FOR THE RECORD 9 Greg Baer, THE QUARTERLY JOURNAL OF THE CLEARING HOUSE AND BANK POLICY INSTITUTE Bank Policy Institute

MY PERSPECTIVE 14 Jim Colassano, The Clearing House

Q1 2019, VOLUME 7, ISSUE 1 STATE OF BANKING 20 Michael O’Grady, Northern Trust

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UPFRONT FEATURED ARTICLES

For the Record Banks and the Next Recession 9 Has the enhanced resilience and resolvability of 26 Bankers and regulators must consider how changes in the large banks reduced the likelihood of another financial system could affect us in the next recession. We financial crisis or increased it? should take actions now that would reduce those impacts. by Greg Baer, CEO, Bank Policy Institute by Douglas J. Elliott, Oliver Wyman My Perspective 14 Corporates see the RTP network as an innovative Expectations and Economics platform for improving the customer experience. 34 of Financial Crises by Jim Colassano, Senior Vice President Standard models of expectations cannot explain the in the Product Development and Strategy group, 2008 financial crisis. Here is a more realistic alternative. The Clearing House by Nicola Gennaioli, Bocconi University, and Andrei Shleifer, Harvard University

The CECL Approach 42 The current expected credit loss approach is a good idea that will yield procyclicality. by Stephen G. Ryan, Stern School of Business, New York University

Balancing Banking 48 Regulation to Deal with Risky Lending and Runs When banks perform multiple services, regulating them gets even more complicated. by Anil Kashyap, University of Chicago Booth School of Business, Bank of England, NBER, and CEPR, Dimitrios P. Tsomocos, Saïd Business School and St. Edmund Hall, University of Oxford, and Alexandros P. Vardoulakis, STATE OF BANKING Board of Governors of the Federal Reserve System

Michael O’Grady, FRB and FDIC Cast a Critical 20 Northern Trust 58 Eye on Resolution Plans Northern Trust’s chairman, president, and CEO While the living-will process continues to evolve, it is likely discusses emerging technology and more with that many of the central tenets and requirements will Greg Baer, CEO of the Bank Policy Institute. remain in place for the foreseeable future. by Neil Bloomfieldand Kate Wellman, Moore & Van Allen

4 BANKING PERSPECTIVES QUARTER 1 2019 EDITOR Greg MacSweeney

DESIGN & PRODUCTION Big Yellow Taxi, Inc.

Banking Perspectives is the quarterly journal of The Clearing House and the Bank Policy Institute. Its aim is to inform financial industry leaders and the policymaking community on developments in bank policy and payments. The journal is a forum for thought leadership from banking industry executives, regulators, academics, policy experts, and industry observers.

58 Established in 1853, The Clearing House is the oldest payments company in the United States. It is owned by the world’s largest FinTech and the New commercial banks, which collectively hold more than half of all 64 Financial Landscape U.S. deposits and which employ over 1 million people in the A recent conference spotlighted some of the advantages United States and more than 2 million people worldwide. Its and potential problems of FinTech lenders. affiliate, The Clearing House Payments Company L.L.C., which is by Itay Goldstein, The Wharton School, University of regulated as a systemically important financial market utility, owns Pennsylvania, Julapa Jagtiani, Federal Reserve Bank of and operates payments technology infrastructure that provides Philadelphia, and Aaron Klein, The Brookings Institution safe and efficient payment, clearing, and settlement services to financial institutions. It clears almost $2 trillion each day.

The Bank Policy Institute (BPI) is a nonpartisan public policy, DEPARTMENTS research, and advocacy group, representing the nation’s leading banks and their customers. BPI’s members include Contributors universal banks, regional banks, and the major foreign 6 Information on the authors from this edition. banks doing business in the United States. Collectively, BPI’s members employ almost 2 million Americans, make nearly half Bank Conditions Index of the nation’s small business loans, and are an engine for financial innovation and economic growth. 72 A quantitative assessment of the resiliency of the U.S. banking sector. Copyright 2019 The Clearing House Association L.L.C. All rights reserved. All content is owned by The Clearing House Association Research Rundown L.L.C. or its licensors. The views expressed herein are not 74 Highlights from academic research on banking issues. necessarily those of The Clearing House Association L.L.C., its affiliates, customers, or owners. Any use or reproduction of any of Featured Moments the contents hereof without the express written permission of The 78 Images from The Clearing House + Bank Policy Institute Clearing House Association L.L.C. is strictly prohibited. 2018 Annual Conference. The Clearing House Bank Policy Institute 1114 Avenue of the Americas 600 13th Street NW 17th floor Suite 400 New York, NY 10036 Washington, D.C. 20005 212.613.0100 202.289.4322

BANKING PERSPECTIVES QUARTER 1 2019 5 Contributors

Neil Bloomfield its international coordination. Elliott has University. He is an expert in the areas of been a visiting scholar at the International corporate finance, financial institutions, and Neil Bloomfield is Monetary Fund (IMF), as well as a financial markets, focusing on financial fragility Co-Head of the Financial consultant for the IMF, the World Bank, and crises and on the feedback effects Regulatory Advice and and the Asian Development Bank. Elliott between firms and financial markets. Before Response Team at Moore graduated from Harvard College magna cum joining Wharton, Professor Goldstein served on & Van Allen. He has more laude with an A.B. in sociology in 1981. In the faculty of Duke University’s Fuqua School of than a decade of 1984, he graduated from Duke University Business. He had also worked in the research experience advising with an M.A. in computer science. department of the Bank of Israel. major financial institutions and other highly regulated entities in responding to government Nicola Gennaioli Julapa Jagtiani investigations, including responding to global investigations into LIBOR and other reference Nicola Gennaioli Dr. Julapa Jagtiani is rates, foreign exchange trading, and the studies topics at the Senior Special Advisor at allegations raised by the Panama Papers. intersection of psychol- the Federal Reserve Bloomfield shares these insights as an Adjunct ogy, finance, and Bank of Philadelphia Professor at Wake Forest University School of economics. He and a fellow member of Law. He also frequently advises clients as they obtained a Ph.D. in the Wharton Financial implement programs to comply with regulatory economics from Institutions Center. requirements, including requirements related to Harvard University in 2004. Today he is a Previously, Jagtiani was Senior Economist at recovery and resolution planning and CCAR. Professor of Finance at Bocconi University the Chicago Fed and Kansas City Fed, and she in Milan. He is also a Managing Editor of was Associate Professor of Finance at Baruch Douglas J. Elliott the Review of Economic Studies, a leading College, City University of New York. At the journal in economics, and he holds Federal Reserve, Jagtiani has participated in Douglas J. Elliott is a appointments in various international several supervisory policy projects, including Partner in the financial scientific associations. serving on the Basel Qualification Team, CCAR services consulting Stress Testing team, and, recently, on the practice of Oliver Itay Goldstein Federal Reserve FinTech Task Force. Jagtiani Wyman, where he received her Ph.D. and MBA from the NYU focuses on public Itay Goldstein is the Joel Stern School of Business. policy and its S. Ehrenkranz Family implications for the financial sector. He was Professor in the Finance Anil Kashyap the lead author of a 170-page report Department at the analyzing the impacts of the Basel capital Wharton School of Anil Kashyap is the and liquidity rules and has written the University of Edward Eagle Brown extensively on the future direction of Pennsylvania. He is Professor of Economics financial regulation. also the coordinator of the Ph.D. program in and Finance at the Finance. He holds a secondary appointment as University of Chicago’s Prior to joining the firm, he was a Fellow a Professor of Economics at the University of Booth School of in Economic Studies at the Brookings Pennsylvania. Goldstein has been on the faculty Business and an external Institution, where he wrote and spoke of the Wharton School since 2004. He earned member of the Bank of England’s Financial extensively on financial regulation and his Ph.D. in economics in 2001 from Tel Aviv Policy Committee. He co-founded the U.S.

