Banks as Liquidity Provider of Second to Last Resort Til - - PowerPoint PPT Presentation

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Banks as Liquidity Provider of Second to Last Resort

* Any views expressed represent those of the author only and not necessarily those of the Federal Reserve

Bank of New York or the Federal Reserve System.

Til Schuermann* Federal Reserve Bank of New York

Q-Group, October 2008

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Talk based on joint work with Evan Gatev and Phil

Strahan (Boston College, Finance)

First: how it’s supposed to work Then: how it seems not to be working now….

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3M TED Spread

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LIBOR - OIS Spread

2 Jan 2002 - 25 Sep 2008

0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08

%

1-month 3-month Max (9/25/08): 1.860%, 1.966% 1-month 3-month avg (thru July 2007) 8.7 10.9 std dev (thru July 2007) 3.1 3.5 avg (since Aug 2007) 50.7 70.0 std dev (thru July 2007) 25.0 20.6

(Jan 2, 2002 - Sept. 25, 2008)

LIBOR-OIS Spread (bp)

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Some data

What’s a few trillion between friends….. Early 2007:

– ABCP + SIV + ARS + TOB + VRDN ≈ $2.2 trn – O/N tri-party repo: $2.5 trn – Hedge funds AUM: $1.8 trn – Assets of 5 i-banks: $4 trn – Assets of 5 U.S. BHCs: $6 trn – Assets of all U.S. banks: $10 trn

Meanwhile, sum of write-offs to date (> $500bn)

exceeds cost of S&L crisis (~ $250bn in current $)

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Bank liquidity management

A bank offers two short-term liquidity contracts

A L E

Loan commitments Transaction deposits

Seems very unstable

– What if demand spikes for both at the same time? – And what if that happens systematically (affecting all banks) – Worry about bank runs

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Bank liquidity management

A bank offers two short-term liquidity contracts

A L E

Loan commitments Transaction deposits

Other sources of bank liquidity

– Hold cash and liquid assets – Access to the inter-bank market – Borrow from the central bank

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But maybe combining the 2 contracts reduces risk . . .

Diversification synergy

– Combining transactions deposits and loan commitments reduces idiosyncratic risk (Kashyap, Rajan & Stein, JF 2002) – Transaction deposits hedge the systematic liquidity risk exposure of loan commitments

Flight to quality

– Banks can bear systematic shocks to liquidity demand due to funding inflows (Gatev and Strahan, JF 2006) – Deposit-lending synergy is stronger in a liquidity crisis (e.g. Fall 1998)

Seems related to government safety net

– Funding flows not related to bank solvency or size – Effects absent prior to FDIC (Pennacchi JME 2006)

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Research questions

How does bank risk (stock volatility) vary with liquidity

exposure? – Exposure from deposits – Exposure from loan commitments

Is there evidence of a natural hedge to mitigate

liquidity risk? – Does the hedge become more evident when liquidity becomes scarce? – Case study: Fall 1998 (Gatev, Schuermann & Strahan, NBER 2005)

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Sample: Time-Series / Cross-Section Data

Largest (based on market cap) 100 US banks each

year, 1990-2002

Drop bank-years when M&As occur

– In 1990 leaves 85 banks – Number of banks ranges between 98 (2002) and 68 (1996)

Market data (weekly stock returns) and call report data Almost 50,000 bank-week observations

– Cluster data (errors) by bank to avoid assuming independence over time for each bank: 170 unique banks

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Loan-Deposit synergy: early evidence

Unused Commitments / (Commitments + Loans) (LC) bottom third bottom third middle third top third Stock-return Volatility 28% 29% 32% Assets (Billions of $s) 10.58 10.20 7.14 Equity / Assets 8% 8% 11% middle third Stock-return Volatility 29% 29% 30% Assets (Billions of $s) 17.85 21.64 16.53 Equity / Assets 8% 8% 7% top third Stock-return Volatility 36% 32% 31% Assets (Billions of $s) 34.63 89.10 83.36 Equity / Assets 8% 8% 8% Mean Commitments Ratio 0.30 0.31 0.37 Transactions Deposits / Total Deposits (TD):

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Research design to address questions

Dependent variable = stock-return volatility (weekly)

