Predicting failure in the commercial banking industry

The ability to predict bank failure has become much more important since the mortgage foreclosure crisis began in 2007. The model proposed in this study uses proxies for the regulatory standards embodied in the so-called CAMELS rating system, as well as several local or national economic variables to produce a model that is robust enough to forecast bank failure for the entire commercial bank industry in the United States. This model is able to predict failure (survival) accurately for commercial banks during both the Savings and Loan crisis and the mortgage foreclosure crisis. Other important results include the insignificance of several factors proposed in the literature, including total assets, real price of energy, currency ratio and the interest rate spread.bank failure; banking crises; CAMELS ratings

Competitive advantage: a study of the federal tax exemption for credit unions

This study evaluates the federal tax exemption for credit unions. It reviews the industry’s history, its unique exemption, the motivation behind this tax treatment, the eroding case for special treatment, the size of the tax break and its effects on credit unions, their competitors, and their members. The nation’s credit unions always have been exempt from federal income taxation. Federally chartered credit unions are even exempt from state and local income taxation. Saving and loan associations, also originally largely exempt from taxation, lost their exemption on 1951 and calls for tax reform, including those of former Presidents Jimmy Carter and Ronald Reagan, included provisions to end the special exemptions of credit unions. But the credit union tax exemptions have survived. At least in part, these exemptions arose from the cooperative nature of credit union ownership and limits on their ability to compete because of their legal “field of membership” restrictions, which limited who could be a depositor and borrower from a credit union. Nonetheless, credit unions have competed with other financial institutions, especially banks, with a major cost advantage, the tax exemption. Tax exemption has allowed credit unions to grow much more rapidly than banks. Unusual growth was also fostered by steady erosion of limits on credit union membership over the past two decades. In 1998, the US Supreme Court struck down the liberalization of membership rules, but the US Congress promptly passed new legislation overriding the court. As a result the processes of consolidation, merger and broadening of geographic markets accelerated while credit unions were allowed to keep their tax exemptions. Thus, Congress created new tensions by weakening the case for tax exemption without addressing its continuing legitimacy. Today credit unions continue to grow faster than banks, have little practical limitations on membership, make business loans that increasingly have no limits on who can borrow, how much or for what purpose. Even the limits that Congress imposed, as they otherwise removed limits on credit union markets and competition, have broad loopholes and remain under serious challenge by the credit union industry. The tax loss to the federal Treasury is estimated here to be $2 billion and to be growing rapidly. Indeed, the tax loss over the five years, 2004-2008 is estimated to be$12.6 billion and reaches $31.3 billion over the ten-year window 2005-2014. The size of the tax loss is substantially higher than estimates prepared by official arbiters including the Office of Management and Budget or the Congressional Budget Office. The annual loss in tax revenue could accrue to several different credit union constituencies: members, as depositors (higher “dividends,” or interest rates, on their “shares,” or deposits), borrowers (lower interest rates on loans), or shareholders (through greater retained earnings). The benefits of the tax break could also accrue to management, workers or other suppliers through inflated costs or inefficient operations. Based on other studies of differences between credit unions and banks and on direct and indirect evidence gathered for this study, it is found that the principal effect of the tax break is to enlarge the retained earnings or equity of the credit union industry. A higher ratio of equity to assets has made possible a larger and faster growing industry than would otherwise have been possible. There is some evidence that certain type loans have lower rates at credit unions. These are for loans that have become less profitable and less available at banks, such as auto loans. There is also some evidence that part of the tax advantage is absorbed by higher costs than they would have in a taxed, or more competitive, environment. Overall the dominant effect is to boost the equity ratio. Over the past ten years, credit unions have had an equity ratio, the ratio of equity to total assets that is more than 25 percent larger than that of banks. This is about the size of effect predicted by economic theory if the dominant effect of the tax break is to raise this measure. The equity ratio is a cushion against losses in asset value that could threaten the solvency of a financial institution. It is also a constraint on growth because a relatively safe institution cannot allow its assets to grow faster than its equity if it is holding its desired equity ratio. Despite the fact that the risk of credit union assets, largely shorter term consumer loans and consumer mortgages, is much smaller than the risks of bank assets, which are largely business loans and securities, credit unions hold a higher cushion against risk. These unusually large holding of equity cannot be realized through stock sales by the owners/members of credit unions and they do not yield competitive risk-adjusted yields on assets that they would have to earn if credit unions were subject to the same taxes as banks. Removing the tax exemption would level the playing field, reducing the excessive growth and relative size of credit union assets. It would also raise about$2 billion in tax revenue, either directly from credit unions or from more profitable and more highly taxed banks, where credit union deposits and assets would migrate if the tax exemption were ended. Finally it would raise the rate of return on some $65 billion of capital that is squirreled away in credit unions, earning lower rates of return than would be the case at taxed banks. Some analysts have argued that small institutions (under$10 million in assets) should continue to be tax exempt because of their special character and, perhaps, innate inefficiencies. But the corporate income tax already takes smallness into effect by taxing low-income firms at lower tax rates (15%, instead of up to 35% for large firms, or up to 39 percent for mid-sized corporations).Credit Union; tax incidence; tax subsidy

