Right
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To Mindy Ring
Allen N. Berger
To My Parents, My Daughter Arya, and My Mentors
Christa H.S. Bouwman
Preface
We met in the summer of 2004 when Christa was a PhD student at the University of Michigan and Allen was a senior economist at the Federal Reserve Board in Washington. We were introduced via email by Arnoud Boot of the University of Amsterdam, who had been a former teacher of Christa and a professional colleague of Allen. Arnoud asked Allen if he would take on Christa as an intern for the summer and Allen agreed, and our long-term collaboration began. Eventually, Christa graduated, moved to Case Western Reserve University in Cleveland, and then went on to become an Associate Professor with Tenure and Republic Bank Research Fellow at Texas A&M University in College Station. Allen moved to the University of South Carolina in Columbia, where he is now H. Montague Osteen, Jr., Professor in Banking and Finance and Carolina Distinguished Professor.
Our first project, started in the early summer of 2004, was to test the theories of the effects of bank capital on liquidity creation. We quickly realized that there were no available measures of liquidity creation that incorporated the liquidity created or destroyed by all commercial bank assets, liabilities, and off-balancesheet activities, so we developed our own measures of bank liquidity creation. Our preferred measure, “cat fat,” classifies all bank financial activities as liquid, semiliquid, or illiquid. It uses categories for loans (the Call Report only allows classification by category or maturity, but not both) and both category and maturity for other assets, liabilities, and off-balance-sheet activities. We later found a contemporaneous working paper by Deep and Schaefer (2004) that measured bank liquidity transformation, but for reasons described in the book, did not suit our purposes. When we presented the paper the next May at the 2005 Federal Reserve Bank of Chicago Bank Structure and Competition conference, we were surprised that all of the attention and questions were on the liquidity creation measures, rather than on the tests of the effects of capital on liquidity creation. As a result, we flipped the order to focus first on the liquidity creation measures, eventually adjusted the title of the paper to be simply “Bank Liquidity Creation,” and it was published in the Review of Financial Studies in 2009.
In early 2008, when the recent financial crisis was just underway, but well before the widespread panic of September 2008 when Lehman Brothers failed, we began work on financial crises. We developed a paper that linked financial crises with bank capital, liquidity creation, and monetary policy. We eventually separated it into two papers, one on bank capital and financial crises which was published in the Journal of Financial Economics in 2013, and one on liquidity
Introduction
This chapter gives the focus of the book: to inform readers about liquidity creation by commercial banks, financial crises, and their links. It also describes commercial banks and indicates how they differ from other financial institutions. Finally, it provides a brief overview of all the other chapters in the book. Specifically, it introduces liquidity creation theories and measurement; how liquidity creation may be used to measure bank output and bank liquidity; alternative approaches to defining and dating financial crises; links between bank liquidity creation and these crises; how much liquidity banks create during normal times and financial crises; the effects of bank capital, other bank characteristics, and government policies and actions on liquidity creation; and many more topics.
1.1 THE FOCUS OF THE BOOK
The purpose of the book is to inform bank executives, financial analysts, researchers (including academics and students), and policy makers (including legislators, regulators, and central bankers) about bank liquidity creation, financial crises, and the links between the two. The book explains that bank liquidity creation is a more comprehensive measure of a bank’s output than traditional measures. It discusses that when a bank creates liquidity for the public, it makes itself illiquid in the process. It then shows how normalized liquidity creation (i.e., liquidity creation divided by assets) may be used as a direct measure of bank illiquidity, or an inverse measure of bank liquidity. The book describes how high levels of bank liquidity creation may cause or predict future financial crises, and how bank liquidity creation tends to fall during such crises. It reviews the existing theoretical and empirical literature, provides new econometric analyses using liquidity creation and financial crisis data, raises new questions to be addressed in future research, and provides links to websites with data and other materials to address these questions. The information in this book is generally not available in other banking textbooks (e.g., Freixas and Rochet, 2008; Saunders and Cornett 2014; and Greenbaum, Thakor, and Boot, 2016).