6 BANKING PERSPECTIVES QUARTER 1 2019 Monetary Policy Forum, serves as a consultant effects on banks’ financial reporting on financial a B.A., M.A., M.Phil., and a Ph.D. from for the Federal Reserve Bank of Chicago, a stability. Ryan served on the Financial Yale University. research associate for the National Bureau of Accounting Standards Advisory Council for the Economic Research, and a research fellow for period 2000–2003 and on the Federal Reserve Alexandros P. Vardoulakis the Centre for Economic Policy Research. Bank of New York’s Financial Advisory Roundtable for the period 2012–2018. Alexandros Vardoulakis Aaron Klein is a Principal Andrei Shleifer Economist at the Aaron Klein is a Fellow Federal Reserve Board. in Economic Studies Andrei Shleifer is John Before joining the and serves as Policy L. Loeb Professor of Board, he worked as an Director of the Center Economics at Harvard economist at the on Regulation and University. He holds an European Central Bank and Banque de Markets. He focuses undergraduate degree France. He has participated in various on financial regulation from Harvard and a international working groups and is and technology, macroeconomics, and Ph.D. from MIT. Before currently a member of the Nonbank infrastructure finance and policy. Previously, coming to Harvard in 1991, he taught at Monitoring Experts Group of the Financial Klein directed the Bipartisan Policy Center’s Princeton and the University of Chicago’s Stability Board. His principal areas of Financial Regulatory Reform Initiative and Booth School of Business. Shleifer has research are banking, macro-finance, and served at the Treasury Department as Deputy worked in the areas of comparative corporate monetary theory and policy. Vardoulakis is Assistant Secretary for Economic Policy. governance, law and finance, behavioral currently doing research on the effects of finance, and institutional economics. financial regulation on financial stability Before his appointment as Deputy Assistant and real economic activity. He received his Secretary in 2009, he served as Chief Dimitrios P. Tsomocos D.Phil. in Financial Economics from the Economist of the Senate Banking, Housing, and University of Oxford, Saïd Business School. Urban Affairs Committee for Chairmen Chris Dr. Dimitrios P. Dodd and Paul Sarbanes. Klein is a graduate Tsomocos is a Professor Kate Wellman of Dartmouth College and the Woodrow Wilson of Financial Economics School for Public Affairs at Princeton University. at Saïd Business Kate Wellman is a School and a fellow in member of the of the Stephen G. Ryan management at St. Financial Regulatory Edmund Hall, University Advice and Response Stephen G. Ryan is of Oxford. He co-developed the Goodhart- team at Moore & Van Professor of Accounting Tsomocos model of financial fragility in 2003 Allen. She advises clients and the Charlotte Lindner while working at the Bank of England. The on recovery and MacDowell Faculty Fellow impact has been significant, and more than resolution planning, corporate governance, and at the Stern School of 10 central banks have calibrated the model, other regulatory compliance issues. Wellman Business, New York including the Bank of Bulgaria, the Bank of also has experience representing major University. His research Colombia, the Bank of England, and the financial institutions in investigations by examines financial reporting by financial Bank of Korea. Before joining the Saïd government authorities, including regarding institutions and for financial instruments, Business School in 2002, Dimitrios was an foreign exchange trading and the allegations including banks’ loan-loss reserving and the economist at the Bank of England. He holds raised by the Panama Papers.

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FOR THE RECORD The Next Financial Crisis and the Great Buffer Fallacy BY GREG BAER, BANK POLICY INSTITUTE

The primary focus of post- reforms certainly have reduced the chances securitization specialists were just as crisis financial regulation that a large bank or its non-bank affiliate will optimistic about real estate as others. has been to make large bank cause or propagate such a crisis, which leads This evidence points against the view holding companies – that is, many to assume that the chances of a financial that bankers knew something about banks and their non-bank crisis are lower. But financial crises are about the housing bubble that others did not. affiliates – more resilient collapses in asset prices and unpredictable (and When the bubble collapsed, they lost and resolvable. The former unpredicted) contagions and connections. money on their homes, they lost money includes sharp increases in on equity holdings in their firms, and capital requirements and first-of-their-kind One safe assumption about the next crisis is many lost their jobs. This does not look liquidity requirements that have dramatically that it will come as a surprise – to everyone. In like superior knowledge.1 increased liquidity levels. The latter includes a their book A Crisis of Beliefs: Investor Psychology reinvention of how such companies are resolved and Financial Fragility, excerpted in this issue, That financial crisis came as a considerable as a legal matter as well as the issuance of more Nicola Gennaioli and Andrei Shleifer present surprise not only to the market but also to the than $1 trillion of so-called “bail-in” debt to considerable research on the beliefs and Federal Reserve as the central bank and bank make such resolution a practical reality. Those expectations of all relevant actors as the financial regulator. As Gennaioli and Shleifer relate: changes have focused almost exclusively on crisis loomed, and they use concepts from larger banks – those with $50 billion or more behavioral economics to provide insights about Only six weeks before the Lehman in assets. Much of the debate about post-crisis future crises. Importantly, they debunk what they bankruptcy, in early August 2008, both regulation is whether those requirements, when refer to as the “moral hazard” or “too big to fail” the Federal Reserve and professional viewed holistically, are under- or overcalibrated theory of the crisis: the view that large financial forecasters predicted continued growth and whether their costs are worth their benefits. firms saw the risk but took it with the knowledge of the U.S. economy. Contrary to that that subsequent taxpayer support would limit prediction, the U.S. financial system In this issue of Banking Perspectives, we their losses but not their gains. As they report: nearly melted down after the Lehman attempt to answer a somewhat broader bankruptcy, and the economy slid into question: Has the enhanced resilience and [W]e have little evidence that the banks a deep recession. resolvability of large banks reduced the had any superior knowledge about chances of the next financial crisis – or actually the risk of the assets in which they The [Federal Reserve’s] June 2008 increased those chances? Of course, those invested, at least in 2005 and 2006 Greenbook forecast next year [2009] …. To the contrary …, banks showed real GDP growth at 1.13 percent, which substantial optimism and disregard for was actually revised slightly upward on GREG BAER is the Chief Executive Officer at the downside risks. Likewise, the study by July 30. ... Perhaps most remarkable Bank Policy Institute. Heng, Raina and Xiong … showed that in this regard is a document prepared