Financial wellbeing and some problems in assessing its link to financial education

In 2009, the National Endowment for Financial Education initiated a project to study the “Implications of a Quarter Century Research in Personal Finance.” As part of that effort, one of the major themes chosen was to study the measurement and evaluation of participant outcomes. This paper is part of the investigation of measurement and evaluation. It focuses more on what the macro-measures of financial wellbeing are that financial education is aimed at improving and the extent to which these larger scale measures can be improved by financial education, as well as obstacles to good evaluations and limitations of correlation outcomes. The case for improving financial education rests upon (1) the hypothesis that financial education can improve financial wellbeing, (2) the documented low state of financial literacy and individual satisfaction with their financial knowledge, behavior and financial outcomes of consumer decision making, and finally (3) the stress that recent financial shocks have put on household wellbeing. This article also reviews some of those recent changes and the initial recovery from the most recent shock to wellbeing. Section I reviews macro measures of wellbeing and the principal measures and approaches of most studies of the effects of financial education programs. Section II reviews the extent of two major shocks to household net worth in the past decade, some of the potential stress for households this created and the implications for the importance of financial education. Section III reviews some of the principal obstacles to effective assessment and the difficulties with reliance on simple correlations of financial programs and outcomes for such assessments.Financial wellbeing, financial education, educational assessment.

Responding to the 2007- 09 financial crisis: A new Consumer Financial Protection Agency?

esident Obama has released a sweeping plan to respond to the financial crisis and to insure that it is not repeated by altering and expanding the federal regulatory framework for financial services firms. The plan outlines detailed and demanding reporting deadlines for various existing federal regulatory institutions to formulate plans for the changes and asks Congress for action on the plan by the end of this year. One of the main components of the plan is to create a new federal agency, the Consumer Financial Protection Agency (CFPA), to protect consumers and investors from deceptive or dangerous products. This is one of the four broad components of comprehensive regulatory reform proposed by the President and the one that has received the greatest endorsement from congressional leaders in terms of the urgency of action. Not surprisingly, the financial services industry has responded, arguing that a new regulator for consumer protection is not necessary and that it contradicts one of the principal goals of regulatory reform. This paper reviews the status quo, advantages and disadvantages of the proposed changes and the extent to which it addresses or does not address perceived issues arising from the financial crisis.Financial regulatory reform; Consumer Financial Protection Agency; financial crisis;

Deficits and the Economy: All Deficits Are Not Created Equal

Recent academic and popular discussions of budget deficits rely upon a simplistic and, in large part, false conception of their effects. The recent literature ignores the fact that deficit effects depend on their source and on private sector responses to them. It also matters whether budget changes arise passively through the workings of the business cycle and whether deficit-inducing policy actions are permanent or transitory. More often than not, deficits are associated with lower interest rates. One reason is that large movements in budget deficits are principally due to the business cycle. Recessions lower investment and interest rates and also lower capital inflows. The widely popular idea that current account deficits arise from budget deficits is also not correct. Current account movements are related to international capital flows that respond more to incentives for domestic investment than to budgetary developments. Not surprisingly, the key expectations of the simple theory now circulating, especially about interest rates, the current account deficit and the dollar, are precisely opposite to what modern theory and evidence indicate. Investment and asset allocation decisions that rely on the popular misrepresentations of why and how deficits matter do material damage to investor interest.deficit; twin deficits; interest rates; fiscal policy

U.S. Monetary Policy and Stock Prices: Should the Fed Attempt to Control Stock Prices?

