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Center for Financial Research

CFR Working Paper Series 2005


The CFR sponsors original research on issues associated with deposit insurance, banking performance, risk measurement and management, corporate finance, and financial policy and regulation. The results of CFR-sponsored research, FDIC staff research, and other invited papers on these CFR research lines appear in the CFR Working Paper Series.

Working Paper Series:
Working Paper NumberTitle
2005-14 Asset Salability and Debt Maturity: Evidence from 19th Century American Railroads
Efraim Benmelech
2005-13 Why are Firms Using Interest Rate Swaps to Time the Yield Curve?
Sergey Chernenko
Michael Faulkender
Todd Milbourn
2005-12 Estimating Systemic Risk in the International Financial System
Söhnke M. Bartram
Gregory W. Brown
John E. Hund
2005-11 Correlation, Price Discovery and Co-movement of ABS and Equity
Andreas A. Jobst
2005-10 Should the FDIC Worry about the FHLB? The Impact of Federal Home Loan Bank Advances on the Bank Insurance Fund
Rosalind L. Bennett
Mark D. Vaughan
Timothy J. Yeager
2005-09 Payday Lending: Do the Costs Justify the Price?
Mark Flannery
Katherine Samolyk
2005-08 Relationship Lending, Accounting Disclosure, and Credit Availability during the Asian Financial Crisis
Wenying Jiangli
Haluk Unal
Chiwon Yom
2005-07 The Depositor behind the Discipline: A Micro-level Case Study of Hamilton Bank
Andrew Mitsunori Davenport
Kathleen Marie McDill
2005-06 Do Bank Failures Affect Real Economic Activity?
State-Level Evidence from the Pre-Depression Era

Carlos D. Ramirez and Philip A. Shively
2005-05 Regulatory Capital and Earnings Management in Banks: The Case of Loan Sales and Securitization
N. Emre Karaoglu
2005-04 Unbiased Capital Allocation in an Asymptotic Single Risk Factor (ASRF) Model of Credit Risk
Paul Kupiec
2005-03 Are the Causes of Bank Distress Changing? Can Researchers Keep Up?
Thomas B. King, Daniel A. Nuxoll and Timothy J. Yeager
2005-02 Asymmetric Information and Liquidity Constraints: A More Complete Test
Dmytro Holod and Joe Peek
2005-01 Measuring Marginal Risk Contributions in Credit Portfolios
Paul Glasserman

Asset Salability and Debt Maturity: Evidence from 19th Century American Railroads - PDF 956k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-14
Efraim Benmelech
May 2005

    Abstract
    I investigate the effect of assets’ liquidation values on capital structure by exploiting the diversity of track gauges in 19th century American railroads. The abundance of track gauges limited the redeployability of rolling stock and tracks to potential users with similar track gauge. Moreover, potential demand for both rolling stock and tracks was further diminished when many railroads went under equity receiverships and were prevented from participating in the market for used capital. Using a unique dataset of more than 220 19th century American railroads, I find that railroads that had more redeployable cars, and that conformed to a commonly used track gauge, had longer debt maturities. In addition, the potential demand for a railroad’s rolling stock and tracks were significant determinants of debt maturity. Interestingly, there is no evidence that salability or industry-demand for assets were correlated with leverage.

    JEL classification: G32 G33 L92 N21 N71

    Keywords: Capital structure, Debt maturity, Liquidation, Salability, Gauge, Railroads.

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Why are Firms Using Interest Rate Swaps to Time the Yield Curve? - PDF 572k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-13
Sergey Chernenko
Michael Faulkender
Todd Milbourn
October 10, 2005

    Abstract
    In this paper, we explore the managerial decision-making process with a particular eye on why managers are timing the interest rate market. We ask whether the documented sensitivity of interest rate swap usage to the term structure is a function of managers trying to meet earnings forecasts, attempting to boost near-term results prior to raising external capital, or simply to increase their compensation? Using a very large, hand-collected dataset of swap activity, our empirical findings suggest that the choice of interest rate exposure is primarily driven by a concern to meet consensus earnings forecasts and raise managerial pay.

