Federal Reserve Bank of New York Number 2 2006 ResearchUpdate

Research and Statistics Group www.newyorkfed.org/research

Mark Gertler Becomes Newest Resident Scholar

he Research Group welcomes Mark and has been a visiting scholar at the Gertler to its Program for Resident Federal Reserve Bank of New York on T Scholars for 2006-07. and off since 1994. Professor Gertler, the Henry and Lucy Professor Gertler joins current resident Moses Professor of Economics at NYU scholars Nobuhiro Kiyotaki of the London and Chair of the Economics Department, School of Economics and Suresh M. is known for his research on macroeco- Sundaresan of Columbia Business School. nomic theory, monetary economics, and The Research Group established its finance. He has published extensively, Program for Resident Scholars in 2004 coauthoring with Ben Bernanke, Glenn to attract to the New York Fed, for a stay Hubbard, and Mark Watson, and his work of at least six months, outstanding has appeared in the American Economic researchers with an international reputa- Review, the Journal of Political Economy, tion. The scholars are selected from the the Quarterly Journal of Economics, and top academic and policy institutions in the Review of Economic Studies. areas related to the Bank’s broad policy Professor Gertler has a distinguished career in academia. He is also a coeditor interests. Resident scholars pursue their of the American Economic Review and own research agendas while participating has been on the editorial boards of the fully in the Group’s activities. They work Journal of Money, Credit, and Banking; closely with the director of research, con- Economics Letters; the NBER tribute to policymaking discussions, and Macroeconomics Annual; and the Journal provide intellectual leadership by advising of Financial Intermediation. In addition, and collaborating with the Group’s he is a Fellow of the Econometric Society economists. ■ Research Update ■ Number 2, 2006

Economic Policy Review Sheds Light on Bank Market Size, Repo Contracting Conventions tudies of the banking and repo mar- more statewide than local? Getting the kets highlight the new issue of the definition right matters a lot in terms of S Economic Policy Review (vol. 12, how the government enforces antitrust no. 1). policy; bank mergers that might appear In “Local or State? Evidence on Bank anticompetitive under the local market Market Size Using Branch Prices,” concept might seem less worrisome if Don Morgan and Paul Edelstein argue markets are viewed as statewide. that bank branch prices—the amount one Using prices on 110 branch sales over bank pays to buy another bank’s branches— the 1990s, the authors run a “horse may be a better indicator of market size race” to determine which measure 2 than bank deposit rates and other of bank concentration—state or measures. local—explains more of the variation in Morgan and Edelstein explain that branch prices. They find that prices in since the 1960s, each Federal Reserve the ten northeast states analyzed are Bank has defined the markets in its more closely correlated with state-level District as local, that is, metropolitan sta- concentration, suggesting that banking tistical areas or small groups of rural markets, at least in the northeast, are not counties. However, because banks are necessarily local. now free to branch all over a state, the Still, Morgan and Edelstein caution local concept of banking markets may be that their finding may be based on an outdated—perhaps banking markets are arguably small sample of banks as well as

Publications and Papers

The Research and Statistics Group produces a wide range of publications: ■ The Economic Policy Review—a policy-oriented journal focusing on economic and financial market issues. ■ EPR Executive Summaries—online versions of selected Economic Policy Review articles, in abridged form. ■ Current Issues in Economics and Finance—concise studies of topical economic and financial issues. ■ Second District Highlights—a regional supplement to Current Issues. ■ Staff Reports—technical papers intended for publication in leading economic and finance journals, available only online. ■ Publications and Other Research—an annual catalogue of our research output.