This article rejects the linkages in proposals that the Federal Reserve Bank (Fed) target equity prices. The real federal funds rate (RFF) and stock prices (SP) are uncorrelated; causality tests show a positive effect of SP on RFF and a negative effect of SP on RFF. These results occur as part of the dynamics of a negative cointegrated relationship between SP and RFF. A theoretically expected inverse relation between SP and inflation accounts for the results. The negative effect of SP on FF is also confirmed in a Taylor Rule estimate. Higher stock prices anticipate lower, not higher, inflation.Monetary Policy; Bubbles; Asset Prices; Inflation.

Why Are Interest Rates So Low?

Interest rates have been unusually low in this decade. Some prominent analysts have suggested that this is due to a saving glut, especially in China. A more likely source of the lower real interest rate level is a fall in the demand for capital goods and its financing. This article looks at whether capital spending and its financing have been weak, possibly accounting for declining real interest rates. It shows that private investment has been weak by historical standards; and this has probably reflected low rates of return to global investment, as well as significant changes in the prices of capital goods relative to other goods and services. The implications of these developments are very different and also different from the excess saving hypothesis.interest rates, saving, capital formation

Monetary policy in disarray

Monetary policy has become difficult to characterize or follow since 2007. A debate as to whether interest rate targets or monetary aggregate targets are better indicators of policy and prospective outcomes has given way to a new credit policy built on inflating the Federal Reserve (Fed) balance sheet to provide private sector credit. This policy grew out of the Great Depression and has led the Fed to ignore monetary growth and render a federal funds rate target impotent by pushing it to zero. To implement the more than doubling of the Fed’s assets, the Fed took up commercial banking policies. Three examples are: selling Treasury assets to fund private assets, paying subsidies to banks for holding reserves and attracting a new class of Treasury debt sterilized in Fed deposits. These actions insulated monetary aggregates and the effective monetary base from the explosion in the Fed’s balance sheet. The new credit policy severed the tight link that had existed for over 70 years between Fed credit and its effective monetary base. Fortunately, it also insulated the economy from a more than doubling of the general price level. But these actions have turned the balance sheet of the Fed into a collection of illiquid and risky private assets. A similar portfolio of government securities that has the longest duration in history and therefore the greatest interest rate risk limits the Fed’s ability to reduce its assets or the excess reserve position of banks, exceeding $1.5 trillion and costing the taxpayer over$3.3 billion, from 2009 to mid-2011. The subsidy and excess reserve levels of the first half of 2011 will cost $2.3 billion per year going forward. Finally, the paper rebuts claims by Fed officials that the Fed has successfully followed the framework of monetary policy developed by Milton Friedman. The paper concludes with recommendations for Congressional restrictions on the Fed and Treasury to ensure that the Fed focus on responsible monetary policy and not its failed credit policy.monetary policy; credit policy; central banking; Milton Friedman; business cycles

Is the Distribution of Income Shifting Away from Workers?

A popular and highly politicized theme today is that US workers are falling behind as their real wages fall and income gets redistributed to the rich. The Hamilton Project at the Brookings Institution, led by Robert Rubin, Lawrence Summers and Roger Altman, is dedicated to the study of this problem. The development of a wealth gap, shown by a decline in worker compensation relative to household wealth, has caught the attention of many critics because it suggests that workers are falling behind compared with those with income from capital. This inference is questioned here.Inequality; real wages; income distribution

Is The U.S. Dollar Set to Plummet in Value?

Many analysts believe that the U.S. dollar is set to fall sharply because of the large U.S. current account deficit. The international transactions of a nation involve many currencies and countries, and the value of a currency is determined by all of these. The large U.S. current account deficit with the rest of the world is, according to some analysts, a risk to the overall value of the dollar. In their view, the dollar is at risk of a major decline. For many observers, it is the current account itself that is the cause of concern. The implications for the currency are important because some suspect that a currency overvaluation is the source of the problem and that the remedy will be a painful fall in the value of the dollar. Whether and how the currency will change depends on investment incentives here and abroad and on economic policy changes that will affect those incentives and not so much on the size of the current account balance.exchange rate; current account; currency imbalances