    JEL Codes: G32

    Key Words: Interest Rate Swaps, Market Timing, Myopia, Speculation

    CFR Research Program: Corporate Finance

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Estimating Systemic Risk in the International Financial System - PDF 879k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-12
Söhnke M. Bartram
Gregory W. Brown
John E. Hund
July 2005

    Abstract
    Using a unique and comprehensive dataset, this paper develops and uses three distinct methods to quantify the risk of a systemic failure in the global banking system. We examine a sample of 334 banks (representing 80% of global bank equity) in 28 countries around 6 global financial crises (such as the Asian and Russian crises and September 11, 2001), and show that these crises did not create large probabilities of global financial system failure. First, we show that cumulative negative abnormal returns for the subset of banks not directly exposed to a negative shock (unexposed banks) rarely exceed a few percent. Second, we use structural models to obtain more precise point estimates of the likelihood of systemic failure. These estimates suggest that systemic risk is limited even during major financial crises. For example, maximum likelihood estimation of bank failure probabilities implied by equity prices suggests the Asian crisis induced less than a 1% increase in the probability of systemic failure. Third, we also obtain estimates of systemic risk implied by equity option prices of U.S. and European banks. The largest values are obtained for the Russian crisis and September 11 and these show increases in estimated average default probabilities of only around 1-2%. Taken together our results suggest statistically significant, but economically small, increases in systemic risk around even the worst financial crises of the last 10 years. Although policy responses are endogenous, the low estimated probabilities suggest that the distress of central bankers, regulators and politicians about the events we study may be overstated, and that current policy responses to financial crises and the existing institutional framework may be adequate to handle major macroeconomic events.

    Keywords: Systemic risk, default risk, credit risk, banks, exposure, emerging markets, 9/11

    JEL Classification: G3, F4, F3

    CFR research programs: Deposit Insurance

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Correlation, Price Discovery and Co-movement of ABS and Equity - PDF 1,686k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-11
Andreas A. Jobst
July 2005

    Abstract
    Asset-backed securitization (ABS) has become a viable and increasingly attractive risk management and refinancing method either as a standalone form of structured finance or as securitized debt in Collateralized Debt Obligations (CDO). However, the absence of industry standardization has prevented rising investment demand from translating into market liquidity comparable to traditional fixed income instruments, in all but a few selected market segments. Particularly low financial transparency and complex security designs inhibits profound analysis of secondary market pricing and how it relates to established forms of external finance. This paper represents the first attempt to measure the intertemporal, bivariate causal relationship between matched price series of equity and ABS issued by the same entity. In a two-dimensional linear system of simultaneous equations we investigate the short-term dynamics and long-term consistency of daily secondary market data from the U.K. Sterling ABS/MBS market and exchange traded shares between 1998 and 2004 with and without the presence of cointegration. Our causality framework delivers compelling empirical support for a strong co-movement between matched price series of ABS-equity pairs, where ABS markets seem to contribute more to price discovery over the long run. Controlling for cointegration, risk-free interest and average market risk of corporate debt hardly alters our results. However, once we qualify the magnitude and direction of price discovery on various security characteristics, such as the ABS asset class, we find that ABS-equity pairs with large-scale CMBS/RMBS and credit card/student loan ABS reveal stronger lead-lag relationships and joint price dynamics than whole business ABS.

    Keywords: co-movement, causality test, vector autoregression (VAR), vector error correction mechanism (VECM), short-term price dynamics, price discovery, asset-backed securities (ABS), securitization, mortgage-backed securities (MBS), collateralized debt obligation (CDO), captive finance, Pfandbrief, cointegration

    JEL Classification: G10, G12, G24

    CFR research programs: risk measurement

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Should the FDIC Worry about the FHLB? The Impact of Federal Home Loan Bank Advances on the Bank Insurance Fund - PDF 530k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-10
Rosalind L. Bennett
Mark D. Vaughan
Timothy J. Yeager
July 2005

    Abstract
    Does growing commercial-bank reliance on Federal Home Loan Bank (FHLBank) advances increase expected losses to the Bank Insurance Fund (BIF)? Our approach to this question begins by modeling the link between advances and expected losses. We then quantify the effect of advances on default probability with a CAMELS-downgrade model. Finally, we assess the impact on loss-given-default by estimating resolution costs in two scenarios: the liquidation of all banks with failure probabilities above two percent and the liquidation of all banks with advance-to-asset ratios above 15 percent. The evidence points to non-trivial increases in expected losses. The policy implication is that the FDIC should price FHLBank-related exposures.

