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  • Liberty Street Economics: Cost Benefits of Big Banks

    There has been a lot of discussion about the potential problems with very large banks, and about policy efforts to minimize the risk of those "too big to fail." But one thing that policy makers have to consider when thinking about breaking up big banks are the costs associated. Conventional wisdom suggests that bigger banks have cost benefits. New York Fed researchers Anna Kovner , James Vickery , and Lily Zhou have been testing that conventional wisdom. For the most part, they find that the larger the bank, the more cost advantages. While they do note some caveats about their findings, they argue out that "limiting the size of banking firms could still be an appropriate policy goal, but only if the benefits of doing so exceed the attendant reductions in scale efficiencies." Here is an excerpt from their latest paper: Large Bank Holding Companies Have Lower Noninterest Expense Ratios Our analysis focuses on U.S. bank holding companies over the period 2001 to 2012. We find a negative relationship between bank size and noninterest expense ratios, robust to the expense measure or set of controls used. Quantitatively, a 10 percent increase in assets is associated with a 0.3-0.6 percent decline in noninterest expense scaled by income or assets. In dollar terms, our estimates imply that for a BHC of average size, an additional $1 billion in assets reduces noninterest expense by $1 to $2 million per year, relative to a base case where operating cost ratios are unrelated to size. No Flattening of the Relationship between Size and Cost Even for the Largest BHCs These results hold across the size distribution of banking firms and over different parts of our sample period. As shown in the chart below of the efficiency ratio and bank size, which is based on our statistical estimates, we find no evidence that these lower operating costs flatten out above some particular size threshold. This is in contrast to the early academic literature on scale economies, which suggested that these economies taper off above a relatively low size threshold. If anything, the estimated slope steepens, although the statistical uncertainty associated with the estimate becomes larger due to the small sample size. Read Do Big Banks Have Lower Operating Costs? here .
  • Marketplace: Remembering the Biggest Consumer Bank Failure in US History--Washington Mutual

    Five years ago a major financial institution failed. No, not that one. Washington Mutual, was one of the largest consumer banks in the country. But it went under just 6 days before Congress set up the Troubled Assets Relief Program (TARP), which they went on to protect other institutions like WaMu that had overextended themselves in the credit bubble years. Kai Ryssdal and his Marketplace producers have not forgotten WaMu. They invited Kirsten Grind onto the air yesterday. Grind has written the book on the WaMu collapse. And the book is titled, The Lost Bank: The story of Washington Mutual and the Biggest Bank Failure in American History .
  • A Potential Model for Putting the International back in International Banks

    The international bank, as we knew it before 2008, seems to have gone away. Instead, it has been replaced by banks that Dirk Schoenmaker refers to as multinational banks, "under which the national subsidiaries are supervised separately." Schoenmaker--Dean of the Duisenberg School of Finance and Professor of Finance, Banking and Insurance at the VU University Amsterdam, and author of Governance of International Banking --thinks this may be temporary, and he believes that international banking will again be international. Writing at Vox , he outlines the model he expects: The solution is a supranational approach for supervision and resolution. The bottom line is to arrange an appropriate fiscal backstop through burden sharing (see also, Goodhart and Schoenmaker 2009). The Banking Union in Europe is moving into that direction with proposals for a European Resolution Board, backed up by the European Stability Mechanism. The Banking Union will save the international banking model for the Eurozone. Figure 2 shows the improvement in resolution. The starting point is that a recapitalisation is efficient when the benefits (in the form of financial stability) exceed the costs. The solid diagonal in Figure 2 represents the line where benefits (B) and costs (C) are equal. The left dashed line measures the home country benefits.1 Basically, the home country only considers their local share of the benefits, ignoring the cross-border impact of averting bank failure. In the diagram area A – where there is no bank recapitalisation since the costs outweigh the benefit – there is an efficient outcome. Area B – where there is a recapitalisation – is, similarly, efficient. Area C, however, involves inefficiency. This is where the recapitalisation would be socially efficient considering spillovers but the costs for one nation exceed the one-nation benefit. Put simply, the home country will not do the recapitalisation. In the supranational approach (all benefits in the home country and the rest of Europe are incorporated by the supranational body), area C, which indicates the area of inefficiency, is smaller under the supranational line than under the home country line. Read Is there a future for international banks here .
  • Impact of China's Rules Changes on Lending Rates