BANKING PERSPECTIVES QUARTER 1 2019 9 ArticleThe Next Title Financial Goes Here Crisis and the Great Buffer Fallacy

The rationale for [capital and liquidity] is a safe port in the next storm, and they have chosen the banking system that they oversee buffers is that when stress occurs banks will ... as that port. That choice is understandable allow their capital levels to drift down toward regulatory given banks’ stable deposit base, their now- unique access to the discount window, and the minimums in order to engage in lending, market fact that the regulators regulate and examine making and other activities that support the them. Thus, so the thinking might go, we can economy. Unfortunately, I’ve never met a market worry less about the non-banks because we will count on banks to continue extending participant who believes it. credit and making markets.3

Meanwhile, bank regulation becomes more and more complex over time, leading to more by the Fed Forecasting staff on July 30, to these institutions as banks, but understand restrictions, whether through regulation (overt) 2008, for the August 5, 2008 FOMC that non-banks may often also undertake some or examination (covert). In their article, Kashyap meeting. As the governors were aware of these activities, and it is often conceptually and his co-authors find that when a standard of the stresses in the financial system, hard to explain why regulations are based on economic model of banking is expanded to the staff was asked to prepare the organizational form rather than function.” reflect a broader range of services that banks forecasts for the scenarios of “severe Indeed. I’ve periodically asked people the provide (for example, providing deposits and financial stress,” which was the worst following question, “Is Goldman Sachs subject making information-intensive loans), the results case they considered. In this scenario to enhanced prudential standards and a G-SIB indicate that multiple regulatory requirements the Fed forecasters expected -0.5 surcharge because of the risk that its commercial are needed to get the socially optimal outcome. percent real GDP growth in the second bank will impose a loss on the Deposit Insurance This seems intuitively correct. half of 2008 with real growth rising to Fund or because of the systemic risk inherent 0.5 percent in 2009 and 2.6 percent in in its non-bank broker-dealer?” The answer has The issue, though, is the cost of a multiplicity 2010. The unemployment rate in this been the latter, without exception. And yet, if of rules aimed at only 15 to 20 financial scenario was expected to peak at 6.7 that is the case, why are significant players in institutions and their activities. There are two percent in 2009. It actually peaked at the financial markets unaffiliated with a bank main costs. First is a reduction in the level of 10 percent. Six weeks before Lehman, not subject to such standards – and indeed not economic activity, which is inarguable, yet the Fed forecasters had no idea what subject to any prudential standards at all? rarely acknowledged in regulatory proposals was coming.2 or academic work.4 (For example, while I think it’s easy for a cynic to conclude that in their book, Gennaioli and Shleifer note From a distance, it is difficult to understand the focus of the federal financial regulators is that various factors lead to increased risk of the monomaniacal focus of post-crisis either political or self-interested. Clearly, large financial instability – such as securitization regulation on large commercial banks and their banks are political bogeymen, and regulators and innovation – they do not acknowledge that non-bank affiliates, and the indifference or even will be held to account if they, as opposed there may be a societal cost to constraining enthusiasm with which regulators have watched to non-banks over which they exercise those factors.) Second, and the focus here, is a much commercial banking and trading move no jurisdiction, run into trouble. I think, possible shift (as opposed to reduction) of risk to outside the regulated banking sector. One of however, the motivation may be subtler and those who may be less able to manage it – either the many intriguing parts of the article in this more reasonable. Exactly because regulators non-bank financial companies or consumers or issue by Anil Kashyap, Dimitrios P. Tsomocos, cannot know what the cause of the next crisis non-financial businesses – or to government- and Alexandros P. Vardoulakis is a disclaimer will be or how it will spread across markets, guaranteed securities for which taxpayers at the beginning: “Throughout, we will refer they want to be absolutely certain that there directly bear the risk.

