Center for Financial Research
CFR Working Paper Series 2009
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.
FDIC Center for Financial Research Working Paper No. 2009-11
Rosalind L. Bennett, FDIC Division of Insurance and Research
Haluk Unal, Smith School of Business, University of Maryland and FDIC CFR
In this paper, we examine how the cost to the FDIC of resolving bank failures differs between two types of resolution methods of failed banks: liquidation and a private-sector reorganization. An FDIC liquidation is analogous to a Chapter 7 bankruptcy and a private-sector reorganization is analogous to a Chapter 11 bankruptcy. Our findings show that private-sector reorganizations do not deliver the expected cost-savings prior to the passage of FDICIA in 1991, a period of industry distress. We obtain this result when we control for the selection bias that arises from the resolution process. In contrast, during the post-FDICIA period, we observe that private-sector reorganizations yield significant cost savings over FDIC liquidations. We also find that the direct costs are lower for private-sector reorganizations over the sample period. When compared to nonfinancial bankruptcy costs, FDIC resolution methods appear to be less costly than Chapter 7 and Chapter 11 bankruptcies.
Keywords: bank failures, bankruptcy costs, bank resolution costs, FDIC receivership
JEL codes: G21, G28, G33
FDIC Center for Financial Research Working Paper No. 2009-10
Paul H. Kupiec
I develop methods that produce consistent estimates of the Vasicek-Basel IRB (VAIRB) credit risk model parameters. I apply these methods to Moody's data on corporate defaults over the period 1920–2008 and assess the model fit and construct hypothesis tests using bootstrap methods. The results show that the VAIRB does not capture the variability in Moody's default data: there are numerous episodes in which obligors default with much greater frequency than predicted. This pattern is consistent with a missing common factor that affects default correlation only intermittently—a missing factor similar to the frailty covariate in Duffie et al. (2009). Unlike Lopez (2004), I find the VAIRB correlation parameter to be larger for lower-rated credits. I use estimates of the VAIRB error distribution to construct capital allocations for model risk and find that the capital buffers for model risk are substantial, especially for lower-graded credits. VAIRB common factor estimates exhibit positive autocorrelation and thus long time series are usually necessary to produce reliable model estimates. Alternatively, I use common factor and correlation parameter estimates from the 1920-2008 data to control for common factor realizations when estimating unconditional default rates (PDs) from short samples. I estimate PDs and confidence intervals using default data for Moody's alpha-numeric rating grades (1998-2008). After correcting for common factor effects, sample average default rates are shown to overstate the PD for most credit grades in this sample period.
Keywords: Portfolio Credit Risk Measurement, Corporate Ratings, Basel II, Vasicek Credit Risk Model, Economic Capital Allocation
JEL codes: C31, C33, C51, C52, C53, G13, G21, G28, G32, G33
FDIC Center for Financial Research Working Paper No. 2009-9
Kyung So Im, Junsoo Lee, Margie Tieslau
This paper proposes new unit root tests that are more powerful when the error term follows a non-normal distribution. The improved power is gained by utilizing the additional moment conditions embodied in non-normal errors. Specifically, we follow the work of Im and Schmidt (2008), using the framework of generalized methods of moments (GMM), and adopt a simple two-step procedure based on the "residual augmented least squares" (RALS) methodology. Our RALS-based unit root tests make use of non-linear moment conditions through a computationally simple procedure. Our Monte Carlo simulation results show that the RALS-based unit root tests have good size and power properties, and they show significant efficiency gains when utilizing the additional information contained in non-normal errors---information that is ignored in traditional unit root tests.
Keywords: Unit root test, Generalized methods of moments (GMM), Residual augmented least squares (RALS), Non-normality.
JEL codes: C22, C12, C13.