    JEL Classification: G21, G28, K23

    Key Words: Deposit-insurance pricing, Federal Deposit Insurance Corporation (FDIC), Federal Home Loan Bank (FHLB), moral hazard, secured funding

    CFR Research Programs: deposit insurance; banking performance & the economy

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Payday Lending: Do the Costs Justify the Price? - PDF 597k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-09
Mark Flannery
Katherine Samolyk
June 2005

    Abstract
    The payday advance industry makes small, very short-term consumer loans through an extensive network of storefront shops. Customer demand for this product appears to be very strong, and the industry has grown dramatically over the past decade. Yet many observers view the industry with suspicion. The fees charged on payday advances convert to very high annualized rates of interest (APRs). And the media (and others) circulate anecdotes about payday borrowers who renew their loans frequently and become burdened by the high associated fees. Some analysts claim that the industry could not survive without these chronic troubled borrowers. Yet it is difficult to understand the determinants of the industry’s profitability because researchers have had very limited access to micro level data about payday advance firms. Using proprietary store-level data provided by two large payday lenders, we study store costs and profitability. We examine how profitability is related to the borrowing patterns of payday advance customers, default losses, and store characteristics. We also ask how profitability varies with local economic and demographic conditions. We find that fixed operating costs and loan loss rates do justify a large part of the high APRs charged on payday advance loans, and that a store’s loan volume is a key determinant of its profitability. However, we do not find that loan renewals or loans from frequent borrowers are more profitable than other loans per se, although they certainly contribute to a store’s loan volume. Finally, controlling for loan volume, we also do not find that economic and demographic conditions in the neighborhoods where stores are located have much of an effect on profitability, although they do slightly influence default losses.

    Key Words: consumer finance, consumer credit, payday lending, predatory lending

    JEL Classification: G21, G23, G28

    CFR Research Programs: policy and regulation

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Relationship Lending, Accounting Disclosure, and Credit Availability during the Asian Financial Crisis - PDF 629k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-08
Wenying Jiangli
Haluk Unal
Chiwon Yom
June 2005

    Abstract
    In this paper we examine whether the intensity of banking relationships, measured by the number of banks with which a firm does business, benefits firms by making credit more available during periods of financial stress. We model credit availability to be determined jointly with the decision to post collateral and with the firm’s choice of the number of lending relationships. Our main finding is that relationship banking increased the likelihood of obtaining credit during the Asian crisis for Korean and Thai firms. In contrast, we observe no significant association between relationship banking and credit availability for Indonesian and Philippine firms. We consider accounting disclosure a possible alternative factor that can explain the observed country differences. Our results show that except for Indonesia, audited financial information and accounting disclosure have no material impact on banks’ credit decisions.

    Key Words: relationship lending, accounting disclosure, credit availability

    JEL Classification: G20, G21, G28

    CFR Research Programs: bank performance and the economy, corporate finance

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The Depositor behind the Discipline: A Micro-level Case Study of Hamilton Bank - PDF 665k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-07
Andrew Mitsunori Davenport
Kathleen Marie McDill
June 2005

    Abstract
    Though uninsured depositors are recognized as a source of market discipline, the possible disciplinary effect of decisions made by fully insured depositors have gone largely unexamined. Using proprietary administrative deposit data at the account level, this paper analyzes depositor behavior at a recently failed institution. The results suggest that although uninsured deposits exited at a greater rate than insured deposits, the vast majority of deposits withdrawn were fully insured. Among types of deposit accounts, the rates of withdrawal for fully insured individual, joint, and trust accounts were relatively high. Uninsured business account owners were highly sensitive to the bank’s deteriorating condition. In contrast, owners of uninsured individual retirement accounts effectively exerted no market discipline.

