Opening Remarks

Speaker:

Lisa Ryu

Optimal Stress Tests and Diversification

Authors:

Keeyoung Rhee (Korea Development Institute)

Discussant:

Basil Williams (New York University)

Abstract:

We present a model to study whether a regulator should reveal imperfect information about banks' financial health or not. Stress tests can restore market confidence in banks. However, the regulator's information is inevitably imperfect, thereby misclassifying some financially sound banks as risky. To avoid being misclassified, banks will choose portfolios that the regulator deems safe, making the financial system less diversified than without the stress tests. As a consequence, while it is always ex post optimal to reveal stress test results, this policy is not ex ante optimal. We show that the ex-ante optimal policy is non-monotonic in the underlying economic state: information should be revealed either in very good times or in very bad times.

Keywords:

Stress tests, optimal disclosure, portfolio diversification

JEL classification:

D82, G11, G18

Break

Prudential Policies and Their Impact on Credit in the United States

Authors:

Paul Calem

Ricardo Correa

Seung Lee

Discussant:

Amar Radia (Bank of England)

Abstract:

We analyze how two types of recently used prudential policies affected the supply of credit in the United States. First, we test whether the U.S. bank stress tests had any impact on the supply of mortgage credit. We find that the first Comprehensive Capital Analysis and Review (CCAR) stress test in 2011 had a negative effect on the share of jumbo mortgage originations and approval rates at stress-tested banks—banks with worse capital positions were impacted more negatively. Second, we analyze the impact of the 2013 Supervisory Guidance on Leveraged Lending and subsequent 2014 FAQ notice, which clarified expectations on the Guidance. We find that the share of speculative-grade term-loan originations decreased notably at regulated banks after the FAQ notice.

Keywords:

bank stress tests; CCAR; Home Mortgage Disclosure Act (HMDA) data; jumbo mortgages; leveraged lending; macroprudential policy; Shared National Credit (SNC) data; Interagency Guidance on Leveraged Lending; syndicated loan market

JEL classification:

G21, G23, G28

How Do Banks Adjust to Stricter Supervision?

Authors:

Maximilian Eber (Harvard)

Camelia Minoiu (IMF)

Discussant:

Deborah Lucas (MIT)

Abstract:

We exploit a discontinuity in the assignment mechanism of the European Central Bank's Comprehensive Assessment in order to identify the effects of increased regulatory scrutiny on bank balance sheets. We find that banks adjust to stricter supervision by reducing leverage, and most of the adjustment stems from shrinking assets rather than from raising equity. We estimate a 7 percent reduction in leverage, two thirds of which are due to asset shrinkage. Securities are adjusted much more strongly than the loan book. On the liability side, banks mostly reduce their reliance on wholesale funding. Using data on syndicated loan issuance, we find that very weak banks also reduce the supply of credit. The evidence highlights banks' reluctance to adjust capital when target leverage changes and suggests that macroprudential considerations matter for stress-testing in practice.

Keywords:

Bank stress testing, deleveraging

JEL classification:

C21, E51, G21, G28

Empirically Evaluating Systemic Risks in CCPs: The Case of Two CDS CCPs

Authors:

Sean Campbell

Ivan Ivanov

Discussant:

Matthew Pritsker

Abstract:

Using a unique data set of weekly CDS positions of major CDS clearing dealers, we empirically evaluate the systemic stability of two CCPs that clear CDS contracts. Our methodology considers both micro- and macroprudential risks to the central clearing system. We show that individual clearing members may pose considerable risk to a CCP as losses of individual dealers in a stress scenario may be large. We show that the combined stress losses of a clearing member across multiple CCPs may be substantially larger than its losses to a single CCP due to a high and positive correlation in the economic exposures of the clearing member across CCPs. Last, we show that there is a potential for several clearing members to experience large losses simultaneously to a given CCP highlighting crowded trades concerns. The methodology explored in this paper documents the feasibility of performing integrated and coordinated stress testing of CCPs on an ongoing basis. These results suggest that the accumulation of systemic risk in the central clearing system may be non-trivial and that the proposed stress tests may be a useful tool for measuring and managing such risk.

How vulnerable are mutual funds to fire sales?

Authors:

Nicola Cetorelli

Fernando Duarte

Thomas Eisenbach

Discussant:

Celso Brunetti

Abstract:

This paper presents an innovative conceptual framework and analytical methodology to analyze liquidity risk in investment funds. In an application to U.S. open ended mutual funds we estimate investors' sensitivities to funds' performance shocks and trace the consequences, from redemptions to potential asset fire sales and its broader economic impact. We found that the potential for broad economic spillovers of U.S. open ended mutual funds has increased six‐fold since 2010. The main factors driving this dynamics are the overall increase in asset size of such investment vehicles but also an overall increase in investors' liquidity sensitivities. The analysis also identifies which funds may be more or less prone to redemption risk and which funds may contribute the most to the asset sale spillovers.

Break

Business Complexity & Risk Management: Evidence from Operational Risk Events in U.S. BHCs

Authors:

Ali Ozdagli

Jianlin Wang

Anna Chernobai (Syracuse)

Discussant:

William Keeton (University of Missouri - Kansas City)

Abstract:

Recent regulatory proposals tie the systemic importance of a financial institution to its complexity. However, we know little about how complexity affects a bank's behavior, including its risk management. Using the gradual deregulation of banks' nonbank activities during 1996-1999 as a natural experiment, we show that the frequency and magnitude of operational risk events in U.S. bank holding companies have increased significantly with their business complexity. This trend is particularly strong for banks that were bound by regulations beforehand, especially for those with an existing Section 20 subsidiary, and weaker for the other banks that were not bound and for nonbank financial institutions that were not subject to the same regulations to begin with. These results reveal the darker side of post-deregulation diversification, which in earlier studies has been shown to lead to improved stock and earnings performance. We use operational risk events as a risk management measure because (i) the timing of the origin of each event is well identified, and can be years before it is materialized into a loss in the balance sheet, and (ii) the risk events can serve as a direct measure of materialized failures in risk management without being influenced by the confounding factors that drive asset prices, such as implicit government guarantees. Our findings have important implications for the regulation of financial institutions deemed systemically important, a designation tied closely to their complexity by the Bank for International Settlements and the Federal Reserve.

Keywords:

Operational risk, bank holding companies, nancial deregulation, Glass-Steagall Act, business complexity

JEL classification:

G18, G20, G21, G32, L25

Determinants of Auto Loan Defaults and Implications on Stress Testing

Authors:

Deming Wu (OCC)

Xinlei Zhao (OCC)

Discussant:

Donghoon Lee

Abstract:

We examine the determinants of auto loan defaults using a sample of credit bureau data over an 11-year period. We find that loans aged five years or more have significantly higher default probabilities. This finding raises concerns about the increasing maturity of auto loans in recent years. Moreover, although incorporating macroeconomic variables barely improves the model fit, macro variables show strong impacts in stress testing results because of the magnitude of the scenarios prescribed by the Federal Reserve. Furthermore, model instability is an inherent challenge in stress testing, as we find the coefficients of macroeconomic variables demonstrate incorrect signs in subsample analyses.

Keywords:

Auto loans; used car prices; unemployment; changes in house price index; loan age; stress testing

JEL classification:

G21