The book’s website (http://booksite.elsevier.com/9780128002339) contains more than three decades of quarterly liquidity creation data on virtually every commercial bank in the United States. At the time of this writing, these data cover the period 1984:Q1–2014:Q4. It also provides links to other websites
savings accounts. However, the distinction between thrifts and commercial banks has blurred over time. Many thrifts have commercial loans and transactions deposits similar to those of commercial banks, but in the United States by law, they cannot have more than 20% of their lending in commercial loans, and they must pass a qualified thrift lender test that assures that at least 65% of their assets are in residential mortgages or mortgage-backed securities. This makes them especially vulnerable to downturns in the housing market. Thrifts are also prudentially regulated and supervised to curb moral hazard and keep them safe. They are regulated and supervised by the OCC or state agencies, depending on whether they are nationally or state chartered, respectively.
Most thrifts are small relative to the largest commercial banks. However, there are some large ones. Similar to commercial banks, the largest thrifts are generally in holding companies. The largest public thrift holding companies in the United States, each with assets over $10 billion as of 2014:Q4, are New York Community Bancorp (owns New York Community Bank), Hudson City Bancorp Inc. (owns Hudson City Savings Bank), EverBank Financial Corp. (owns EverBank), Investors Bancorp Inc. (owns Investors Bank), Astoria Financial Corp. (owns Astoria Bank), and TFS Financial Corp. (owns Third Federal Savings and Loan Association of Cleveland). Some of the large depository institutions that failed during the subprime lending crisis of 2007:Q3–2009:Q4 were thrifts, including IndyMac Bank and Washington Mutual.
Credit unions make loans and issue deposits much like commercial banks. However, they are run in a very different way. Credit unions in the United States are not-for-profit institutions owned by their deposit account holders, called members, who also often take out consumer loans and home mortgages. Some credit unions also provide restricted quantities of member business loans. All members are required to have a common bond with each other, which typically means they work for the same employer and/or live in the same geographical area. Credit unions do not pay taxes, and any profits earned may be re-invested, paid out as dividends, or used to improve deposit and loan rates to its members. Many credit unions provide services aimed at community development. Credit unions are overseen by the National Credit Union Administration (NCUA), which also provides them deposit insurance.
Credit unions are typically much smaller than commercial banks in terms of assets, but there are a few large ones. The largest credit unions in the United States, each with over $10 billion in assets as of 2014:Q4, are Navy Federal Credit Union, State Employees’ Credit Union (North Carolina), Pentagon Federal Credit Union, Boeing Employees Credit Union, and SchoolsFirst Federal Credit Union (California).
Finance companies are financial firms that make loans like commercial banks, but do not issue deposits. Instead they issue short- and long-term debt, such as commercial paperg and bonds, as well as equity to finance the loans. Finance companies are typically less highly levered than commercial banks because they do not have insured deposit funding and must rely on more equity to signal solvency to potential creditors. Finance companies may specialize in commercial
or consumer loans. Some specialize in making loans to customers of a particular retailer or manufacturer. Finance companies are less regulated than deposit-taking institutions in part because they are not subject to the moral hazard incentives created by deposit insurance and other elements of the government safety net, such as access to the Federal Reserve’s liquidity facilities and too-big-to-fail protection.
An example of a finance company that makes loans to customers of a particular firm is Ford Motor Credit Company. A finance company that makes consumer loans is J.G. Wentworth and a finance company that makes commercial loans is Nations Equipment Finance, LLC.
Investment banks are financial firms that typically aid nonfinancial and other financial firms in issuing publicly traded equity and debt in cooperation with financial markets. They also often assist firms involved in mergers and acquisitions (M&As), and may provide additional services including market making (i.e., facilitating trading in certain securities by quoting firm buy and sell prices for these securities) and the trading of derivatives.
Investment banks have traditionally not been regulated as much as depository institutions and have not had access to the government safety net (deposit insurance, access to the Federal Reserve’s liquidity facilities, and too-big-tofail protection). During the subprime lending crisis (2007:Q3–2009:Q4), out of the five largest investment banks, one failed (Lehman Brothers) and two were bought out (Bear Stearns and Merrill Lynch). Two investment banks (Goldman Sachs and Morgan Stanley) were granted access to liquidity from the Federal Reserve and received capital support from the US Treasury. Since the crisis, both have given up their independence and are now subsidiaries of financial holding companies that also own commercial banks. The main advantage to them is that they can now access liquidity through insured deposits and from the Federal Reserve when needed, the main cost is that they are now subject to bank holding company regulations and supervision.