Federal Reserve Bank of New York www.newyorkfed.org/research

on how the data are parsed. “Branch participants were thus spurred to revise price data certainly advance the local- the conventions dramatically. versus-state debate,” they note. “With The study points to three key develop- enough such data, that question might be ments in the evolution of repo contract- settled once and for all.” ing conventions attributable to market participants’ actions: the recognition of In his study of the repo market, accrued interest on repo securities, a Ken Garbade considers how contracting revision to how federal bankruptcy law conventions for repurchase agree- applied to repos, and the accelerated ments changed in one key decade growth of tri-party repo—a new form of (“The Evolution of Repo Contracting repo. Conventions in the 1980s”). The author describes how the growth According to the author, market partici- of the market, new uses for repos, and pants acted together to bring about the 3 the appearance of previously unappreciated recognition of accrued interest on repo risks fueled dramatic changes in the con- securities and to petition Congress to ventions. In the 1950s and 1960s, dealers amend federal bankruptcy law. Collective used repos to borrow money; in the action was necessary in both cases 1970s, they engaged in more complex because uncoordinated, individual solu- repo operations, also borrowing securities tions would have been too costly. The to cover short selling and thus adding emergence of tri-party repo reflected the risk to the market. Moreover, rising inter- efforts of individual market participants est rates and growing Treasury indebted- to seek an operationally cheaper, more ness attracted many new, smaller, and flexible alternative to conventional repos. less sophisticated creditors to the market. Given these changes, “contracting con- In the volume’s lead article, John ventions that were not inefficient in the Kambhu analyzes how the risk associated context of the repo markets of the 1950s with convergence trading affects market and 1960s—including neglect of accrued liquidity and asset price volatility in the interest, ambiguity about whether repos interest rate swap market. (This paper were loans or transactions, and relatively was summarized in the previous issue of costly mechanisms for removing repo Research Update.) securities from the control of The articles are available at borrowers—proved inadequate by the www.newyorkfed.org/research/epr/ early 1980s,” observes Garbade. Market index.html.

Research and Statistics Group Research Update ■ Number 2, 2006

New Publication Focuses on the Upstate New York Economy he New York Fed’s Buffalo Branch the coming years, employers may face a recently published the first issue of particular challenge filling positions in T Upstate New York Regional growing services occupations with rela- Review, a newsletter reporting on topics tively high retirement rates, such as of importance to the upstate economy. health care, community and social In “Baby-Boomer Retirements and services, and education. Emerging Labor Market Pressures,” Upstate New York Regional Review Richard Deitz studies the demand for is an expanded and more comprehensive new workers in upstate New York created version of its predecessor publication, The by the combination of retirements and Regional Economy of Upstate New York. the region’s economic restructuring. His Copies are available at www.newyorkfed.org/ 4 analysis of projected hiring rates upstate buffalo. suggests that although there will be demand for workers in all occupations in

Recently Published

Adam Ashcraft. 2006. “New Evidence on João Santos. 2006. “Identifying the Effect the Lending Channel.” Journal of Money, of Managerial Control on Firm Credit, and Banking 38, no. 3 (April): 751-76. Performance,” with Renée B. Adams. Journal of Accounting and Economics 41, Gauti Eggertsson. 2006. “The Deflation no. 1-2 (April): 55-85. Bias and Committing to Being Irresponsible.” Journal of Money, Credit, João Santos. 2006. “Insuring Banks and Banking 38, no. 2 (March): 283-322. against Liquidity Shocks: The Role of Deposit Insurance and Lending of Last James Harrigan. 2006. “Timeliness and Resort.” Journal of Economic Surveys 20, Agglomeration,” with Anthony J. Venables. no. 3 (July): 459-82. Journal of Urban Economics 59, no. 2 (March): 300-16. Cédric Tille. 2006. “Current Account Adjustment with High Financial João Santos. 2006. “The American Integration: A Scenario Analysis,” with Keiretsu and Universal Banks: Investing, Michele Cavallo. Federal Reserve Bank of Voting, and Sitting on Nonfinancials’ San Francisco Economic Review 2006: Corporate Boards,” with Adrienne S. 31-45. ■ Rumble. Journal of Financial Economics 80, no. 2 (May): 419-54.

