Category Archives: Credit and Banking

Beyond the LTV Ratio: Lending Standards, Regulatory Arbitrage, and Mortgage Default

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Abstract

Booming house prices are historically correlated with loose lending standards. Nonetheless, in Spain the loan-to-value (LTV) ratio failed to capture imbalances during the last housing boom. Using loan-level data from millions of mortgages we show that inflated collateral valuations, used by banks as a mechanism to circumvent regulation, distorted the informative value of LTV, and masked the accumulation of risk. We identify that regulation relying upon a single measure is more prone to suffer from regulatory arbitrage, and that the optimal policy mix varies over the financial cycle. Overall, our study provides useful insights for the implementation of borrower-based measures.

In Search of a Risk‐Free Asset: Search Costs and Sticky Deposit Rates

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Abstract

I examine the role of costly consumer search for the pricing of deposits. Estimates of a model of heterogeneous search cost households reveal a large fraction of high-search-cost depositors composed of elderly and less financially sophisticated households. Those households grant banks significant monopoly power that results in low and asymmetric interest rate pass-through. The predictions of the estimated model are consistent with responses in the Survey of Consumer Finances to questions related to financial sophistication, search for investment return, and deposit allocations across multiple bank accounts. The estimated model also reveals a nonmonotone relationship between bank entry, deposit rates, and consumer surplus.

Liquidity Provision and Financial Stability

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Abstract

When financial intermediaries' key characteristic is provision of liquidity through their liabilities, with financial frictions, the financial sector in the aggregate is likely to overaccumulate equity, thus decreasing liquidity provision and household welfare. Aggregate household welfare is therefore decreasing in the level of aggregate intermediary equity even though the individual value of intermediaries is increasing in equity, which is why intermediaries overaccumulate equity. Subsidizing intermediary dividends can improve welfare by encouraging earlier payout and decreasing aggregate equity in the financial sector. This policy increases the likelihood that intermediaries provide more liquidity and improves the stability of the economy, even though asset prices fall.

Secured Loans and Risky Assets in a Monetary Economy

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Abstract

We study the implication of secured credit with a default option for monetary equilibrium. The intermediary structure has the feature of costly state verification, with the monitoring cost interpreted as the cost of foreclosing assets once a default occurs. Without monitoring costs, uncertainty in asset payoffs does not matter for allocation. The asset price can exhibit a liquidity premium because more assets as collateral raises the borrower's credit limit. When there are monitoring costs, the asset's liquidity premium is strictly positive because pledging more assets reduces the default probability and thus the chance to incur monitoring costs. Under some circumstances, increased risk to dividends of the pledged asset may decrease the marginal borrowing cost to such an extent that bank lending rises, and higher default rates are accompanied by larger aggregate liquidity.

Does the Exchange Rate Respond to Monetary Policy in Mexico? Solving an Exchange Rate Puzzle in Emerging Markets

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Abstract

This paper argues that the null or weak response of emerging market currencies to domestic monetary policy documented in the literature is the result of wide event windows. An event study with intraday data for Mexico shows that an unanticipated tightening appreciates the currency and flattens the yield curve, consistent with the evidence for advanced economies. With daily event windows, however, only the yield curve responds to monetary policy. Noise in daily exchange rate returns explains the lack of response of the currency. Such noise gives rise to a bias that declines after controlling for potential omitted variables.

Portfolio Selection under Systemic Risk

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Abstract

This paper proposes a modified Sharpe ratio to construct optimal portfolios under systemic events. The portfolio allocation problem is solved analytically under the absence of short-selling restrictions and numerically when short-selling restrictions are imposed. This approach is made operational by embedding it in a multivariate dynamic setting using dynamic conditional correlation and copula models. We evaluate the out-of-sample performance of our portfolio empirically over the period 2007 to 2020 using ex post final wealth paths and systemic risk metrics against mean–variance, equally weighted, and global minimum variance portfolios. Our portfolio outperforms all competitors under market distress and remains competitive in noncrisis periods.

The Demand for Trade Protection over the Business Cycle

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Abstract

We build measures of the demand for trade protection, and relate them to permanent productivity and transitory monetary shocks identified from U.S. data. The demand for trade protection is countercyclical conditional on productivity shocks and procyclical conditional on monetary shocks. A two-country dynamic stochastic general equilibrium (DSGE) model with trade in intermediate and final goods, sticky prices, and incomplete financial markets is proposed, in which tariffs are determined in a repeated noncooperative policy game. The resulting trade policies are consistent with the empirical evidence about the cyclical pattern of trade protection demand.

Deregulation and Financial Intermediation Cost: An International Comparison

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Abstract

Calculations for 15 countries reveal falling unit costs of financial intermediation in most cases, especially where unit cost was high during the 1970s. This result coincides with the concomitant convergence of both unit cost and the deregulation index over the period: Countries with a high unit cost were initially more strictly regulated and subsequently deregulated more. Despite this, the international unit cost barely declined due to the decreasing weight of low unit cost countries in total financial production after the mid-1980s. Focusing on the specific effect of deregulation, the econometric analysis displays a negative and significant link between deregulation change and unit cost variation. Further analyses reveal that the effect of a change in deregulation depends on banks' market power. Thus, the stagnating unit cost observed in the United States and the United Kingdom, the two largest providers of financial services, could be due to weaker deregulation reforms—deregulation was already high in these countries during the 1980s—and a concomitant reduction in competition.

Downward Nominal Wage Rigidity and Determinacy of Equilibrium

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Abstract

It is well known in the literature that there is a tension between the frequency and duration of the zero lower bound (ZLB) on the nominal interest rate and the determinacy of equilibrium. In this short paper, I show that the presence of downward nominal wage rigidity (DNWR) resolves the tension by preventing a vicious cycle of price declines and output contractions under the ZLB. Consequently, the model with DNWR can replicate the long-lived ZLB episodes observed in the data. It also implies a plausible size of output and inflation declines at the ZLB.

Competition and Bank Payout Policy

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Abstract

Leveraging branch-level data on bank deposits, we provide evidence of a negative impact of branching restrictions on payout ratios, which occurs only for banks with a low charter value, as proxied by the market-to-book ratio. The results for the market-to-book ratio extend to the Lerner index, the return on assets, and the Z-score, suggesting that risk-shifting incentives drive our results rather than signaling incentives or agency costs. Our results are robust to different proxies for banking competition and identification strategies, and bootstrap simulations suggest that our results are not due to confounding factors.