Working Papers 1996: Abstracts
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The authors derive optimal
financial claim for a bank when the borrowing firm's uninformed stakeholders
depend on the bank to establish whether the firm is distressed and whether
concessions by stakeholders are necessary. The bank's financial claim is
designed to ensure that it cannot collude with a healthy firm's owners to seek
unnecessary concessions or to collude with a distressed firm's owners to claim
that the firm is healthy. To prove that a request for concessions has not come
from a healthy firm/bank coalition, the bank must hold either a very small or a
very large equity stake when the firm enters distress. To prove that a
distressed firm and the bank have not colluded to claim that the firm is
healthy, the bank may need to hold equity under routine financial conditions.
(127 KB, 41 pages)
With seemingly minor amendments to the standard techniques of measuring banking technology, we have uncovered important empirical phenomena that point to the crucial role played by financial capital in banking and financial intermediation. The authors employ a standard cost function, conditioned on the level of financial capital, but they model the demand for financial capital so that it can logically serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. This allows scale economies to be computed without assuming that the bank chooses a level of capitalization that minimizes cost. Hence, a wider range of cost configurations is accommodated.
The authors find evidence that bank managers are risk
averse and use the level of financial capital to signal the level of risk. For
any given vector of outputs, risk-averse managers increase the level of
financial capital to control risk and employ additional amounts of labor and
physical capital to improve risk management and to preserve capital. When scale
economies are calculated, increasing size and the consequent improvement in
diversification allow risk-averse banks to economize on their costly tradeoff
and achieve significant scale economies. When these roles of financial capital
are ignored in analyzing banking costs, the measured scale economies disappear.
Our results seem to reconcile the disparity between the finding of constant
returns to scale of previous studies that ignored financial capital and assumed
risk-neutral bank managers and the recent wave of large bank mergers, which
bankers claim are driven in part by scale economies.
(117 KB, 33 pages)
96-3 Tom Stark and Dean Croushore, "Evaluating McCallum's Rule When Monetary Policy Matters"
This paper provides new
evidence on the usefulness of McCallum's proposed rule for monetary policy. The
rule targets nominal GDP using the monetary base as the instrument. We analyze
the rule using three very different economic models to see if the rule works
well in different environments. Our results suggest that while the rule leads
to lower inflation than there has been over the last 30 years, instability
problems suggest that the rule should be modified to feed back on the growth
rate of nominal GDP rather than the level.
(486 KB, 47 pages)
96-4 Sherrill Shaffer, "Capital Requirements and Rational Discount Window Borrowing"
When banks face capital
regulations and stochastic deposit supply, their decisions to borrow at the
discount window will be affected by a broader range of variables than previous
theoretical and empirical studies have recognized. Moreover, those decisions
can respond discontinuously to changes in market parameters and to the form of
rationing rule by which the discount window is administered. Risk aversion can
complicate these linkages considerably, even causing some banks to prefer a
positive discount rate that may exceed the actual level.
(375 KB, 31 pages)
96-5 Stephen Morris, "Speculative Investor Behavior and Learning"
As traders learn about the true distribution of
some asset's dividends, a speculative premium occurs as each trader anticipates
the possibility of re-selling the asset to another trader before complete
learning has occurred. Small differences in prior beliefs lead to large
speculative premiums during the learning process. This phenomenon helps explain
a paradox concerning the pricing of initial public offerings. The result casts
light on the significance of the common prior assumption in economic models.
(252 KB, 27 pages)
96-6 Karen K. Lewis, "Consumption, Stock Returns, and the Gains from International Risk-Sharing"
Standard theoretical
models predict that domestic residents should diversify their portfolios into
foreign assets much more than observed in practice. Whether this lack of
diversification is important depends on the potential gains from risk-sharing.
General equilibrium models and consumption data tend to find that the costs are
small, typically less than 0.5% of permanent consumption. On the other hand,
stock returns imply gains that are several hundred times larger. In this paper,
the author examines the reasons for these differences and finds that the
primary differences are due to (a) the much higher variability of stocks,
and/or (b) the higher degree of risk aversion required to reconcile an
international equity premium. Furthermore, contrary to conventional wisdom,
treating stock returns as exogenous does not necessarily imply greater gains.
(395 KB, 42 pages)
A frequently cited explanation for why foreign exchange interventions affect
the exchange rate is that these interventions signal future monetary policy
intentions. This explanation says that central banks signal a more
contractionary monetary policy in the future by buying domestic currency today.
Therefore, the expectations of future tighter monetary policy make the domestic
currency appreciate, even though the current monetary effects of the
intervention are typically offset by central banks. Of course, this explanation
presumes that central banks, in fact, back up interventions with subsequent
changes in monetary policy. In this paper, the authors empirically examine this
presumption.