Federal Reserve Bank of New York www.newyorkfed.org/research

New Titles in the Staff Reports Series

The following new Staff Reports are inputs play in determining the degree to available at www.newyorkfed.org/ which exchange rate fluctuations are trans- research/staff_reports. mitted to consumption prices. While the distribution sector dampens the sensitivity of consumption prices of tradable goods to MACROECONOMICS exchange rates by reducing the import AND GROWTH content of the final consumption good, it No. 245, April 2006 also enhances sensitivity because the Volatility Accounting: A Production prices of imported inputs used in the pro- Perspective on Increased duction of distribution services are also Economic Stability sensitive to exchange rates. Calibration Kevin J. Stiroh exercises show that the United States has the lowest expected CPI sensitivity to 5 Stiroh examines the declining volatility of exchange rates—less than 5 percent— U.S. output growth from a production per- while the cross-country exchange rate spective. At the aggregate level, increased pass-through to CPI averages closer output stability reflects decreased volatility to 15 percent. in both labor productivity growth and hours growth as well as a significant No. 249, April 2006 decline in the correlation. The decline in Expectations and Contagion in output volatility can also be traced to less Self-Fulfilling Currency Attacks volatile labor input and total factor produc- Todd Keister tivity growth and the smaller covariance Keister presents a model in which currency between them. At the industry level, the crises can spread across countries as a decline in volatility appears widespread, result of the self-fulfilling beliefs of market with about 80 percent of component participants. An incomplete-information industries showing smaller contributions to approach is used to overcome many unde- aggregate output volatility after 1984, sirable features of existing multiple- although most of the aggregate decline equilibrium explanations of contagion. reflects smaller covariances between indus- If speculators expect contagion across tries. These results suggest that labor mar- markets to occur, they have an incentive ket changes are an important source of to trade in both currency markets to take increased output stability. advantage of this correlation. These actions, in turn, link the two markets in INTERNATIONAL such a way that a sharp devaluation of one currency will be propagated to the other No. 247, April 2006 market, fulfilling the original expectations. Distribution Margins, Imported Even though this contagion is driven solely Inputs, and the Sensitivity of by expectations, the model places the CPI to Exchange Rates restrictions on observable variables that José Manuel Campa and Linda S. Goldberg are broadly consistent with existing This paper decomposes the sources of con- empirical evidence. sumer price index stability for twenty-one countries, focusing on the important role that the distribution sector and imported

Research and Statistics Group Research Update ■ Number 2, 2006

No. 250, April 2006 is on average 29 percentage points lower in A Decomposition of the Sources of arm’s-length transactions than in multi- Incomplete Cross-Border Transmission national transactions because the higher Rebecca Hellerstein markups from a double optimization along According to conventional wisdom, relative the distribution chain create more opportu- price changes are the primary mechanism nity for markup adjustment following a by which shocks are transmitted across bor- shock. This difference may explain up to ders. Yet traded goods prices exhibit signifi- 20 percent of the incomplete transmission cant inertia in response to shocks such as of foreign-cost shocks to the United States exchange rate changes. The author uses a in the aggregate. structural model to quantify the relative importance of manufacturers’ and retailers’ BANKING AND FINANCE local-cost components and markup adjust- ments as sources of this incomplete trans- No. 246, April 2006 6 mission. The model is applied to a panel Two-Sided Markets and Intertemporal data set of one industry with retail and Trade Clustering: Insights into wholesale prices for Universal Product Trading Motives Code–level products. Markup adjustments Asani Sarkar and Robert A. Schwartz by manufacturers and retailers explain two- Sarkar and Schwartz show that equity mar- thirds of the incomplete transmission, and kets are typically two-sided and that trades local-cost components account for the cluster in certain trading intervals for both remaining third. Foreign manufacturers NYSE and Nasdaq stocks under a broad generally bear more of the cost (or reap range of conditions—news and non-news more of the benefit) of an exchange-rate- days, different times of the day, and a spec- induced marginal cost shock than do trum of trade sizes. By “two-sided,” the domestic consumers, domestic manufac- authors mean that the arrivals of buyer- turers, or the domestic retailer. initiated and seller-initiated trades are posi- No. 251, April 2006 tively correlated; by “trade clustering,” they Arm’s-Length Transactions as a mean that trades tend to bunch together in Source of Incomplete Cross-Border time with greater frequency than would be Transmission: The Case of Autos expected if their arrival were a random Rebecca Hellerstein process. Controlling for order imbalance, and Sofia Berto Villas-Boas number of trades, news, and other microstructure effects, Sarkar and Schwartz Hellerstein and Villas-Boas present new find that two-sided clustering is associated evidence of a positive relationship between with higher volatility but lower trading costs. an industry’s share of multinational trade and its rate of exchange rate pass-through to prices. They develop a structural econo- metric model with both manufacturers and retailers to quantify how firms’ organization of their activities across borders affects their pass-through of a foreign cost shock and apply the model to auto market data. Firms’ pass-through of foreign cost shocks