    China made some significant reforms to its financial system at the end of last week. The biggest change was eliminating a lower limit on interest rates. Banks in China now have more leeway to set their own lending rates. The Wall Street Journal 's Michael Casey says that the move should make banks more competitive, even though most lending rates have been above the state-set floor already. But, he adds, there is a lot of additional liberalization of the financial system that can still be done. Casey discusses the potential impact of liberalizing China banking on the global market in this Moneybeat interview with Paul Vigna.
  • Banks and Startups

    When John Mullins went to business school, he didn't hear his professors or fellow students talk about entrepreneurship. And he went to Stanford, in the heard of Silicon Valley. Now Mullins teaches at the London Business School, and he spends a lot of his time looking into successful entrepreneurship. In this interview with the Wall Street Journal , Mullins discusses the challenges of getting financing for startups. He says banks are of little help--at least at the early stages.
  • Interest Rate Liberalization Key to China Becoming a High-Income Country

    For China to become a high-income country, policy makers have to make some significant changes. Pingfan Hong , Chief of the Global Economic Monitoring Unit of the United Nations Department of Economic and Social Affairs, says those changes must begin with financial reform. And top on his list is liberalizing interest rates. From Project Syndicate : In many ways, China is breaking the mold. Despite severe financial repression, it has experienced extremely high savings and investment, owing mainly to Chinese households’ strong propensity to save and massive government-driven investment, particularly by local governments. The adverse effects of financial repression in China are reflected primarily in its economic imbalances. Low interest rates on deposits encourage savers, especially households, to invest in fixed assets, rather than keep their money in banks. This leads to overcapacity in some sectors – reflected in China’s growing real-estate bubble, for example – and underinvestment in others. More important, financial repression is contributing to a widening disparity between state-owned enterprises (SOEs) and small and medium-size enterprises (SMEs), with the former enjoying artificially low interest rates from commercial banks and the latter forced to pay extremely high interest rates in the shadow-banking system (or unable to access external financing at all). Interest-rate liberalization – together with other financial reforms – would help to improve the efficiency of capital allocation and to optimize the economic structure. It might also be a prerequisite for China to deepen its financial markets, particularly the bond market, laying a solid foundation for floating the renminbi’s exchange rate and opening China’s capital and financial accounts further – a precondition for the renminbi’s eventual adoption as an international reserve currency. Read China's Interest Rate Challenge here .
  • Not All Capital is Good Capital: Why Regulators Need to Look at Equity When Evaluating Banks

    Sometimes financial institutions go under even though it looks like they have plenty of capital, and we all wonder how it happened. Wharton School professor of finance Richard Herring says that is because we are looking at the wrong numbers. We should be looking at equity, and he believes new regulatory frameworks proposed at Basel III are a step in the right direction. But he fears that some policymakers are eager to return to the old definitions of capital and liquidity. He speaks about the best ways to measure financial stability in this interview with Knowledge@Wharton Steve Sherretta :
  • The Impact of Risk Averse Bankers on Inflation

    In their latest World Economic Outlook , IMF analysts pointed out that inflation "has become less responsive to cyclical conditions." This prompted Simon Wren-Lewis to consider valid explanations. At his Mainly Macro blog, he puts forward one that has to do with banks, risk, and sacrificing long term strategy because of short term fears: The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run. So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view. However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy. The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins. Read the full post here .
  • Global Ethics Corner: 'When Banks Fail, Who Should Pay?'