– Conditional return volatility: GARCH(1,1) – Realized volatility (total or residual)

Modeling Bank Risk

Volatility = α + β1LoanCommitmentst-1,i + β2DepositBaset-1,i +β3(LoanCommitmentst-1,i*DepositBaset-1,i ) + OtherControls + εi,t

β1, β2 > 0 (Exposure); β3 < 0

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Control variables

Market conditions

– Volatility of S&P500 – Paper-bill spread (3M non-financial) – Yield on 3M T-bill

Bank characteristics

– Size: Log of assets – Capital ratio: Capital/assets – Inter-bank access: Fed funds purchased/assets – Liquid assets: (cash + securities)/assets

Other risks (market, credit risk)

– Trading assets/assets – C&I loans/assets – CRE loans/assets – NPL/assets – Loan-loss provision/assets – Net charge-offs/assets – Credit rating

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Low TD banks: risk ↑ as LC ↑

Figure 1a: Stock Return Volatility for Low Transactions Deposit Banks

1990 - 2002

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Unused commitments / (commitments + loans)

slope = 0.28 (5.55)

Time average of annualized bank stock return volatility and commitment ratio for bank with below-median levels of transaction deposits for 170 largest U.S. banks (plot is for 85 banks). Source: Volatility based on authors' calculations using data from CRSP. Commitment ratio is from Call Reports.

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High TD banks: risk unchanged as LC ↑

Figure 1b: Stock Return Volatility for High Transactions Deposit Banks

1990 - 2002

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Unused commitments / (commitments + loans)

slope = -0.10 (-1.22)

Time average of annualized bank stock return volatility and commitment ratio for bank with above-median levels of transaction deposits for 170 largest U.S. banks (plot is for 85 banks). Source: Volatility based on authors' calculations using data from CRSP. Commitment ratio is from Call Reports.

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Results of multivariate regressions

Direct exposure coefficients (β1 & β2) positive

– By themselves, more exposure to LC & TD increases risk

Hedge coefficient (β3) negative Results insensitive to volatility measure: GARCH or

realized (total or residual)

Results robust when controlling for market and credit

risk

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Reverse causality?

Why are there some banks on the “off-diagonal”?

– E.g. Low LC exposure but high TD (upper right corner) – Smallest banks, bank-dependent clientele but little liquidity insurance provided

Still, reverse causality is possible

– Risk mgmt motive drives bank choice of TD and LC rather than other way around – Maybe (otherwise) safe banks choose to expose themselves to greater liquidity risk (high LC, high TD)

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Idiosyncratic vs. systematic liquidity demands

During ‘normal’ times, diversification synergy comes

from reducing effect of idiosyncratic liquidity demands

What if there is a systematic shock to liquidity?

– All borrowers show up demanding liquidity – But: supply of TD increases too

Hedging effect should be even stronger . . . And it is! Look at the times of low liquidity (top 5% of paper-bill

spread distribution: >75bp; avg. = 40bp) – Hedging term (β3) nearly triples in size

Also consider Fall 1998 liquidity (flight to quality)

crisis

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3M non-fin CP spread (basis points)

weekly, Jan - Dec 1998 20 40 60 80 100 120 140

J F M A M J J A S O N D

• Oct. 16, 1998: 125bp

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Low TD banks: risk ↑ 2x faster as LC ↑

Figure 3a: Stock-Return Volatility for Low-Transactions Deposit Banks

Fall 1998

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Unused Commitments / (Commitments + Loans)

slope = 0.46 (2.69)

Time average of annualized bank stock return volatility and commitment ratio for bank with below-median levels of transaction deposits for 64 largest U.S. banks (plot is for 32 banks). Source: Volatility based on authors' calculations using data from CRSP. Commitment ratio is from Call Reports.

Old slope: 0.28

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High TD banks: risk unchanged as LC ↑

Figure 3b: Stock-Return Volatility for High-Transactions Deposit Banks

Fall 1998

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Unused Commitments / (Commitments + Loans)

slope = -0.16 (-0.66)

Time average of annualized bank stock return volatility and commitment ratio for bank with below-median levels of transaction deposits for 64 largest U.S. banks (plot is for 32 banks). Source: Volatility based on authors' calculations using data from CRSP. Commitment ratio is from Call Reports.

