Banks as Liquidity Provider of Second to
Last Resort
Til Schuermann*
Federal Reserve Bank of New York
Q-Group, October 2008
* 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.
Filename
ƒ Talk based on joint work with Evan Gatev and Phil
Strahan (Boston College, Finance)
ƒ First: how it’s supposed to work
ƒ Then: how it seems not to be working now….
Filename
1
3M TED Spread
Filename
2
LIBOR - OIS Spread
2 Jan 2002 - 25 Sep 2008
2
1.8
1.6
1.4
%
1.2
avg (thru July 2007)
std dev (thru July 2007)
LIBOR-OIS Spread (bp)
1-month
3-month
8.7
10.9
3.1
3.5
avg (since Aug 2007)
std dev (thru July 2007)
50.7
25.0
Max (9/25/08):
1.860%, 1.966%
70.0
20.6
(Jan 2, 2002 - Sept. 25, 2008)
1
0.8
1-month
3-month
0.6
0.4
0.2
Filename
Sep-08
May-08
Jan-08
Sep-07
May-07
Jan-07
Sep-06
May-06
Jan-06
Sep-05
May-05
Jan-05
Sep-04
May-04
Jan-04
Sep-03
May-03
Jan-03
Sep-02
May-02
Jan-02
0
3
Some data
ƒ What’s a few trillion between friends…..
ƒ 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
ƒ Meanwhile, sum of write-offs to date (> $500bn)
exceeds cost of S&L crisis (~ $250bn in current $)
Filename
4
Bank liquidity management
ƒ A bank offers two short-term liquidity contracts
Loan
commitments
L
A
Transaction
deposits
E
ƒ 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
Filename
5
Bank liquidity management
ƒ A bank offers two short-term liquidity contracts
Loan
commitments
L
A
Transaction
deposits
E
ƒ Other sources of bank liquidity
– Hold cash and liquid assets
– Access to the inter-bank market
– Borrow from the central bank
Filename
6
But maybe combining the 2 contracts
reduces risk . . .
ƒ 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
ƒ 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)
Filename
ƒ Seems related to government safety net
– Funding flows not related to bank solvency or size
– Effects absent prior to FDIC (Pennacchi JME 2006)
7
Research questions
ƒ How does bank risk (stock volatility) vary with liquidity
exposure?
– Exposure from deposits
– Exposure from loan commitments
ƒ 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)
Filename
8
Sample: Time-Series / Cross-Section Data
ƒ Largest (based on market cap) 100 US banks each
year, 1990-2002
ƒ Drop bank-years when M&As occur
– In 1990 leaves 85 banks
– Number of banks ranges between 98 (2002) and
68 (1996)
ƒ Market data (weekly stock returns) and call report data
ƒ Almost 50,000 bank-week observations
– Cluster data (errors) by bank to avoid assuming
independence over time for each bank: 170 unique
banks
Filename
9
Loan-Deposit synergy: early evidence
Unused Commitments /
(Commitments + Loans) (LC)
bottom third
Stock-return Volatility
Assets (Billions of $s)
Equity / Assets
middle third
Stock-return Volatility
Assets (Billions of $s)
Equity / Assets
top third
Stock-return Volatility
Assets (Billions of $s)
Equity / Assets
Mean Commitments Ratio
Filename
Transactions Deposits / Total Deposits (TD):
bottom third
middle third
top third
28%
29%
32%
10.58
10.20
7.14
8%
8%
11%
29%
17.85
8%
29%
21.64
8%
30%
16.53
7%
36%
34.63
8%
32%
89.10
8%
31%
83.36
8%
0.30
0.31
0.37
10
Research design to address questions
ƒ Dependent variable = stock-return volatility (weekly)
– Conditional return volatility: GARCH(1,1)
– Realized volatility (total or residual)
ƒ 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
Filename
11
Control variables
ƒ Market conditions
– Volatility of S&P500
– Paper-bill spread (3M non-financial)
– Yield on 3M T-bill
ƒ Bank characteristics
– Size: Log of assets
– Capital ratio: Capital/assets
– Inter-bank access: Fed funds purchased/assets
– Liquid assets: (cash + securities)/assets
ƒ 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
Filename
12
Low TD banks: risk ↑ as LC ↑
Figure 1a: Stock Return Volatility for Low Transactions Deposit Banks
1990 - 2002
0.8
0.7
0.6
0.5
0.4
slope = 0.28 (5.55)
0.3
0.2
0.1
0
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Unused commitments / (commitments + loans)
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.
Filename
13
High TD banks: risk unchanged as LC ↑
Figure 1b: Stock Return Volatility for High Transactions Deposit Banks
1990 - 2002
0.8
0.7
0.6
0.5
0.4
0.3
slope = -0.10 (-1.22)
0.2
0.1
0
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Unused commitments / (commitments + loans)
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.
14
Filename
Results of multivariate regressions
ƒ Direct exposure coefficients (β1 & β2) positive
– By themselves, more exposure to LC & TD
increases risk
ƒ Hedge coefficient (β3) negative
ƒ Results insensitive to volatility measure: GARCH or
realized (total or residual)
ƒ Results robust when controlling for market and credit
risk
Filename
15
Reverse causality?
ƒ 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
ƒ 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)
Filename
16
Idiosyncratic vs. systematic liquidity demands
ƒ During ‘normal’ times, diversification synergy comes
from reducing effect of idiosyncratic liquidity demands
ƒ What if there is a systematic shock to liquidity?