10 BANKING PERSPECTIVES QUARTER 1 2019 UPFRONT

We already see evidence of this in numerous under the Fed’s most recent Comprehensive and bail-in debt – that is, debt readily convertible markets. Non-banks originated more than half Capital Analysis and Review (CCAR) stress tests, to capital – held by those banks (in light blue). of mortgages in 2017 and account for about which already require a bank to meet capital 80% of originations of mortgages insured by minimums and hold a buffer post-stress. A Thus, if one reads the red bar as the amount of the Federal Housing Administration and the fifth,de facto, buffer may be forthcoming in the capital necessary for the largest banks to survive Department of Veterans Affairs. Moreover, form of the current expected credit loss (CECL) a financial crisis even worse than the global non-banks are vulnerable to liquidity pressures accounting methodology, which will require financial crisis of 2007–2008, which is how the both at origination and during the servicing of banks at the origination of a loan to establish a Federal Reserve calibrates its stress scenario, such loans; thus, non-bank failures could be quite reserve against all future expected losses (with no then you can see that the affected banks hold a costly for taxpayers. Banks are shifting out of offset for future expected income). As Stephen mountain of buffer. If those buffers will never holding the term part of leveraged loans, which G. Ryan notes in his article in this issue, “under be used, they represent a significant drain on are largely funded instead in collateralized loan CECL, banks will record far larger [provisions for banking activity and economic growth. obligations and non-banks now dominate home loan losses] at inception for both heterogeneous lending to low- and moderate-income (LMI) and long-lived homogeneous loan types than The rationale for these buffers is that when borrowers. Moreover, small-dollar lending to they accrued under the [incurred loss model].” stress occurs, banks will treat these them LMI communities is increasingly being done by as buffers, not legal or practical minimum non-bank lenders. Market depth in corporate The impact of these buffers can best be seen in requirements, and therefore allow their capital securities markets has diminished and as bank- this chart, which compares the projected peak- levels to drift down toward regulatory minimums affiliated broker-dealers hold less inventory the to-trough pre-tax net losses from the Federal in order to remain engaged in lending, market capital cost of holding and hedging inventory has Reserve’s recent CCAR stress (in red) with the making, and other activities that support the risen. In sum, post-crisis regulation has forced amount of capital held by the CCAR blanks (in economy. They will also use their buffers to acquire banks and their affiliates to manage fewer risks dark blue) and the amount of loan loss reserves troubled firms, or their assets, lessening fire-sale for the economy, leaving those risks either to be risk. This belief is an important foundation of post- managed by non-bank financial companies; not crisis capital (and liquidity) regulation. Indeed, one LOSS-ABSORBING RESOURCES OF to be managed at all, and thus retained by non- THE LARGEST U.S. BANKS COMBINED could say that is the most important foundation of financial firms; or held by the government. LOSS-ABSORBING RESOURCES OF THE post-crisis capital (and liquidity) regulation. ($LARGEST BILLIONS) U.S. BANKS COMBINED ($ BILLIONS)

What is of even greater concern, though, is how $2,270 Unfortunately, I’ve never met a market markets will behave in the next financial crisis. participant who believes it. Rather, market $1,262 ~20 % participants universally believe that banks will Consistent with the view that banks will never allow their liquidity and capital levels serve as a safe port in the next financial crisis, to drop, even if that means shrinking their regulators not only have imposed significantly $1,008 balance sheets and turning away deposits. In higher minimum capital requirements on $446 his article, Douglas J. Elliott describes those banks but also required them to hold so-called A s reasons ably. He provides what I think is an roecte etotro “buffers” above those minimums. One is a ret et losses important insight, namely, “[I]t’s possible that capital conservation buffer of 2.5%; another is seerel erse scerio the key to predicting actions by banks and the so-called G-SIB surcharge that currently their key constituencies is not the total level of Tile coo eit ranges from 0.0% to 3.5%; and a third, though oloss reseres reerre stoc capital and liquidity but the margin of capital currently set at zero in the United States, is the TA loter et and liquidity above regulatory minimums. countercyclical capital buffer. The Fed has also If so, the recession-related risks have likely cles ol te s rticiti i A proposed a fourth buffer, the stress capital buffer, A oreesie itl Alsis eie become higher, not lower, as a result of the TA Totl ossAsori cit which would be based on hypothetical losses orce icil eerl esere or increased requirements.”5 My colleagues and I

BANKING PERSPECTIVES QUARTER 1 2019 11 ArticleThe Next Title Financial Goes Here Crisis and the Great Buffer Fallacy

have a less eloquent phrase we use to express increased demand for repo to fund expanding imposed on banks (which are almost certainly the same thought: the Great Buffer Fallacy. government debt met reduced supply from de facto minimum requirements), and the banks concerned about their leverage ratios and absence of requirements on non-banks is an In sum, when internal constraints or credit G-SIB surcharges; as a result, Treasury repo rates area ripe for study through the lens of behavioral rating agency standards operate as the binding traded above 7%, nearly triple their normal rate. economics and game theory. I fear we would not constraint on bank capital and liquidity levels, a The ramifications here are significant enough like what we would find (and further fear that bank might choose to operate at somewhat lower that they have reduced the Federal Reserve’s may be why some people aren’t looking). n capital or liquidity levels under stress – continuing options in monetary policy: The Fed’s efforts to lend and make markets. By contrast, when to reduce the size of its balance sheet have run ENDNOTES supervisory or regulatory constraints are the headlong into heavy bank demand for reserves, 1 Nicola Gennaioli and Andrei Shleifer, A Crisis of Beliefs: Investor Psychology and Financial Fragility binding constraints, banks will be unwilling to driven importantly by the liquidity coverage (Princeton, N.J.: Princeton University Press, 2018). 6 operate at lower levels even if those constraints are ratio and other liquidity requirements. 2 Ibid. temporarily reduced or “meant to be used.” This 3 The preamble to the Federal Reserve’s countercycli- could make for a messy crisis. As Elliott states, “All BEHAVIORAL ECONOMICS AND cal capital buffer final rule states, “It is designed to increase the resilience of large banking organizations in all, there is clearly a risk that non-banks, taken FINANCIAL REGULATION when there is an elevated risk of above-normal as a whole, could either choose or be forced to pull As an early adherent of behavioral economics losses. Increasing the resilience of large banking back on their activities more sharply in a recession and the work of Kahneman and Tversky in organizations will, in turn, improve the resilience of the broader financial system” (emphasis added). than banks have historically done or would likely particular,7 I believe that work can have valuable “Regulatory Capital Rules: The Federal Reserve do in the future.… The aggregate impact of contributions to financial regulation. We publish Board’s Framework for Implementing the U.S. Basel III Countercyclical Capital Buffer.” 12 CFR 217, much tougher prudential requirements for banks here an article that examines how our innate Sept. 16, 2016. https://www.federalregister.gov/ without any significantly expanded regulation of biases make it difficult for us to foresee crises – documents/2016/09/16/2016-21970/regulato- ry-capital-rules-the-federal-reserve-boards-frame- non-banks that operate in similar markets has something readily observed in recent financial work-for-implementing-the-us-basel-iii likely increased pro-cyclicality.” crises. I think a far more significant application 4 A reduction in economic activity is the cost of higher could be toward how buffers would work in capital requirements used in studies of the optimal level of capital by the BIS (2010), the Bank of We already have some hints of how markets practice, which reflects how banks and regulators England (2015), the IMF (2016), the Minneapolis might behave, based on rather low-stress events would behave. Why would a bank in the midst of Fed (2017), and the Federal Reserve Board (2017). like reporting dates. At the end of last year, market uncertainty and regulatory scrutiny choose 5 It is worth noting that the countercyclical capital buffer was designed with the intention that regulators to report that it was no longer in compliance – or, would lower it in times of financial stress, and Elliott put another way, no longer able to comply – with therefore believes it is worth further study as a poten- tial compromise in this area. Of course, this means The Fed’s efforts its regulatory capital and liquidity buffers? For that the buffer will be imposed sufficiently ahead of that matter, would a regulator in the midst of time – that is, that the same regulators who could to reduce the size not identify a looming crisis a few weeks ahead of its market uncertainty publicly allow a bank to do so advent last time will do so a year or more ahead next of its balance sheet have – for example, by lowering a previously imposed time – and that they will have the political courage to countercyclical capital buffer? Anecdotal evidence tell the American people and the Congress that their run headlong into heavy response to an actual, ongoing crisis is to lower the and some back-of-the-envelope game theory capital requirements on large U.S. banks. bank demand for reserves, seems to suggest that they would not. 6 “The Future of the Federal Reserve’s Balance Sheet,” Vice Chairman for Supervision Randal K. Quarles, driven importantly by the speech at the 2019 U.S. Monetary Policy Forum, liquidity coverage ratio To quote Amos Tversky, “People are not so sponsored by the Initiative on Global Markets at the complicated. Relationships between people University of Chicago Booth School of Business, New York, New York, February 22, 2019. and other liquidity are complicated.”8 So it is with financial 7 G. Baer and G. Gensler, The Great Mutual Fund Trap requirements. regulation, and it seems that the failure to (New York: Random House, 2002), 170-75. consider the relationship between the minimum 8 “The Undoing Project: A Friendship That Changed Our requirements imposed on banks, the “buffers” Minds,” Michael Lewis (W. W. Norton & Company, 2016).