(345 KB, 33 pages)
96-8 Satyajit Chatterjee and Dean Corbae, "Money and Finance with Costly Commitment"
The authors develop a variant
of Townsend's turnpike model where the trading friction is related to a
commitment problem rather than spatial separation alone. Specifically,
expenditure on financial services is necessary to ensure commitment. When
commitment is costless, the equilibrium allocation is equivalent to that from
an Arrow sequential markets equilibrium. When commitment is prohibitively
expensive, the allocation is similar to the Townsend equilibrium. The authors
use numerical examples to study the consequences of costly commitment for
co-existence of money and credit, asset pricing, welfare implications of
currency and variations in its growth rate, and the relationships between
income and financial development.
(308 KB, 28 pages)
Nationally chartered
banks will be allowed to branch across state lines beginning June 1, 1997.
Whether they will depends on their assessment of the profitability of such a
delivery system for their services and on their preferences regarding risk and
return. The authors investigate the probable effect of interstate branching on
banks' risk-return tradeoff, accounting for the endogeneity of deposit
volatility. If interstate branching improves the risk-return tradeoff banks
face, banks that branch across state lines may choose a higher level of risk in
return for higher profits. The authors find distinct efficiency gains due to
geographic diversity.
(119 KB, 37 pages)
Dynamic
open economy models with time-separable, deterministic utilities fail to
account for observed dynamics of exchange rates and international relative
prices and quantities. This paper examines the ability of extensions of
existing open economy models to account for exchange rates, international
relative prices, and international trade quantities. The extensions involve
preferences with taste shocks and nontime-separable utilities in habit
persistence form. Quantitative properties of calibrated versions of the models
are examined in light of time series properties of key international variables.
(295 KB, 27 pages)
Estimates of bank cost
efficiency can be biased if bank heterogeneity is ignored. The author compares
X-inefficiency measures derived from a model that constrains the cost frontier
to be the same for all banks in the nation and a model that allows the cost
functions and error terms to differ across Federal Reserve Districts. The
author finds that the data reject the single cost function model;
X-inefficiency measures based on the single cost function model are, on
average, higher than those based on the separate cost functions model; the
distributions of the one-sided error terms on which X-inefficiency measures are
based are wider for the single cost function model than for the separate cost
functions models; and the ranking of Districts by the level of X-inefficiency
differs in the two models. The differences in efficiency across Districts
reflect more than just differences in bank size, geographic size, or population
of the Districts. These results suggest that it is important when studying
X-inefficiency to account for differences across the markets in which banks are
operating and, more generally, that since X-inefficiency is, by construction, a
residual, it will be particularly sensitive to omissions in the basic model.
(113 KB, 30 pages)
96-12 James J. McAndrews, "Retail Pricing of ATM Network Services"
This paper develops a model of wholesale and retail
fee-setting for automated teller machine (ATM) network services, and
comparative statics results are derived. Retail ATM fees are shown to be
dependent on the demand-side network effect and economies of scale in
production of network services. These, in turn, are functions of the size of
the ATM network. Survey data on bank fees are linked with the bank's probable
ATM network membership, and the retail ATM fees are regressed on ATM network
size and other variables in a reduced-form estimation. The results suggest that
both network effects in demand and economies of scale influence retail ATM
network service fees, with economies of scale becoming dominant for the largest
ATM networks.
(383 KB, 27 pages)
Cyclical
dynamics at the regional level are investigated using newly developed
times-series techniques that allow a decomposition of aggregate data into
common trends and common cycles. The authors apply the
common-trend/common-cycle representation to per capita personal income for the
eight BEA regions using quarterly data for the period 1948:1-93:4. Their
analysis reveals considerable differences in the volatility of regional cycles.
Controlling for differences in volatility, the authors find a great deal of
comovement in the cyclical response of four regions (New England, Mideast,
Great Lakes, and Southeast), which they call the core region, and the nation.
The authors find some evidence of comovement of the Plains, Rocky Mountain, and
Far West regions and the nation, but to a much lesser extent than the
comovement among the core regions and the nation. Finally, the cyclical
response of the Southwest region is strongly negatively correlated with that of
all the other regions and the nation.
(664 KB, 46 pages)
The Riegle-Neal Interstate Banking and Branching Efficiency Act, passed in September 1994 and effective June 1, 1997, will allow nationally chartered banks to branch across state lines. This act will remove impediments to interstate expansion and permit the consolidation of existing interstate networks.
What will be the impact of this legislation on bank performance and bank safety? Removing impediments to geographic expansion should improve the risk-return tradeoff faced by most banks. However, this paper argues that economic theory does not tell us whether an improvement in the risk-return tradeoff will lead to a reduction in the volatility of bank returns or in the probability of insolvency.
The authors investigate the role of geographic
diversification on bank performance and safety using bank holding company data.
The authors find that an increase in the number of branches lowers insolvency
risk and increases efficiency for inefficient bank holding companies; an
increase in the number of states in which a bank holding company operates
increases insolvency risk but has an insignificant effect on efficiency. Branch
expansion raises the risk of insolvency for efficient bank holding companies,
while an increase in the number of states has an insignfiicant effect on
insolvency risk.