    Key Words: depositor discipline, account types, uninsured, insured

    JEL Classification: G20, G21, G28

    CFR Research Programs: deposit insurance, policy and regulation

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Do Bank Failures Affect Real Economic Activity? State-Level Evidence from the Pre-Depression Era - PDF 623k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-06
Carlos D. Ramirez
Philip A. Shively
June 2005

    Abstract
    This paper provides empirical evidence documenting the existence of a credit channel during the pre-Depression era using a newly constructed, state-level quarterly time series from 1900Q1 through 1931Q2 for the 48 contiguous states. It also investigates the source and size of the credit channel, and it examines the dynamic effects of bank failures on business failures. Granger-causality tests find evidence that bank failures cause commercial failures at the aggregate U.S. level and over half of the 48 states. The cross-sectional variation allows us to test two explanations of the credit channel discussed in the literature: (i) a reduction in consumption spending from the slow liquidation of failed-bank de- posits, and (ii) a decrease in investment spending from a disruption of credit to bank-dependent firms. Our results support both theories, but the evidence in favor of the first is stronger statistically. Branch banking restrictions, state- sponsored deposit insurance, and differences in the agricultural-manufacturing share of commerce do not affect the empirical importance of an independent credit channel. Using aggregate U.S. level data, our structural model indicates that bank failures account for about 25% of commercial failures, and that bank failures have only minor subsequent effects within the banking sector.

    Key words: Credit channel, Bank runs, Deposit insurance, Granger causality

    JEL classifications: E32, E51, G21

    CFR Research Program: Banking and the Economy

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Regulatory Capital and Earnings Management in Banks: The Case of Loan Sales and Securitization - PDF 704k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-05
N. Emre Karaoglu
May 2005

    Abstract
    In this paper, I investigate whether banks use loan sales and securitizations (loan transfers) to manage regulatory capital and earnings. My analysis suggests that banks use gains from loan transfers to influence both reported earnings and regulatory capital after controlling for other economic motivations. The gains can be attributed both to cherry-picking of loans whose market values exceed their book values and also to overvaluation of the retained interests that are carried at fair market value in the case of securitizations. In addition, the use of securitizations for financial statement management is positively associated with the degree of financial reporting discretion available to managers. Finally, regulatory capital considerations seem to play a significant role in the decision to transfer loans, while earnings management considerations are more important in the calculation of reported gains conditional on performing a transfer, particularly in the case of securitizations.

    Key words: securitization, loan sales, accounting, capital standards, risk measurement

    JEL Classification: G18, G14, G21, M41

    CFR research programs: bank regulatory policy, risk measurement

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Unbiased Capital Allocation in an Asymptotic Single Risk Factor (ASRF) Model of Credit Risk - PDF 328k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-04
Paul Kupiec
February 2005

    Abstract
    This paper derives unbiased capital allocation rules for portfolios in which credit risk is driven by a single common factor and idiosyncratic risk is fully diversified. The methodology for setting unbiased capital allocations is developed in the context of the Black-Scholes-Merton (BSM) equilibrium model. The methodology is extended to develop an unbiased capital allocation rule for the Gaussian ASRF structural model of credit risk. Unbiased capital allocations are shown to depend on yield to maturity as well as probability of default, loss given default, and asset correlations. Unbiased capital allocations are compared to capital allocations that are set equal to unexpected loss in a Gaussian credit loss model—an approach that is widely applied in the banking industry and used to set minimum bank regulatory capital standards under the Basel II Internal Ratings Based (IRB) approach. The analysis demonstrates that the Gaussian unexpected loss approach substantially undercapitalizes portfolio credit risk relative to an unbiased capital allocation rule. The results include a suggested correction for the IRB capital assignment function. The corrected capital rule calls for a substantial increase in minimum capital requirements over the existing Basel II IRB regulatory capital function.