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LG5983_Clearing House Ad_Banking Perspectives Mag_2018.indd 1 9/27/2018 11:38:05 AM MY PERSPECTIVE Corporates See RTP Network as Innovative Platform for Improving Customer Experience

BY JIM COLASSANO, THE CLEARING HOUSE

hen it comes to understanding When it comes to the emerging real-time payments the real-time payments revolution revolution now underway, in our experience, the more now underway, corporate corporates learned about the RTP network, the more customers are a good gauge of they came to understand the network’s potential. TCH what this new wave of payments has had the benefit of gaining insights on this highly innovationW will offer to consumers and businesses. Many important group of payments systems users through businesses are far ahead on the learning curve in terms of regular engagement with representatives of corporations what this next generation of payments innovation offers. of all sizes. Specifically, in 2017, The Clearing House In fact, we’ve found that once companies understand the launched its RTP Corporate Advisory Group, consisting benefits provided by real-time payments, it’s hard to slow of an array of corporate users bringing various them down. perspectives to the table. When the group first met, its members simply came to learn more about TCH’s new It’s worth nothing that it hasn’t always been this way. real-time payments offering, the RTP network, which is When corporates first started to discuss the options for the first new payments “rail” in the United States in over faster payments a few years ago, the concept of conducting 40 years. At the time, most were waiting for use cases for payments in real time was interesting but not compelling. the RTP network to develop, saying almost universally: Some companies even felt that real-time payments might “We need our banks to work with us to find applicability be a “solution in search of a problem” and that such a for RTP payments.” system might be overly complex. Working with this group since its founding, we can The conversational nature of say that the members of the RTP Corporate Advisory Group are not bashful. They’ve been open, transparent, messaging on the RTP network and exceptionally engaged about what the RTP network is perfect for enhancing the customer means to them and why it matters to the companies they represent. The companies they represent are large and service component of any small, and they come from a wide spectrum of industries. payment-related encounter. By no means was everyone in the room a payments expert – that was by design.

The group’s 15 members, from a variety of U.S.-based If financial institutions and The Clearing House, companies, quickly grasped the significance of real-time which launched the RTP network in 2017, had accepted payments coming through the RTP network, and in less the corporates’ initial reaction, it would have been a than a year they began to develop business cases where major error. In looking back now, we see that – as is the RTP system would serve a foundational role. In often the case – new technology, especially something brainstorming sessions at the 2017 Corporate Advisory that is radically different than existing solutions, is Group meeting, the use cases were almost exclusively often met with skepticism. Furthermore, it often takes low-volume payment pain points, such as payments time for the true power of new innovations to be fully that were cash-based or payments with unique timing understood. One might perhaps recall erroneous requirements (such as paying entertainers or staff at negative predictions about the prospects for mobile sporting events), that could be solved with the immediacy phones or, later, smartphones. and irrevocability of the RTP network.

14 BANKING PERSPECTIVES QUARTER 1 2019 UPFRONT

Of note, in 2018, the use cases came to be more focused For example, during the group’s summer 2018 meeting, on the precision of payments versus their speed. Comments even the more skeptical corporate practitioners from a year such as “you can make payments exactly when they are earlier (“This is interesting, but there’s little application due, right down to the second” and “the money actually for my company.”) had made lists of pilot-ready and moves instantly, without any settlement risk” became immediately valuable use cases for the RTP network, commonplace. At this point, it was clear the applicability including student tuition refunds, high-risk vendor of real-time payments was becoming more apparent payments, internal payments between divisions, patient to corporate users. “With the RTP network, we’ll know trials, and same-day exception payments. One practitioner immediately that the payment has been received by the noted that his research after the 2017 meeting revealed beneficiary – as opposed to only knowing when it doesn’t more than 12,000 payroll exceptions annually, more than get there,” said one Advisory Group member. Also maturing 3,000 of them made with expensive wire transfers. were use cases that afforded new competitive opportunities – an example would be gig economy payments to specialized Across the board, this group of corporate contractors that would attract the contractors to the hiring practitioners made clear that the RTP network is organization based on the speed of the payment. fundamental to the future of payments and to their company’s success. In short, this group has transitioned Many of the ideas capitalized on the RTP network’s from “curious observers” to “engaged advocates” to messaging capabilities coupled with the real-time “enthusiastic early adopters.” Today, members of this characteristics of RTP payments, such as an instant refund group and corporates nationwide are aggressively to a consumer with a service issue or a rebate to a customer. pressing their banks, and each other, to launch early- Specifically, the Advisory Group said the conversational stage programs within their company across a variety nature of messaging on the RTP network is perfect for of payment applications such as payroll, refunds, JIM COLASSANO Jim Colassano is a Senior enhancing the customer service component of any payment- contractor payments, and emergency payment requests. Vice President in the related encounter. When a customer uses the request for Product Development payment capability on the RTP network, billers are assured RTP ENGAGEMENT AS A PROXY and Strategy group at The Clearing House. He has that they will receive payments that are “ready to post” to FOR INNOVATION over 25 years of experience their accounts receivable systems. Innovative companies are always looking for services in the payments and cash and tools that can help them create more value for management business, and joined TCH in 2016 After a year of learning how solutions based on the their customers and partners. To the RTP Corporate to assist in the build-out RTP network could be applied to their business, almost Advisory Group, the RTP network stands for innovation, and launch of the RTP all of the Corporate Advisory Group members said they especially when it comes to measuring banking partners network. Before joining TCH, Colassano spent are now ready for payments on the RTP network (for on their ability to offer innovative products and 10 years with HSBC as comparison, in 2017, only one-third of the group said services. In other words, members of the RTP Corporate a product executive in they were ready). In other words, given a year to learn Advisory Group are increasingly using RTP engagement, its Payments and Cash Management group. Prior more about the RTP network and its potential for their readiness, and expertise as a proxy for a bank’s overall to joining HSBC, he spent companies, some members of the Corporate Advisory innovation and technology capabilities. 15 years with JPMorgan Group were launch-ready, others pilot-ready. What was Chase in a variety of cash and treasury management readily apparent was the Corporate Advisory Group Members of our corporate group strongly expressed that roles. Colassano holds members were beginning to see the importance of the the RTP network will fundamentally change their industry, master’s degrees in RTP network and the value it could provide for their and they are starting to act accordingly. “I can’t afford for banking and finance from Pace University. company, in terms of speed and functionality. our bank to be late to the game,” said one member of the