    Here's a useful conversation starter from the Carnegie Council 's Global Ethics Corner . It sets up the key questions over the IMF, EU, and European Central Bank bailout of Cyprus. While Cyprus as a nation is rather singular, the issues raised by the terms of the bailout are relevant across Europe moving forward:
  • Can Investors Spot the Next Cyprus?

    While we continue to watch events in Cyprus , MarketWatch 's Jim Je l ter looks at countries that might be "the next Cyprus." To be more specific, Jeiter notes other countries where the overall economy is highly dependent on the banking sector. Switzerland and the UK, for example, are two countries that are, as Jelter puts it, "most exposed to the ups and downs of their banks":
  • Watching Cyprus

    In Europe, all eyes are out to sea...looking at the island nation of Cyprus. On Saturday, Cypriot leaders agreed to a plan with EU authorities that includes a "one time tax" on bank deposits. This has set off protests in Cyprus and a lot of discussion, whether we will see a run on the banks there, and what the long term effects on the European and global economies will be. The Guardian has a running, minute-by-minute blog following events in Cyprus, here . But for those just getting up to speed on the news, we recommend a short piece from Antonio Fatas When it comes to the government of Cyprus, they are hopeful that everyone will understand that this was a one-time event and that the country can now move forward. From CNBC here is a quote from the Cyprus finance minister Michael Sarris: "Absolutely, there is no capital restrictions, people can move. We hope people will believe us, believe the collective leadership of the European Union, that this was a necessary step, but a single shot at the problem, and that from now on they can be very confident that nothing will happen to their savings." This will not happen, people will not believe them (not to mention the fact that the parliament has postponed the approval of the agreement that was scheduled to happen on Sunday). Prepared for several rounds of panic. I doubt the banking system will be able to operate without some capital restrictions over the coming days. On the other side, there are those who panic that this is the prelude of bank runs in Greece, Spain, Portugal or Italy. This is certainly a possibility and we have already seen withdrawals of deposits in some of these countries during this crisis, but it will take a lot of panic to produce a significant bank run. The reason is that there are still costs or barriers to produce a widespread bank run in these countries. The assumption that all the depositors in these banks will immediately open an account in Germany and transfer all their funds is (fortunately) not obvious. There are significant restrictions in opening of bank accounts even within the Euro area if depositors do not have residence in the country where the bank is established. Of course, there is always the option of hiding all your deposits under your mattress (or a cash vault) but both they represent a risk or they simply are not practical enough. Having said that, in the event where there is a strong perception that a similar "one-time-tax" is about to happen in other countries, these barriers will not be enough, so a bank run cannot be ruled out either. Read the full piece here .
  • McKinsey Quarterly: Predicting Changes in China for 2013

    A lot of analysts are expecting 2013 to be a year of change in China. At McKinsey Quarterly , Gordon Orr , a Director and Chairman of McKinsey Asia , recently predicted 10 ways in which "China might surprise us," this year. Here they are: 1. Banks underperform 2. Pork or chicken prices rise 100 percent 3. Local protests intensify—and succeed more often 4. China spends more on infrastructure 5. Online competition bankrupts a major main-street retailer 6. Even the middle classes hedge their bets 7. European soccer teams invest in the Chinese Super League 8. Investment in overseas agriculture is the “next big thing” 9. A third-tier city goes bankrupt 10. National holiday weeks are abolished (please) You can read Orr's explanations for each of these predictions (and then come to your own conclusions on which ones are based on analysis and which ones seem based more on Orr's own values and hopes) here .
  • James Hamilton's Monetary Policy Review