Federal Reserve Bank of New York www.newyorkfed.org/research

No. 248, April 2006 No. 252, May 2006 Three Decades of Financial Sector Risk Visible and Hidden Risk Factors Joel F. Houston and Kevin J. Stiroh for Banks Til Schuermann and Kevin J. Stiroh This study examines the evolution of risk in the U.S. financial sector using firm-level Schuermann and Stiroh examine the com- equity market data from 1975 to 2005. mon factors that drive the returns of U.S. Over this period, financial sector volatility bank holding companies from 1997 to has increased steadily, reaching extraordi- 2005. They compare a range of market nary levels from 1998 to 2002. Much of models and show that the market factor this recent turbulence can be attributed to clearly dominates in explaining bank a series of major financial shocks, and returns. Even in the authors’ broadest there is evidence of an upward trend in model, however, considerable residual varia- volatility only for the common sector tion remains. A principal component component. While idiosyncratic volatility analysis shows that this residual variance is remains dominant, a combination of com- relatively diffuse, although the largest 7 mon shocks, deregulation, and diversifica- banks do tend to load in the same direction tion has reduced its relative importance on the first component. Compared with the since the early 1990s. Within the financial returns of large firms in other sectors, bank sector, commercial banks show the largest returns are relatively well explained with rise in volatility, which also reflects industry standard risk factors. This finding assuages shocks and not the idiosyncratic compo- some concerns about systemic risk, but it nent. Despite these changes, the authors does leave open the possibility of systemic find that the links between the financial concerns through the “broad channel” if sector and economic activity have declined many banks respond to unexpected shocks in recent years. in similar ways. ■

Other New Publications

■ The Federal Reserve Bank of New York’s 2005 Annual Report is available. www.newyorkfed.org/aboutthefed/annualreports.html

Research and Statistics Group Research Update ■ Number 2, 2006

Papers Presented by Economists in the Research and Statistics Group

“On the Market Discipline of “Dollar Depreciation: Implications for Informationally Opaque Firms: Exporters, Importers, and the U.S. Evidence from Bank Borrowers in the Trade Balance,” Linda Goldberg. Seminar Federal Funds Market,” Adam Ashcraft. cosponsored by the Buffalo branch of the Financial Intermediation Research Society Federal Reserve Bank of New York and the conference, Shanghai, China, June 3. World Trade Center Buffalo Niagara, With Hoyt Bleakley. Buffalo, New York, June 14.