BANKING PERSPECTIVES QUARTER 1 2019 15 My Perspective

payments is to tell a story. Case studies from similar RTP NETWORK CORPORATE ADVISORY customers are the key to unlocking their creativity and GROUP MEMBER COMPANIES uncovering RTP use cases. The participants in the RTP Network Corporate Advisory Group include: Case studies, success stories, and customer testimonials have one thing in common – they’re Computershare focused on why and what, not how. There’s a place for the operational details, but it’s not in the early stages of Duke Energy creating interest and demand. “Show me the painting Elytus before you tell me about the artist, the oils, and the brushes,” commented one group member. Global Holdings

Melio & Company Members of the Corporate Advisory Group were Michigan State University clear on their advice for banks – position customers to see the value of the RTP network and its applicability, Nationwide Insurance then move quickly to early adoption and tell the early Netflix adoption stories to drive further expansion. “Show me how RTP is working in a company like mine. I’m more Sysco interested in where it’s working than how it works.” Trion Solutions However, as more companies start to embrace the Uber functionality of the RTP network and as word of the United Telemanagement Corporation network spreads, the challenge to stay in front gets Verizon harder. Every corporate treasurer and payments leader has a boss. The last thing they want is for their boss to ask them why they’re not using an innovative, game- Corporate Advisory Group during a recent call when he changing tool such as the RTP network before they’ve announced that his organization was rebidding its entire had a chance to share their vision for how it can be used banking relationship largely because its lead bank hasn’t throughout their company. demonstrated leadership on the RTP network. While this may be a strong step, it is consistent with the consistent CUSTOMER EXPERIENCE RULES message from members of the Corporate Advisory Group This is why most corporates are not approaching the that they want to hear about the RTP network from their RTP network as solely a payments opportunity. While banks, and they feel that they can’t afford to miss the payments – including major new innovations in the opportunity that the RTP network brings to their company. area – are interesting, customer experience matters most. Not surprisingly, corporate internal priorities, BRING US IDEAS project funding, and technology resource allocation When you ask corporates what’s the most valuable thing reflects the desire to improve the customer experience. a bank can do, the answer is always the same: “Bring us So it is no surprise that treasury advisers see the RTP ideas.” The RTP network is the perfect example of exactly network as a chance to enhance, or fundamentally what leading corporate practitioners demand. alter, the customer experience. More than a few of our corporate advisors have their sights set on initiatives The RTP Corporate Advisory Group consistently that are driven and funded by the improvements the suggests the best way to present the case for RTP RTP network brings to their customer experience.

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An example is an immediate payment confirmation interesting and valuable, but disrupting a business by for a utility payment that would eliminate (or greatly revolutionizing the customer payment experience – enhance) a costly call center interaction. that will create a network effect,” said one of the group’s members. Across the board, this group of A SEAT AT THE TABLE corporate practitioners believes Early adopters seek the company of early adopters. In the RTP network is fundamental to the case of the RTP network, members of our group of potential RTP pioneers are very open about their quest the future of payments and to to find the right bank to give a seat at the table. One day, their company’s success. they will use the RTP network with all of their banks, but in the beginning, early-adopter banks will attract early-adopter customers.

Time after time, we witnessed the shift from their One of the early observations from the corporate group traditional treasury perspective to their overall corporate after their first in-depth session on how the RTP network perspective. In fact, when we engaged the corporate could be implemented was that RTP applications could practitioners in brainstorming sessions around the RTP be co-developed or co-invented. Use of the RTP network network’s applicability for their company, they focused would require an in-depth understanding of individual almost exclusively on use cases that improved the corporate payment and messaging practices, which would customer experience, not use cases that saved costs or be best achieved by a joint development effort by banks increased payments efficiency. and their customers. It’s clear that corporate users are looking for banks to step up with innovative tools built This is yet another example of how the RTP network on top of the RTP network. “The effectiveness of the RTP will thrive in a nontraditional approach. Our treasury implementation will be directly proportional to the banks’ executives immediately challenged the “treasury-centric” knowledge of my company,” said one Corporate Advisory approach in favor of a more “customer-centric” approach. Group member.

The Corporate Advisory Group has been engaged It’s also interesting to hear what members of the and supportive of the efforts of The Clearing House to Corporate Advisory Group ask each other. Among their work with the banks to reimagine current bill payment top questions: “How will you choose the bank that gets the practices. TCH and the banks are working together seat at the table?” to create innovative new solutions for payers and opportunities for billers. Similar efforts are underway in A seat at the table is up for grabs. If the feedback the business-to-business space and are being shaped by and actions of our RTP Corporate Advisory Group are the Corporate Advisory Group. representative of other senior treasury executives, it’s a valuable seat that’s becoming more coveted every Members were also quick to point out that the typical day. As one RTP Corporate Advisory Group member call with the typical bank would focus on “incremental said, “We work with plenty of banks, but we innovate payment improvement” idea generation. However, a with a very small group.” As the RTP network becomes completely different team and a completely different commonplace over the next few years, the table will get approach – from both the corporate user and the crowded. But for now, that table belongs to the banks bank – is required for innovative “disruptive payment ready and willing to help their customers innovate on improvement” sessions. “Solving a pain point is the RTP network. n

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Integrating technology into our client experience and high-touch service model in each of [our] businesses is a top priority.