    At Econbrowser , James Hamilton reviews U.S. monetary policy over the last four years. Or, to be exact, over the last 4 years and 4 months, since we have to start at September 2008. The fireworks began when the collapse of Lehman Brothers in September 2008 led to a freezing of credit for all kinds of essential economic activities. The Fed stepped in with a number of emergency lending programs such as the Commercial Paper Lending Facility to help the commercial paper market continue to function, currency swaps to assist foreign central banks cope with emergency dollar needs, and the Term Auction Facility to provide direct liquidity to U.S. banks. These programs totaled over $1.7 trillion at the end of 2008, but have since all been wound down. The Fed came out of it all making a profit that was returned to the U.S. Treasury. The need for these facilities began to ease in 2009, but the economy was far from healthy, with unemployment continuing to shoot up. This led to the Fed's decision in March 2009 to replace the emergency lending with large-scale purchases of mortgage-backed securities guaranteed by Government Sponsored Enterprises and to a lesser extent long-term U.S. Treasury securities. These purchases were popularly described in the financial press as the first round of quantitative easing, or QE1. Their effect was to keep the total value of assets held by the Federal Reserve from falling as the emergency lending programs declined. You may know the rest of the story. But probably not as well as Hamilton. In any case, his summary is quite handy. Read it here .
  • Bernanke: U.S. Economy in Line for a Happy New Year, If...

    Speaking at the Economic Club of New York yesterday, Federal Reserve Chair Ben Bernanke said the U.S. economy is on track for a "very good year." But there are some significant ifs attached. Primary among them are continuing the housing recovery, improved conditions in Europe, further thawing of the credit markets, and the big if, avoiding the so called fiscal cliff: First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law--the so-called fiscal cliff. The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery--indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession. Second, early in the new year it will be necessary to approve an increase in the federal debt limit to avoid any possibility of a catastrophic default on the nation's Treasury securities and other obligations. As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached. A failure to reach a timely agreement this time around could impose even heavier economic and financial costs. As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then. Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend.9 Of course, we should all understand that long-term projections of ever-increasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path--for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines--is thus urgently needed to ensure longer-term economic growth and stability. Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today. Coming together to find fiscal solutions will not be easy, but the stakes are high. Uncertainty about how the fiscal cliff, the raising of the debt limit, and the longer-term budget situation will be addressed appears already to be affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Continuing to push off difficult policy choices will only prolong and intensify these uncertainties. Moreover, while the details of whatever agreement is reached to resolve the fiscal cliff are important, the economic confidence of both market participants and the general public likely will also be influenced by the extent to which our political system proves able to deliver a reasonable solution with a minimum of uncertainty and delay. Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively. Read the full speech here .
  • Bernanke: 'Five Questions about the Federal Reserve and Monetary Policy'

    Ben Bernanke visited Indiana yesterday and gave a nice primer on the machinations of the Federal Reserve. The Federal Reserve Chair put forward answers to these five questions: 1) What are the Fed's objectives, and how is it trying to meet them? 2) What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress? 3) What is the risk that the Fed's accommodative monetary policy will lead to inflation? 4) How does the Fed's monetary policy affect savers and investors? 5) How is the Federal Reserve held accountable in our democratic society? Bernanke's answers might serve as a mini-textbook for economics and public policy students. For example, here's an excerpt from his answer to the second question: As I have discussed, monetary policy is the responsibility of the Federal Reserve--or, more specifically, the Federal Open Market Committee, which includes members of the Federal Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve any taxation, transfer payments, or purchases of goods and services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of securities. The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. The great bulk of these interest earnings is sent to the Treasury, thereby helping reduce the government deficit. In the past three years, the Fed remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending (on unemployment benefits, for example). Even though our activities are likely to result in a lower national debt over the long term, I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit--which would make the needed fiscal actions even more difficult and painful--would worsen rather than improve the prospects for a comprehensive fiscal solution. I certainly don't underestimate the challenges that fiscal policymakers face. They must find ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the economic recovery in the near term. In particular, the Congress and the Administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year. According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession. The Congress and the Administration will also have to raise the debt ceiling to prevent the Treasury from defaulting on its obligations, an outcome that would have extremely negative consequences for the country for years to come. Achieving these fiscal goals would be even more difficult if monetary policy were not helping support the economic recovery. Read the full speech here .
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