(119 KB, 34 pages)
96-15 Richard Voith, "The Suburban Housing Market: Effects of City and Suburban Employment Growth"
Communities in close
proximity to areas of growing employment will experience greater upward housing
demand shifts from job growth than more distant communities, but the housing
market response will depend on the elasticity of supply, which is likely to
differ cross communities. Using a data set of over 88,000 housing sales in
suburban Philadelphia, the author finds that city employment growth has a
significant positive effect on suburban house values; this effect is largest
for housing closest to the central business district and declines with distance
from the CBD. City employment growth has a negative effect on the rate of
suburban house construction; the magnitude of the negative effect increases
with distance. Suburban employment growth has little aggregate effect on house
prices, and there is less variation in locations near the urban fringe. With
regard to the value of real estate assets, city employment growth has a larger
average positive effect on total value, including both price and construction
impacts. Suburban homeowners and developers may, however, have divergent
interests in the spatial pattern of employment growth, since suburban
employment growth adds little to the value of homes in older, fully developed
communities.
(339 KB, 39 pages)
96-16 Theodore M. Crone and Richard Voith, "Risk and Return in the Single-Family Housing Market"
The tradeoff
between risk and return in equity markets is well established. This paper
examines the existence of the same tradeoff in the single-family housing
market. For home buyers, who constitute about two-thirds of U.S. households,
the choice about how much housing and which house to buy is a joint
consumption/investment decision. Does this consumption/investment link negate
the risk/return tradeoff within the single-family hosuing market? Theory
suggests the link still holds. This paper supplies empirical evidence in
support of that theoretical result.
(377 KB, 24 pages)
The authors examine a
firm's choice between public and private debt in a model where the firm's
financing source affects its product market behavior. Two effects are examined.
When frims' risk-taking decisions are strategic substitutes, debt financing
leads to excessively risky product market strategies (as in Brander and Lewis'
(1986) Cournot oligopoly with debt). Lender control through restrictive
covenants — which is characteristic of private debt — can commit the firm to
reduce aggressiveness in product markets and increase expected profits. This is
the monitoring effect. On the other hand, private debt reduces the amount of
public information about a firm that becomes available to its competitors. This
is the confidentiality effect. When firms' risk-taking decisions are strategic
substitutes, firms prefer to precommit to communicate idiosyncratic private
information about costs or demand. By choosing public debt, a firm is able to
precommit to communicate private information. The choice between public and
private debt depends on the relative weights of the monitoring and
confidentiality effects.
(69 KB, 29 pages)
96-18/R Mitchell Berlin and Loretta J. Mester, "Deposits and Relationship Lending"
The authors empirically examine the hypothesis that access
to deposits with inelastic rates (core deposits) permits a bank to make
contractual agreements with borrowers that are infeasible if the bank must pay
market rates for its funds. Access to core deposits insulates a bank's costs of
funds from exogenous shocks, allowing the bank to insulate its borrowers
against exogenous credit shocks. Using a large sample of loans from the Survey
of the Terms of Bank Lending, the authors find that when they control for
competitive conditions in loan markets, banks funded more heavily with core
deposits provide more smoothing of loan rates in response to exogenous changes
in aggregate credit risk. This suggests that a distinctive feature of bank
lending is that firms and banks form multiperiod lending relationships, in
which loans need not break even period by period. It also partially explains
the declining share of bank loans (or near substitutes for bank loans) in
credit markets. As banks have increasingly been forced to pay market rates for
an increasing share of their funds, multiperiod relationship lending has become
increasingly less feasible and bank loans have lost some of their comparative
advantage over securities. The authors' results suggest that access to core
deposits is one of the foundations of relationship lending.
(123 KB, 43 pages)
96-19 James J. McAndrews, "Pricing in Vertically Integrated Network Switches"
Many automated teller machine
(ATM) networks are partially vertically integrated. A group of downstream
retail banks own and operate the upstream network switch. The size of the group
varies from network to network. The same situation exists in other network
businesses, including airline computer reservation systems and credit card
networks. Here the author takes as parametric the size of the group that owns
the upstream network, the monopoly structure of the upstream network switch, as
well as the size of the downstream industry, all the members of which are
connected to the switch. Given these assumptions, the author models the pricing
and output behavior of the group of owners as the number of its members varies.
The analysis suggests that the more inclusive is the ownership group in a
vertically integrated network, the more likely that the network adopts a flat
fee (as a function of volume) pricing schedule. Also, the output of the
downstream industry initially rises as the ownership group expands, but then
contracts as the ownership group includes all of the downstream firms.
(126 KB, 14 pages)
In
this paper, the authors propose a new index of antitrust enforcement. The index
is compiled from quarterly data from the Department of Justice from 1890 to
1989 and is designed to reflect the relative influence of variables that have
deterrent effects. The authors use Hamilton's (1989, 1990) regime-switching
technique to estimate a model in which the enforcement index follows a
regime-specific AR(1) process. The authors find evidence of long-lived regimes.
The high enforcement regime, which lasted from about 1910 to the mid-1960s,
produced enforcement that was, on average, almost twice as high as the low
enforcement regime. In particular, the Reagan years were not a time of
transition to low antitrust enforcement, as is commonly claimed. Rather, the
transition to a low enforcement regime had taken place some 15 years earlier.
(534 KB, 30 pages)
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