STATE OF 20 BANKING PERSPECTIVES QUARTER 1 2019 UPFRONT

Michael O’Grady, Chairman, President, and Chief Executive Officer of Northern Trust, discusses emerging technology and more with Greg Baer, Chief Executive Officer of the Bank Policy Institute.

GREG BAER, BANK POLICY INSTITUTE: I would like provide an overview of how you’re using technology to to start with an overview of Northern Trust. Your main enhance the business? lines of business are corporate and institutional services and wealth management. Should we think of you predominantly O’GRADY: We’ve been making and we’ll continue to as a wealth manager, as a technology company, or a bank? make significant investments in technology. Integrating technology into our client experience and high-touch MICHAEL O’GRADY, NORTHERN TRUST: All of the service model in each of those businesses is a top above. We’re definitely a bank, and the banking capability is strategic priority. important to what we do. But like most other banks, we look to differentiate our services and compete in different ways. The key to deploying new technology is whether it will make what is already an attractive business model even I think of Northern Trust as three primary businesses: more scalable and flexible for us and our clients. wealth management; the institutional asset servicing business, which includes custody and fund administration; Let’s take something such as robotics. If you think and asset management, a business that has been built about the nature of the asset servicing business – up over time serving the other two businesses, with custody, fund administration, middle-office services – it approximately $1 trillion in assets under management. involves processing high volumes of transactions. It’s the type of activity that has been deployed effectively These businesses are integrated, and part of that for many years, yet it’s still ripe for the application of integration is technology. We think one of the advantages robotics and other automation opportunities. we have is our ability to leverage our technology investments across the three businesses. Also, and this is important, it leads to a lower-risk business model. Because we’re able to automate activities BAER: I’ve seen a lot about Northern Trust’s drive to and minimize the opportunity for manual error, operational digitization and use of enhanced technologies. Can you risk is reduced and we can focus more on our clients. BANKING BANKING PERSPECTIVES QUARTER 1 2019 21 State of Banking

The more complex a learning for that yet, but I could definitely see that being client’s needs are, the next stage as we move from automation to robotics and the more we can help. then toward artificial intelligence and machine learning. BAER: Let’s turn to distributed ledger technology (DLT). It does seem like Northern Trust’s business will be well-suited Secondly, consider the use of algorithms. Much of what for blockchain. Are you making progress with DLT? we do involves financial expertise. With algorithms, you have a very disciplined process and in return achieve a very O’GRADY: Yes. We definitely believe that DLT has precise outcome. One example is foreign exchange (FX), applications for what we do. And to date, we’ve experimented which we generally do for asset-servicing clients such as with a number of different applications. One where we’ve investment managers, pension funds, and sovereign wealth had a significant amount of success has been in fund funds. Historically, FX has been executed off of a trading administration for private equity funds. This is an area where desk, and it still is. However, in some instances, we are we have a business, a global business, but as part of that there providing execution using algorithms to get the best price. is a business in Guernsey where we do administration for Trading in this way enables us to access the best pools of private equity funds that are domiciled there. liquidity and execute customized client strategies. In order to test the technology and develop something Another aspect is how we think about developing new that has a practical and commercial use, you need the whole technologies. For many years, we’ve had a team that works ecosystem to be part of the test. So, even if we develop that on FX algorithms. However, early on, we partnered with a as the fund administrator, if the clients, regulators, auditors, sophisticated FX tech company called BEx, and it has been and lawyers don’t accept what you’re doing, then you don’t a very fruitful relationship. It was working well enough that actually have something commercially viable. That’s why we we decided to make an investment in the company. Then, chose Guernsey, because we had that ecosystem that was in 2018, it was working so well that we decided to acquire interested in doing something that was innovative. If you the whole company. That’s just one area, but it shows how step back to compare private equity to the capital markets, we think about innovation and development. We look to it’s highly inefficient on a relative basis. develop technology that fits what we’re doing and enables us to move quickly enough to keep up with the market. We had a good position as both the custodian for asset owners that are investing in private equity and the BAER: A related question is about machine learning (ML). administrator on the other side for the general partner Part of the concern about ML is that developers don’t write (GP). We could see pain points for the system because, for some of the code in advance. Instead, the machine thinks example, the GP has to work with the lawyers in order to put for itself. Do you see a future for ML in your business? the documents together. They send the documents to all the limited partners (LPs), the LPs have their lawyers look at the O’GRADY: Yes, but to your point, you really need to documents, and send them back. With every capital call, you understand the risk you’re potentially taking on by using go through the exercise again. We work on behalf of these LPs ML. This differs from our FX algorithm today where we to do that process, and it is very paper based and takes time program the algorithm, and there is no machine learning. to do, which then has a cost of capital implication.

But if you think about using machine learning to follow If you can put that on distributed ledger technology, trading patterns and if you’ve set up the parameters to now you have something that is transparent to all the get greater efficiency in trade execution, that will make appropriate players and is something that you can the algorithm better over time. We’re not using machine automate for the process of capital calls.