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Conclusions (so far)

Deposit-loan combination reduces bank risk

– Idiosyncratic liquidity demands

Risk-reducing synergy more powerful when paper-bill

spreads are wide – Systematic liquidity demands – Helps with causality

Results not due to other risks (market, credit)

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3M non-fin CP spread (basis points)

weekly, Jan 1997 - Sept 2008 20 40 60 80 100 120 140 160 180

Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

95th %-ile (91bp)

avg (thru July 2007) 32.0 std dev (thru July 2007 22.7 avg (since Aug 2007) 75.1 std dev (thru July 2007 37.8

(Jan 2, 1997 - Sept. 19, 2008)

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It’s good to be a (commercial) bank

When short term funding, e.g. CP, in the capital

markets dries up, go to your bank

If you no longer wish to place your short term funds in

ABCP, go to your bank

How long can this go on?

– Until balance sheet can grow no more

Where does this leave investment banks?

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What’s going on now?

Banks have been hoarding liquidity

– Especially European banks

Deposit flows

– Foreign/domestic ..

New Fed facilities And credit spreads?

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So what’s happening to bank deposits?

Domestic Foreign Total 2001-2005 1.96 1.32 1.86 2006q1-2007q2 1.16 6.30 2.05 2007q3 0.82 6.97 2.07 2007q4 4.20 4.23 4.21 2008q1 2.23

• 0.38

1.70 2008q2

• 1.01

3.08

• 0.16

Entire period 1.75 2.60 1.91

Deposit Growth Rates

Quarter-over-quarter, all commercial banks

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High overnight agency and MBS spreads to Treasury

Source: Bloomberg

0.0 0.5 1.0 1.5 2.0 2.5 2/1/08 3/1/08 4/1/08 5/1/08 6/1/08 7/1/08 8/1/08 9/1/08

Spread %

Agency Spread MBS Spread

March 18: Agency: 1.65% MBS: 2.1% (!)

Agency MBS avg (thru July 2007) 1.8 5.2 std dev (thru July 2007) 11.8 11.4 avg (since Aug 2007) 26.6 31.6 std dev (thru July 2007) 44.7 46.5

(May 21, 1991 - Sept. 23, 2008)

Spread (bp)

• Sept. 17:

Agency: 1.75% MBS: 2.0%

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Abnormally low overnight Treasury repo rates

Source: Bloomberg, FRBNY

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 2/1/08 3/1/08 4/1/08 5/1/08 6/1/08 7/1/08 8/1/08 9/1/08 Rate % Overnight Treasury Repo Fed Funds Target

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Abnormally low overnight Treasury repo rates

Source: Bloomberg, FRBNY

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 2/1/08 3/1/08 4/1/08 5/1/08 6/1/08 7/1/08 8/1/08 9/1/08 Rate % TSLF dates Overnight Treasury Repo Fed Funds Target

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Problems addressed by new lending facilities

TAF: illiquid term markets and the stigma that

accompanies discount window borrowing.

TSLF: illiquid functioning in repo funding markets—

illustrated by abnormal rates and high haircuts.

PDCF: the lack of market-based back-stop credit in repo

markets.

Term Securities Lending Facility (TSLF) Term Auction Facility (TAF) Auction Facilities Primary Dealer Credit Facility (PDCF) Discount Window Backstop Standing Facilities Primary Dealers Depository Institutions

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What can you pledge at the TSLF & PDCF?

TSLF: OMO collateral plus investment grade

securities: private label RMBS, CMBS, Agency CMOs, ABS such as CDOs, CLOs,corporates, munis, MBS (R and C), ABS – So long as it can be priced by the clearing banks

PDCF: above plus sub-investment grade securities

plus equities

Importantly, previously repo-able securitized

instruments are no longer “stuck” on firms’ balance sheets – Facilities designed as liquidity vehicles

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Baa and Aaa Spread (to Treasury)

weekly, Jan. 2, 1998 - Sept 19, 2008

50 100 150 200 250 300 350 400 450 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Baa spread Aaa spread 21 Sept. 2001 11 Oct, 2002 95th %-ile

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Thank You!

http://nyfedeconomists.org/schuermann/