    Key words: economic capital, credit risk internal models, Basel II, Internal Ratings Approach

    JEL Classification: G12, G20, G21, G28

    CFR research programs: risk measurement, bank regulatory policy

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Are the Causes of Bank Distress Changing? Can Researchers Keep Up? - PDF 676k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-03
Thomas B. King
Daniel A. Nuxoll
Timothy J. Yeager
January 2005

    Abstract
    Since 1990, the banking sector has experienced enormous legislative, technological, and financial change, yet research into the causes of bank distress has slowed. One consequence is that current supervisory surveillance models may no longer accurately represent the banking environment. After reviewing the history of these models, we provide empirical evidence that the characteristics of failing banks have changed in the last ten years and argue that the time is ripe for new research using new empirical techniques. In particular, dynamic models that use forward-looking variables and address various types of bank risk individually are promising lines of inquiry. Supervisory agencies have begun to move in these directions, and we describe several examples of this new generation of early-warning models that are not yet widely known among academic banking economists.

    Key words: off-site models, risk measurement, bank examination, bank supervision, bank failure

    JEL Classification: C51, C53, G21

    CFR research programs: risk measurement
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Asymmetric Information and Liquidity Constraints: A More Complete Test - PDF 1,134k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-02
Dmytro Holod
Joe Peek
December 2004

    Abstract
    This study shows that financial market imperfections do matter for a firm’s access to external finance. Prior studies of the importance of liquidity constraints faced by nonfinancial firms have suffered from a glaring weakness. They have been based on a sample of publicly traded firms, omitting precisely those small firms most likely to be liquidity constrained. We overcome this limitation by focusing on the banking sector. Unlike the nonfinancial sector, the banking sector has balance sheet and income data available for all firms, whether or not they are publicly traded. This allows the use of a superior measure of the degree of information asymmetry across firms by distinguishing between publicly traded and non-publicly traded firms. Furthermore, we focus on changes in monetary policy that represent exogenous (to the banks) changes in the financing constraints faced by banks. We find that publicly traded banks, which exhibit a lower degree of information asymmetry, are better able to overcome financial market frictions, compared to the relatively opaque non-publicly traded banks, when monetary policy is tightened. Lending by the more transparent publicly traded banks is less affected by a monetary policy tightening in large part due to their ability to issue uninsured large time deposits. These results are obtained controlling for firm (bank) size, a dimension commonly used in the literature as the measure of the degree of firm access to external finance.

    Key Words: Asymmetric information, liquidity constraints, banks, external finance, monetary policy

    JEL Classification: G21, G32, E51, E52

    CFR Research Programs: Banking and the Economy

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Measuring Marginal Risk Contributions in Credit Portfolios - PDF 716k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2005-01
Paul Glasserman
December 2004

    Abstract
    We consider the problem of decomposing the credit risk in a portfolio into a sum of risk contributions associated with individual obligors or transactions. For some standard measures of risk — including value-at-risk and expected shortfall — the total risk can be usefully decomposed into a sum of marginal risk contributions from individual obligors. Each marginal risk contribution is the conditional expected loss from that obligor, conditional on a large loss for the full portfolio. We develop methods for calculating or approximating these conditional expectations. Ordinary Monte Carlo estimation is impractical for this problem because the conditional expectations defining the marginal risk contributions are conditioned on rare events. We develop three techniques to address this difficulty. First, we develop importance sampling estimators specifically designed for conditioning on large losses. Next, we use the analysis underlying the importance sampling technique to develop a hybrid method that combines an approximation with Monte Carlo. Finally, we take this approach a step further and develop a rough but fast approximation that dispenses entirely with Monte Carlo. We develop these methods in the Gaussian copula framework and illustrate their performance in multifactor models.

    Key Words: Portfolio credit risk, value-at-risk, expected shortfall, Monte Carlo methods

    JEL Classification: G11; G21; C15

    CFR Research Programs: risk measurement.