FDIC Center for Financial Research Working Paper No. 2009-8
As the price of crude oil doubled from June 2007 to June 2008, suspicion grew that price was being driven higher by speculation rather than fundamental supply and demand. After having seen the price drop 70 percent from its peak, this explanation may appear more plausible than ever. This paper introduces a new methodology that uses convenience yield – imputed from futures prices – to detect the influence of speculation on the spot price of a storable commodity. The paper finds the evidence inconsistent with speculation having played a major role in the rise of price to $100 per barrel in March 2008. However, the evidence suggests that speculation did play a role in its subsequent rise to $140. Finally, the analysis finds that the collapse in price was caused by an unanticipated decline in demand rather than by speculators unloading their positions. This implies that, absent the discovery of vast new sources of energy, high oil prices will return with the recovery of the global economy.
Keywords: oil, petroleum, futures price, speculation, convenience yield, bubble
JEL codes: G13, Q33, Q40
FDIC Center for Financial Research Working Paper No. 2009-7
I use an electronic transfer mandate in the UK Child Benefit program, a transfer received by virtually all families with children, to estimate the effect of bank account ownership on the financial behavior of less educated families with children. With the mandate increasing account ownership by as much as 29 percent for less educated families with children, it provides an exogenous increase in account ownership to examine the causal effect of bank account ownership on access to credit, purchase of household durable goods, vehicle ownership, vehicle purchase, and accumulation of financial assets. When a less educated family becomes an owner of a bank account, I find a 71 percentage point increase in the probability of owning a credit card, an increase of 1.4 household durable goods, and no change in vehicle ownership or purchase. Although I find that bank account ownership does not affect the mean level of financial assets, I do find evidence suggestive of an increase in the top half of the financial asset distribution which indicates that there may be heterogeneity in the savings response to owning a bank account. Overall, my findings suggest that the most important benefit of owning a bank account is access to credit and requiring lower income families to own a bank account will not reverse their low average savings levels in the short run.
Keywords: Consumer Finance, Savings, Consumer Credit, Household Finance, Unbanked
JEL Classification: D6, D14, G21, H3
FDIC Center for Financial Research Working Paper No. 2009-6
Paul Kupiec and Carlos Ramirez
This paper investigates the effect of bank failures on economic growth using data from 1900 to 1930, a period that predates active government stabilization policies and includes periods of banking system distress that are not coincident with recessions. Using both VAR and a difference-in-difference methodology that exploits the reactions of the New York and Connecticut economies to the Panic of 1907, we estimate the effect of bank failures on economic activity. The results indicate that bank failures reduce subsequent economic growth. Over this period, a 0.14 percent (1 standard deviation) increase from the mean value of the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real GNP growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as an important component of the cost of systemic risk in the banking sector.
Keywords: bank failures; systemic risk; financial accelerator, vector auto regressions; Panic of 1907; non-bank commercial failures
JEL Classification: N11, N21, E44, E32
FDIC Center for Financial Research Working Paper No. 2009-05
Sanjiv R. Das and Paul Hanouna
In the absence of forward-looking models for recovery rates, market participant tend to use exogenously assumed constant recovery rates in pricing models. We develop a exible jump-to-default model that uses observables: the stock price and stock volatility in conjunction with credit spreads to identify implied, endogenous, dynamic functions of the recovery rate and default probability. The model in this paper is parsimonious and requires the calibration of only three parameters, enabling the identification of the risk-neutral term structures of forward default probabilities and recovery rates. Empirical application of the model shows that it is consistent with stylized features of recovery rates in the literature. The model is exible, i.e., it may be used with different state variables, alternate recovery functional forms, and calibrated to multiple debt tranches of the same issuer. The model is robust, i.e., evidences parameter stability over time, is stable to changes in inputs, and provides similar recovery term structures for different functional specifications. Given that the model is easy to understand and calibrate, it may be used to further the development of credit derivatives indexed to recovery rates, such as recovery swaps and digital default swaps, as well as provide recovery rate inputs for the implementation of Basel II.
Keywords: Implied, Recovery, Loss-Given-Default, Credit Default Swaps
JEL Classification: G0, G1.
