (1920-32) to determine their frequency of default and total loss given default. Default rates on these bonds far exceeded those originated in subsequent periods, driven in part by the greater economic stress of the Depression as well as the lower level of financial sophistication of investors and structures that prevailed in 1920-32. Our results confirm that making loans with higher loan-to-value ratios results in higher rates of default and loss. They also support the business cycle's significance to the performance of CRE assets. Despite the large number of defaults in the early 1930s, the losses, which typically occurred after 1940, are comparable to those for contemporary loans, largely due to the rapid recovery of the economy from the Depression. This finding has relevance today, as numerous entities have a large amount of sub-performing CRE assets to work out. While the data point to better loss performance the quicker a problem loan is worked out, this may not hold true when there is a rapid recovery around the corner

Borrowers' financial constraints and the transmission of monetary policy: Evidence from financial conglomerations

Building on recent evidence concerning the functioning of internal capital markets in financial conglomerates, we conduct a novel test of the balance-sheet channel of monetary policy. Specifically, we investigate how the response of lending to monetary policy differs across small banks that are affiliated with the same bank holding company but operate in different geographical areas. These banks face similar constraints in accessing internal and external sources of funds, but have different pools of borrowers. Because they typically concentrate their lending with small local businesses, we can exploit cross-sectional differences in local economic indicators at the time of a policy shock to study whether the strength of borrowers' balance sheets affects the response of bank lending. We find evidence that the negative response of bank loan growth to a monetary contraction is significantly stronger when borrowers have weaker balance sheets

Has the credit default swap market lowered the cost of corporate debt?

There have been widespread claims that credit derivatives such as the credit default swap (CDS) have lowered the cost of firms’ debt financing by creating for investors new hedging opportunities and information. However, these instruments also give banks an opaque means to sever links to their borrowers, thus reducing lender incentives to screen and monitor. In this paper, we evaluate the effect that the onset of CDS trading has on the spreads that underlying firms pay at issue when they seek funding in the corporate bond and syndicated loan markets. Employing matched-sample methods, we find no evidence that the onset of CDS trading affects the cost of debt financing for the average borrower. However, we do find economically significant adverse effects to risky and informationally-opaque firms. It appears that the onset of CDS trading reduces the effectiveness of the lead bank’s retained share in resolving any asymmetric information problems that exist between a lead bank and non-lead participants in a loan syndicate. On the plus side, we do find that CDS trading has a small positive effect on spreads at issue for transparent and safe firms, in which the lead bank’s share is much less important. Moreover, we document that the benefit of CDS trading on spreads increases once the market becomes sufficiently liquid. In sum, while CDS trading has contributed to the completeness of markets, it has also created new problems by reducing the effectiveness of lead banks’ loan shares as a monitoring device—thus creating a need for regulatory intervention

Are Bank Holding Companies a Source of Strength to Their Banking Subsidiaries?

I present evidence that the cross-guarantee authority granted to the FDIC by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 has unexpectedly strengthened the Federal Reserve's source-of-strength doctrine. In particular, I find that a bank affiliated with a multi-bank holding company is significantly safer than either a stand-alone bank or a bank affiliated with a one-bank holding company. Not only does affiliation reduce the probability of future financial distress, but distressed affiliated banks are more likely to receive capital injections and recover more quickly than other banks. Moreover, the effects of affiliation are strengthened for an expanding bank holding company. However, the effects of affiliation are weakened when the parent has less than full ownership of the subsidiary. Most interestingly, my results show that these differences in behavior across affiliation did not exist before 1989, when the cross-guarantee authority was introduced

Precautionary Reserves and the Interbank Market

Liquidity hoarding by banks and extreme volatility of the fed funds rate have been widely seen as severely disrupting the interbank market and the broader financial system during the 2007-08 financial crisis. Using data on intraday account balances held by banks at the Federal Reserve and Fedwire interbank transactions to estimate all overnight fed funds trades, we present empirical evidence on banks' precautionary hoarding of reserves, their reluctance to lend, and extreme fed funds rate volatility. We develop a model with credit and liquidity frictions in the interbank market consistent with the empirical results. Our theoretical results show that banks rationally hold excess reserves intraday and overnight as a precautionary measure against liquidity shocks. Moreover, the intraday fed funds rate can spike above the discount rate and crash to near zero. Apparent anomalies during the financial crisis may be seen as stark but natural outcomes of our model of the interbank market. The model also provides a unified explanation for several stylized facts and makes new predictions for the interbank market

MBS Ratings and the Mortgage Credit Boom

We study credit ratings on subprime and Alt-A mortgage-backed securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly-rated securities in each deal is decreasing in mortgage credit risk (measured either ex-ante or ex-post), suggesting ratings contain useful information for investors. However, we also find evidence of significant time-variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses, and large rating downgrades) amongst deals with observably higher-risk mortgages based on a simple ex-ante model, and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.

The Mechanics of a Graceful Exit: Interest on Reserves and Segmentation in the Federal Funds Market

To combat the financial crisis that intensified in the fall of 2008, the Federal Reserve injected a substantial amount of liquidity into the banking system. The resulting increase in reserve balances exerted downward price pressure in the federal funds market, and the effective federal funds rate began to deviate from the target rate set by the Federal Open Market Committee. In response, the Federal Reserve revised its operational framework for implementing monetary policy and began to pay interest on reserve balances in an attempt to provide a floor for the federal funds rate. Nevertheless, following the policy change, the effective federal funds rate remained below not only the target but also the rate paid on reserve balances. We develop a model to explain this phenomenon and use data from the federal funds market to evaluate it empirically. In turn, we show how successful the Federal Reserve may be in raising the federal funds rate even in an environment with substantial reserve balances

The Federal Home Loan Bank System: The Lender of Next-to-Last Resort?

The Federal Home Loan Bank (FHLB) System is a large, complex, and understudied government-sponsored liquidity facility that currently has more than $1 trillion in secured loans outstanding, mostly to commercial banks and thrifts. In this paper, we document the significant role played by the FHLB System at the onset of the ongoing financial crises and then provide evidence on the uses of these funds by the System's bank and thrift members. Next, we identify the trade-offs faced by member-borrowers when choosing between accessing the FHLB System or the Federal Reserve's Discount Window during the crisis period. We conclude by describing the fragmented U.S. lender-of-last-resort framework and finding that additional clarity about the respective roles of the various liquidity facilities would be helpful