Some of the largest US investment banks are Goldman Sachs and Morgan Stanley, which as noted are subsidiaries of financial holding companies that also own banks, as well as the largest BHCs’ investment bank subsidiaries (J.P. Morgan, Bank of America Merrill Lynch, Citi, and Wells Fargo Securities).h
Mutual funds, insurance companies, and pension funds are often collectively referred to as institutional investors. Mutual funds are institutions that invest in many different stocks, bonds, and/or money market instruments, and issue shares in their portfolios to investors. Mutual funds thus give small investors access to diversified portfolios of various securities that would be hard to create by these investors individually. Shares in the mutual funds may be redeemed by investors at virtually any time in virtually any quantity. Insurance companies are financial firms that typically invest in securities and issue insurance policies that pay off policy holders when insured events occur. Pension funds similarly invest employees’ savings in securities and pay these employees when they retire.
Examples of large mutual funds, insurance companies, and pension funds are The Vanguard Group (Vanguard), Prudential Financial Inc. (Prudential), and California Public Employees’ Retirement System (CalPERS), respectively.
(Continued)
1.5 USING LIQUIDITY CREATION TO MEASURE BANK OUTPUT
Chapter 5 discusses that bank liquidity creation may be viewed as a measure of the output of a bank. Virtually every empirical study in banking uses a measure of assets or lending as its main measure of bank output. As explained in the chapter, the preferred “cat fat” liquidity creation measure is a superior output measure because it takes into account all bank activities (all assets, liabilities, equity, and off-balance sheet activities). In addition, it gives better weights to different assets than these other measures. For example, “cat fat” assigns a negative weight to marketable securities held by a bank because holding such securities takes something liquid away from the public, reducing the output of the bank. In contrast, these securities are given a positive weight when assets are used to measure output, and a zero weight when lending is used.
1.6 USING LIQUIDITY CREATION TO MEASURE BANK LIQUIDITY
Chapter 6 explains that bank liquidity creation differs from, but is related to, the concept of bank liquidity. Traditional bank liquidity indicators measure how liquid a bank is. They are usually simple ratios that use only a few of the bank’s assets and/or liabilities. In contrast, bank liquidity creation measures how much liquidity the bank creates for its customers, making the bank illiquid in the process. Thus, liquidity creation divided by assets (i.e., normalized liquidity creation) is a direct measure of a bank’s illiquidity and an inverse measure of its liquidity. Normalized “cat fat” liquidity creation is a more comprehensive measure of bank liquidity than traditional indicators since it uses information on all assets, liabilities, equity, and off-balance sheet activities. The chapter discusses that liquidity creation is also related to more complex liquidity measures, such as the Basel III liquidity ratios and the Liquidity Mismatch Index. Correlations between the “cat fat” measure of liquidity creation and the Basel III liquidity ratios are examined. Differences between measures of bank liquidity and market measures of the liquidity of publicly traded bank equity and debt are explained.
1.7 DEFINING AND DATING FINANCIAL CRISES
Chapter 7 indicates that there are many approaches to defining and dating financial crises in the literature, and argues that there is not one that fully dominates the others. Financial crises may feature credit crunches, that is, significant reductions in the supply of credit by financial institutions, such as the one that occurred in 1990:Q1–1992:Q4 in the United States. They may also involve frozen credit markets, such as happened for the commercial paper and
1.10 DO BETTER CAPITALIZED BANKS CREATE MORE OR LESS LIQUIDITY?
Chapter 10 reviews the theory and empirical evidence on the effects of bank capital on liquidity creation. Some theories suggest that banks with higher capital ratios create less liquidity because capital reduces banks’ ability to monitor its clients or because capital “crowds out” deposits. Other theories suggest that higher capital improves banks’ ability to absorb risk and hence their ability to create liquidity. Empirical evidence from the United States and other countries is reviewed. The US evidence suggests a positive effect of capital on liquidity creation for large banks, and a negative effect for small banks. Limited evidence from Europe and the rest of the world is broadly consistent with the US evidence, although the effect on liquidity creation by large bank seems to be weaker, perhaps because large banks in other nations have few off-balance sheet activities.
1.11 WHICH BANKS CREATE THE MOST AND LEAST LIQUIDITY?
Chapter 11 identifies the large, medium, and small banks that create the most and least liquidity (in dollar terms and normalized by assets) in 1984:Q1 and in 2014:Q4. It distinguishes between each bank’s “cat fat” liquidity creation and its on- and off-balance sheet components. It also examines important characteristics of banks – size, capital, portfolio risk, regulator identity, and bank holding company status – and relates these to normalized liquidity creation.