– All borrowers show up demanding liquidity
– But: supply of TD increases too
ƒ Hedging effect should be even stronger . . . And it is!
ƒ Look at the times of low liquidity (top 5% of paper-bill
spread distribution: >75bp; avg. = 40bp)
– Hedging term (β3) nearly triples in size
ƒ Also consider Fall 1998 liquidity (flight to quality)
crisis
Filename
17
3M non-fin CP spread (basis points)
weekly, Jan - Dec 1998
140
Oct. 16, 1998: 125bp
120
100
80
60
40
20
0
J
Filename
F
M
A
M
J
J
A
S
O
N
D
18
Filename
19
Filename
20
Low TD banks: risk ↑ 2x faster as LC ↑
Figure 3a: Stock-Return Volatility for Low-Transactions Deposit Banks
Fall 1998
0.8
0.7
0.6
slope = 0.46 (2.69)
0.5
Old slope: 0.28
0.4
0.3
0.2
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Unused Commitments / (Commitments + Loans)
Filename
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.
21
High TD banks: risk unchanged as LC ↑
Figure 3b: Stock-Return Volatility for High-Transactions Deposit Banks
Fall 1998
0.8
0.7
0.6
0.5
slope = -0.16 (-0.66)
0.4
0.3
0.2
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Unused Commitments / (Commitments + Loans)
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.
Filename
22
Conclusions (so far)
ƒ Deposit-loan combination reduces bank risk
– Idiosyncratic liquidity demands
ƒ Risk-reducing synergy more powerful when paper-bill
spreads are wide
– Systematic liquidity demands
– Helps with causality
ƒ Results not due to other risks (market, credit)
Filename
23
3M non-fin CP spread (basis points)
weekly, Jan 1997 - Sept 2008
180
160
140
avg (thru July 2007)
std dev (thru July 2007
32.0
22.7
avg (since Aug 2007)
std dev (thru July 2007
75.1
37.8
162
(Jan 2, 1997 - Sept. 19, 2008)
120
100
80
95th %-ile (91bp)
60
40
20
Filename
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
0
24
It’s good to be a (commercial) bank
ƒ When short term funding, e.g. CP, in the capital
markets dries up, go to your bank
ƒ If you no longer wish to place your short term funds in
ABCP, go to your bank
ƒ How long can this go on?
– Until balance sheet can grow no more
ƒ Where does this leave investment banks?
Filename
25
What’s going on now?
ƒ Banks have been hoarding liquidity
– Especially European banks
ƒ Deposit flows
– Foreign/domestic ..
ƒ New Fed facilities
ƒ And credit spreads?
Filename
26
So what’s happening to bank deposits?
Deposit Growth Rates
Quarter-over-quarter, all commercial banks
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
Filename
27
High overnight agency and MBS spreads to
Treasury
2.5
2.0
March 18:
Agency: 1.65%
MBS: 2.1% (!)
Spread (bp)
Agency MBS
1.8
5.2
11.8
11.4
avg (thru July 2007)
std dev (thru July 2007)
avg (since Aug 2007)
std dev (thru July 2007)
26.6
44.7
31.6
46.5
Spread %
(May 21, 1991 - Sept. 23, 2008)
1.5
Sept. 17:
Agency: 1.75%
MBS: 2.0%
1.0
0.5
0.0
2/1/08
3/1/08
Source: Bloomberg
Filename
4/1/08
5/1/08
6/1/08
Agency Spread
7/1/08
MBS Spread
8/1/08
9/1/08
28
Abnormally low overnight Treasury repo rates
4.0
3.5
3.0
Rate %
2.5
2.0
1.5
1.0
0.5
0.0
2/1/08
3/1/08
4/1/08
5/1/08
6/1/08
Overnight Treasury Repo
Source: Bloomberg, FRBNY
Filename
7/1/08
8/1/08
9/1/08
Fed Funds Target
29
Abnormally low overnight Treasury repo rates
4.0
3.5
3.0
Rate %
2.5
2.0
1.5
1.0
0.5
0.0
2/1/08
3/1/08
4/1/08
TSLF dates
Source: Bloomberg, FRBNY
Filename
5/1/08
6/1/08
7/1/08
Overnight Treasury Repo
8/1/08
9/1/08
Fed Funds Target
30
Problems addressed by new lending facilities
Depository Institutions
Primary Dealers
Backstop
Standing Facilities
Discount Window
Primary Dealer Credit
Facility (PDCF)
Auction Facilities
Term Auction Facility
(TAF)
Term Securities
Lending Facility (TSLF)
ƒ TAF: illiquid term markets and the stigma that
accompanies discount window borrowing.
ƒ TSLF: illiquid functioning in repo funding markets—
illustrated by abnormal rates and high haircuts.
Filename
ƒ PDCF: the lack of market-based back-stop credit in repo
markets.
31
What can you pledge at the TSLF & PDCF?
ƒ 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
ƒ PDCF: above plus sub-investment grade securities
plus equities
ƒ Importantly, previously repo-able securitized
instruments are no longer “stuck” on firms’ balance
sheets
– Facilities designed as liquidity vehicles
Filename
32
Baa and Aaa Spread (to Treasury)
weekly, Jan. 2, 1998 - Sept 19, 2008
450
Baa spread
400
11 Oct, 2002
Aaa spread
350
300
95th %-ile
250
200
150
21 Sept. 2001
100
50
Filename
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
0
33
Thank You!
http://nyfedeconomists.org/schuermann/
Filename
34