“Money Market Integration,” Leonardo “The International Role of the Dollar Bartolini. Bank of France conference, Paris, and Trade Balance Adjustment,” Linda France, June 6. Goldberg. Conference cosponsored by the Santa Cruz Center for International 8 “Entry into Banking Markets and the Economics, the Federal Reserve Bank Early-Mover Advantage,” Astrid Dick. of San Francisco, and the Center for Journal of Financial Intermediation confer- European Integration Studies at the ence, Shanghai, China, June 4. With Allen University of Bonn (ZEI), Santa Cruz, Berger. Also presented at a Journal of California, May 26. With Cédric Tille. Banking and Finance conference, Beijing, China, June 6. “The Benefits and Challenges of Labor Mobility,” Erica Groshen. Joint European “Personal Bankruptcy and Credit Union—United States conference, Brussels, Market Competition,” Astrid Dick. Belgium, April 10. International Industrial Organization Society conference, Boston, Massachusetts, “The Interaction of Labor Markets and April 8. With Andreas Lehnert. Inflation: Analysis of Micro Data from the International Wage Flexibility “Monetary Policy Tick-by-Tick,” Michael Project,” Erica Groshen. Institute for the Fleming. Bank of Canada conference, Study of Labor (IZA) seminar, Bonn, Ottawa, Ontario, Canada, May 3. With Germany, April 3. With William Dickens, Monika Piazzesi. Also presented at an Lorenz Goette, Steinar Holden, Julian NBER conference, Cambridge, Messina, Mark Schweitzer, Jarkko Turunen, Massachusetts, May 12. and Melanie Ward. Also presented at a National Bank of Belgium seminar, “Distribution Margins, Imported Inputs, Brussels, Belgium, April 5. and the Sensitivity of the CPI to Exchange Rates,” Linda Goldberg. Drexel “Turbulent Firms, Turbulent Wages?” University seminar, Philadelphia, Erica Groshen. Society of Labor Pennsylvania, May 17. Economists conference, Cambridge, Massachusetts, May 5. With Diego Comin and Bess Rabin.

Federal Reserve Bank of New York www.newyorkfed.org/research

“Arm’s-Length Transactions as a “Modeling Global Imbalances and Source of Incomplete Cross-Border Current Account Adjustment,” Paolo Transmission,” Rebecca Hellerstein. Pesenti. European Central Bank seminar, NBER Universities’ Research Conference, Frankfurt, Germany, May 3. Also presented Cambridge, Massachusetts, May 19. at a European University Institute seminar, Florence, Italy, May 11. “A Framework for Identifying the Sources of Local-Currency Price “The Relationship between Expected Stability with an Empirical Application: Inflation, Disagreement, and Some Evidence on the Relative Uncertainty: Evidence from Matched Importance of Menu Costs, Non-Traded Point and Density Forecasts,” Robert Local Costs, and Markup Adjustment by Rich. Midwest Macroeconomics Meetings, Manufacturers and Retailers,” Rebecca Washington University, St. Louis, Missouri, Hellerstein. New York University May 5. With Joseph Tracy. International and Development Economics seminar, New York City, April 4. “Liquidity Spillovers and Cross- 9 With Pinelopi Goldberg. Autocorrelations,” Asani Sarkar. Vrije Universiteit Amsterdam, Amsterdam, the “Banking Policy without Commitment: Netherlands, April 5. With Tarun Chordia Suspension of Convertibility Taken and Avanidhar Subrahmanyam. Seriously,” Todd Keister. Rutgers University Department of Economics “Money and Modern Banking without seminar, New Brunswick, New Jersey, Bank Runs,” David Skeie. Financial March 7. With Huberto Ennis. Also Intermediation Research Society presented at the Midwest Macroeconomics conference, Shanghai, China, June 3. Meetings, Washington University, St. Louis, Also presented at a Journal of Banking Missouri, May 6. and Finance conference, Beijing, China, June 6. “Expectations and Contagion in Self- Fulfilling Currency Attacks,” Todd “The Industry Origins of the Second Keister. Econometric Society and Allied Surge of U.S. Productivity Growth,” Social Sciences Association annual meet- Kevin Stiroh. Conference cosponsored by ing, Boston, Massachusetts, January 7. the International Telecommunication Also presented at the Cornell—Penn State Union and the London Business School, University Macro Workshop, University Geneva, Switzerland, June 5. Park, Pennsylvania, April 14. “The Sources of the Second Surge “Housing Activity and Values and of U.S. Productivity Growth and Consumer Spending,” Jonathan McCarthy Implications for the Future,” Kevin and Charles Steindel. Federal Reserve Bank Stiroh. Conference cosponsored by the of Chicago Bank Structure Conference, Bank of France and the Bank of Canada, Chicago, Illinois, May 18. Paris, France, April 24. With Dale W. Jorgenson and Mun S. Ho.