1.12 HOW DO GOVERNMENT POLICIES AND ACTIONS AFFECT BANK LIQUIDITY CREATION DURING NORMAL TIMES AND FINANCIAL CRISES?
Chapter 12 discusses the effects of government policies and actions on bank liquidity creation. This includes the effects of capital and liquidity requirements (including Basel III), stress tests, capital support or bailouts, regulatory interventions, central bank funding, and monetary policy in various nations. These government policies and actions are described is some detail and existing evidence is discussed. The evidence suggests that some of these policies and actions may have significant effects on bank liquidity creation that differ during normal times and financial crises.
1.13 BANK LIQUIDITY CREATION: VALUE, PERFORMANCE, AND PERSISTENCE
Chapter 13 examines the effects of bank liquidity creation on value and performance and the extent to which liquidity creation is persistent. It reviews the existing literature on the relation between liquidity creation and bank performance. It also provides new empirical analyses on the relations between bank liquidity creation normalized by assets and several key bank performance measures.
Liquidity Creation Theories
This chapter briefly describes in intuitive terms the theories of liquidity creation. Liquidity creation is one of the most important roles that banks play in the economy. The concept goes far back in time. Claims that bank liquidity creation is vital for economic growth date back at least to Smith (1776).1 The contemporary theories of liquidity creation (see below) suggest that banks create liquidity on and off the balance sheet. Examples are given to show how banks do both. Finally, extensions to other financial institutions and markets are discussed.
2.1 LIQUIDITY CREATION ON THE BALANCE SHEET
Contemporary financial intermediation theories focus on bank liquidity creation on the balance sheet (e.g., Bryant, 1980; and Diamond and Dybvig, 1983). In these models, the emphasis is on the liability side of the bank’s balance sheet, with liquidity creation being viewed as the provision of improved risk sharing for depositors subject to uncertainty about their preference for the timing of consumption. Banks are passive on the asset side in the sense that they simply invest in projects with given payoffs. That is, banks create liquidity by giving depositors the right to withdraw on demand. A recent theory emphasizes the importance of both the asset and liability sides for liquidity creation (Donaldson, Piacentino, and Thakor, 2015). In their model, banks are active on the asset side in that bank lending increases aggregate investment in the economy, and the more illiquid the assets are, the more liquidity is created. This approach is closest in spirit to the on-balance-sheet liquidity creation concept embraced in Berger and Bouwman (2009) and used in this book.2
1. Smith (Book II, Chapter II, 1776) highlights the importance of liquidity creation by banks and describes how it helped commerce in Scotland.
2. The modern theory of financial intermediation identifies risk transformation as another main role of banks. According to the risk transformation theories, banks transform risk by issuing riskless deposits to finance risky loans (e.g., Diamond, 1984; Ramakrishnan and Thakor, 1984; and Boyd and Prescott, 1986). The risk transformation role is well studied and beyond the scope of this book. Importantly, while risk transformation may coincide with liquidity creation (e.g., when banks issue riskless liquid deposits to finance risky illiquid loans), the two do not move in perfect tandem – the amount of liquidity created may vary considerably for a given amount of risk transformed. It is therefore essential to study both roles of banks and to distinguish between them.
engage in bank-like activities likely create liquidity in a manner similar to commercial banks to the extent that they provide services similar to those provided by banks. Stock, bond, and other capital markets create liquidity by providing platforms for relatively illiquid claims on companies and governments to be traded and become liquid.
2.4 SUMMARY
This chapter briefly reviews still-evolving liquidity creation theories and provides the intuition behind how banks create liquidity both on and off the balance sheet. On the balance sheet, banks create liquidity by financing illiquid assets (e.g., business loans) with liquid liabilities (e.g., transactions deposits); an example illustrates this. Off the balance sheet, banks create liquidity primarily through loan commitments and similar claims to liquid funds. While existing theories focus on liquidity creation by commercial banks, these theories can be extended to include other types of financial institutions and markets, which also create and destroy liquidity.
The key takeaways are that the theories suggest that banks create liquidity on and off the balance sheet, and that while no theories exist, such theories may be extended to other types of financial institutions and markets.
Panel B: JPMorgan Chase Bank, National Association
TABLE 3.1 Examples Comparing a Large Nonfinancial Firm, a Large Commercial Bank, and a Small Commercial Bank (Cont.)
Panel C: Community Bank of El Dorado Springs
Panel B: JPMorgan Chase Bank, National Association