Center for Financial Research Working Paper No. 2009-04
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, and Douglas D. Evanoff
We explore the effects of mandatory third-party review of mortgage contracts on the terms, availability, and performance of mortgage credit. Our study is based on a natural experiment in which the State of Illinois required ‘high-risk’ mortgage applicants acquiring or refinancing properties in 10 specific zip codes to submit loan offers from state-licensed lenders to review by HUD-certified financial counselors. We document that the legislation led to declines in both the supply of and demand for credit, with statelicensed lenders and lower-quality borrowers disproportionately exiting the affected area. Controlling for the salient characteristics of the remaining borrowers and lenders, we find that the legislation succeeded in reducing ex post default rates among counseled borrowers by close to 4 percentage points (about 35% decline). We attribute this result to actions of lenders responding to the presence of external review and, to a lesser extent, to counseled borrowers renegotiating their loan terms. We also find that the legislation nudged some borrowers to choose less risky loan products in order to eschew counseling.
Keywords: Financial literacy, Lax screening, Subprime crisis, Household finance
JEL Classification: D14, D18, L85, R21
Center for Financial Research Working Paper No. 2009-03
Kristina Minnick, Haluk Unal, Liu Yang
We examine the impact of managerial incentives on acquisitions in the banking industry. We find that banks whose CEOs have higher pay-for-performance sensitivity (PPS) are less likely to engage in value- reducing acquisitions. Conditional on engaging in acquisitions, those higher-PPS banks have significantly better announcement returns: on average these banks outperform the acquires in the lower-PPS group by 1.2% in a three-day window around the announcement. The positive market reaction can be rationalized by long-term performance. Following acquisitions, banks with high PPS experience greater improvement in their operating performance as measured by ROA.
Keywords: Keywords: Pay-for-Performance Sensitivity, CEO Compensation, Acquirer Returns, Bank Mergers
JEL classification: G34, G21
Center for Financial Research Working Paper No. 2009- 02
Edward J. Kane, Rosalind L. Bennett, Robert C. Oshinsky
December 8, 2008
To realign supervisory and market incentives, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) adjusts two principal features of federal banking supervision. First, it requires regulators to examine insured institutions more frequently and makes them accountable for exercising their supervisory powers. Second, the Act empowers regulators to wind up the affairs of troubled institutions before their accounting net worth is exhausted.
Using 1984–2003 data on the outcome of individual bank examinations, this paper documents that the frequency of rating transitions and the character of insolvency resolutions have changed substantially under FDICIA. The average interval between bank examinations has dropped for low-rated banks in the post-FDICIA era. Examiner upgrades have become significantly more likely in the post-FDICIA era even after controlling for the state of the economy. However, in recessions managers are slower to correct problems that examiners identify. As a result, during downturns upgrades become less likely and absorptions become more likely.
Giving the FDIC authority to wind up troubled banks before their tangible net worth is exhausted has reduced the role of government in the insolvency-resolution process. Consistent with an hypothesis that FDICIA has improved incentives, our data show that a markedly larger percentage of troubled banks now search for a merger partner rather than trying to stay in business until the regulators force them to fail. This greater reliance on quasi-voluntary mergers is observable both within and across various stages of the business cycle. These findings suggest that supervisory interventions became more effective at banks during the post-FDICIA era.
JEL Classifications: G20, G28, G21
Keywords: FDICIA, bank supervision, bank monitoring
Center for Financial Research Working Paper No. 2009-01
Carlos D. Ramírez
On September 29, 2008, the House of Representatives voted to reject HR 3997 (known as the original $700 Billion Bailout Bill). On October 3, the House reversed course and voted to approve the Emergency Economic Stabilization Act of 2008 (EESA). This paper applies a political voting model to these two House votes—the rejection of the bill on September 29 and its passage on October 3. Both economic conditions and PAC contributions matter in explaining the two votes, but their effect is attenuated by legislator's power. PAC contributions from the American Bankers Association appear to matter for explaining the legislators who switched. The role of ideology in explaining either the September 29 or October 3 vote is limited.