Research and Statistics Group Research Update ■ Number 2, 2006

“Three Decades of Financial Sector “Could Capital Gains Smooth a Current Risk,” Kevin Stiroh. Conference cospon- Account Rebalancing?” Cédric Tille. sored by the Federal Reserve Bank of University of Wisconsin seminar, Madison, Atlanta and the International Association Wisconsin, April 28. With Michele Cavallo. of Financial Engineers, Atlanta, Georgia, April 18. With Joel Houston. Also presented “Financial Integration and the Wealth at a Swiss National Bank conference, Effect of Exchange Rate Fluctuations,” Zurich, Switzerland, May 31, and the Cédric Tille. Conference cosponsored by International Monetary Fund, Washington, the Santa Cruz Center for International D.C., June 13. Economics, the Federal Reserve Bank of San Francisco, and the Center for “Intertemporal Disturbances,” Andrea European Integration Studies at the Tambalotti. Conference cosponsored by the University of Bonn (ZEI), Santa Cruz, University of Quebec at Montreal and the California, May 27. Interuniversity Center on Risk, Economic 10 Policy, and Employment (CIRPEE), “Catastrophe Bonds, Reinsurance, and Montreal, Quebec, Canada, June 5. the Optimal Collateralization of Risk With Giorgio Primiceri and Ernst Transfer,” George Zanjani. Risk Theory Schaumburg. Society Annual Seminar, Richmond, Virginia, April 22. With Darius Lakdawalla. ■

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Federal Reserve Bank of New York www.newyorkfed.org/research

Research and Statistics Group STAFF REPORTS Publications and Papers: No. 245, April 2006 April-June 2006 Volatility Accounting: A Production Perspective on Increased Publications are available at Economic Stability www.newyorkfed.org/research/ Kevin J. Stiroh publication_annuals/index.html. No. 246, April 2006 Two-Sided Markets and Intertemporal ECONOMIC POLICY REVIEW, Trade Clustering: Insights into VOL. 12 Trading Motives Asani Sarkar and Robert A. Schwartz No. 1, May 2006 No. 247, April 2006 Trading Risk, Market Liquidity, and Distribution Margins, Imported Convergence Trading in the Interest Inputs, and the Sensitivity of Rate Swap Spread the CPI to Exchange Rates 11 John Kambhu José Manuel Campa and Linda S. Goldberg Local or State? Evidence on Bank No. 248, April 2006 Market Size Using Branch Prices Three Decades of Financial Sector Risk Paul Edelstein and Donald P. Morgan Joel F. Houston and Kevin J. Stiroh The Evolution of Repo Contracting No. 249, April 2006 Conventions in the 1980s Expectations and Contagion in Kenneth D. Garbade Self-Fulfilling Currency Attacks Todd Keister CURRENT ISSUES IN ECONOMICS No. 250, April 2006 AND FINANCE, VOL. 12 A Decomposition of the Sources of Incomplete Cross-Border Transmission No. 3, April 2006 Rebecca Hellerstein Alternative Arrangements for the No. 251, April 2006 Distribution of Intraday Liquidity Arm’s-Length Transactions as a James J. McAndrews Source of Incomplete Cross-Border No. 4, May/June 2006 Transmission: The Case of Autos Taking the Pulse of the Rebecca Hellerstein NewYork City Economy and Sofia Berto Villas-Boas Jason Bram and James Orr No. 252, May 2006 Second District Highlights Visible and Hidden Risk Factors for Banks Til Schuermann and Kevin J. Stiroh

The views expressed in the publications and papers summarized in Research Update are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.

Research and Statistics Group