22 BANKING PERSPECTIVES QUARTER 1 2019 UPFRONT

The auditor can also work with the system. We worked BAER: The Fed recently released its prudential regulation with PwC to make sure it is an auditable trail. So far, we tailoring proposal, and Northern Trust appears to have have certain process patents on that application. And a greater level of regulatory scrutiny due to your cross- now the next stage is, how do we scale it up? That’s what jurisdictional activity. Could you walk us through what we are investigating right now. your cross-jurisdictional activity is and how that translates, or doesn’t translate, directly to systemic risk? We’re also working with the ASX (Australian Securities Exchange) because it’s in the process of O’GRADY: We appreciate our position as a global custodian, replacing its settlement system (CHESS), and it’s looking and that is how we’re positioned in the marketplace. We offer for market participants interested in developing DLT. We services to large asset owners and managers, and we do look are also looking at custody to determine the future for to do it in a very low-risk way. The cross-jurisdictional aspect custody infrastructure overall. And there are other areas of it is primarily where we have large asset owner clients where we would look to partner with various market outside the U.S. that have dollar-denominated assets that participants that are already further down the path, then are left on our balance sheet. Since it is on the balance whether it’s foreign exchange or derivatives, for example. sheet of a non-U.S. branch or subsidiary of a U.S. bank, it How can we be a part of what’s happening there? Right will be viewed as a cross-jurisdictional asset or liability – or, now, DLT is both a risk and an opportunity. in some cases, both. That would be the case even though these are stable assets or liabilities related to our clients’ BAER: There has been a lot of discussion recently asset-servicing needs. about bank deposits, and Northern Trust is obviously a huge deposit taker. How do you approach deposits at Now, it is important to have very strong capital and, maybe Northern Trust, and what do you focus on when you are even more importantly, strong liquidity. We have both with determining your strategy? regard to capital and liquidity ratios. It’s also important to have the infrastructure and analytics to go with that, and we O’GRADY: We are in a transition period with regard to have that as well. We’ve invested in both the infrastructure deposits. If you go back three or four years ago when and analytics over the last seven years. It’s at a level that short-term rates were zero, the value of the deposits clearly can serve clients appropriately and also is low-risk. could be negative because of capital requirements. Now we’re in a different time period, but we still look at the BAER: Corporate social responsibility is something for economics. So, for example, if one of our institutional which Northern Trust is certainly known. How are you clients has liquidity needs, we provide it with a number innovating in that area as the industry moves beyond the of alternatives. traditional charitable giving model?

If it says it wants to be on the Northern Trust balance O’GRADY: As you point out, Northern Trust has a long sheet, we can offer that, but we need to know the cost of tradition of corporate social responsibility. We make capital and the level of profitability. If it wants to be in U.S. significant contributions to the global communities in Treasuries, we can offer that as well; that’s priced a certain which we operate. In addition to making grants to support way and has certain economic implications to us. And organizations that meet our guidelines, we have been then, more broadly, it may be part of services that figure innovative in our approach to community development into asset servicing fees. However, I would say we don’t investments. We invest in strategies focused on really look to subsidize one product over another. We’re comprehensive community development as well as issue looking for the entire package to be attractive, but also the areas such as housing, education, health, and community individual services to be relatively aligned with the cost and development. Our investments are long-term, patient the value that we’re providing. capital with a primary focus of creating positive impacts

BANKING PERSPECTIVES QUARTER 1 2019 23 State of Banking

in underserved communities. We focus on capital gaps in However, we have been integrating powerful technology underserved areas and look for new ways to fill those gaps in such a way that it provides a better client experience, that will create sustainable positive change. and also enables us to scale this expertise. That’s really exciting because otherwise your opportunities for growth are For example, we may make a direct investment into an limited. We built an iPad application that was a combination organization with performance-based measures for the of Northern Trust technology and work from a top outside terms of that debt. We have made an investment in a social technology firm. It’s called Goals Driven Wealth Management. impact fund in Denver that provides wraparound social It’s easy to say Goals Driven Wealth Management, and a services for formerly chronically homeless individuals. We number of firms hold themselves out this way. have closed a total of seven of these types of transactions. But what happens is the Northern Trust team members BAER: I assume your private wealth clients also are – the wealth strategist and the portfolio manager and other philanthropic, and I think you provide them philanthropic experts as needed – sit down with the client or potential services as well. How do you work with them? client and go through a number of questions about financial assets and objectives. Our unique platform leverages O’GRADY: Our clients are incredibly active in terms of industry-leading algorithms and a mobile app that allows philanthropy. We have philanthropic advisory services that clients to visualize their assets as they align with their life we offer to our wealthy clients. We help them think through goals – such as to fund a grandchild’s education, donate to how they want to pursue their philanthropic objectives. One charitable organizations, or buy a second home. interesting trend is the crossover between impact investing and their philanthropic activities. Often when we then talk Each goal has a customized portfolio of assets that takes about what we’re doing in impact investing, they’ll ask how into account the specific time horizon and is applied a they can participate in that as well. We’ve collaborated with unique risk tolerance designed to ensure the aspiration can larger clients as part of these impact investing issues. I think be met. Each aspiration is a piece of plan, and every asset there will be more of that going forward. has a purpose. The technology, coupled with the expertise of Northern Trust’s wealth and investment advisers, allows for BAER: How do you differentiate Northern Trust in the the plan to be changed in real time to accommodate real life. wealth management space? BAER: There has been a lot of focus over the last couple of O’GRADY: For Northern Trust, the more complex a client’s years on liquidity, particularly in corporate bonds. There is needs are, the more we can help. Those are the opportunities a widespread recognition that there is not the depth to the that we’re looking for, where our holistic approach to wealth market that there used to be. How does this change your management shines. It tends to be clients with a greater behavior as an asset manager, knowing you may not be able amount of wealth. Part of serving high and ultra-high net to sell in blocks the way you used to be able to? worth clients requires having advisers with deep expertise. You need estate planning lawyers, tax strategists, fiduciary O’GRADY: I would say that although there is some expertise, trust administration, philanthropic services, additional volatility in the market, we haven’t changed family business advisory, oil and gas advisory, and many our investment strategy. In other words, we haven’t other types of specialized areas of expertise. Generally necessarily said we’re going to have higher levels speaking, you wouldn’t say that these types of expertise of liquidity in the fund in order to make up for less lend themselves to automation or technology. At a certain inventory in the market. That said, we have enhanced level, it’s true. We have not pursued a robo adviser – the our analytics about liquidity in the market. It is part of the market where you answer five questions and it something that we closely monitor because it’s a different will give you an asset allocation. marketplace than it was five or 10 years ago. n

24 BANKING PERSPECTIVES QUARTER 1 2019 Transform risk and complexity to your advantage

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505341-2019-The Clearing House Annual Conference 2018 Ad.indd 1 10/25/2018 2:03:52 PM

ANDBANKS THE NEXT RECESSION BY DOUGLAS J. ELLIOTT, OLIVER WYMAN

BANKERS AND REGULATORS MUST CAREFULLY CONSIDER HOW THE MANY CHANGES IN THE FINANCIAL SYSTEM COULD AFFECT US IN THE NEXT RECESSION. WE SHOULD TAKE ACTIONS NOW THAT WOULD REDUCE THOSE IMPACTS.

26 BANKING PERSPECTIVES QUARTER 1 2019 WHEN THE NEXT RECESSION COMES, how will banks and the wider economy be affected? This is a timely question, given fears in the financial markets that one of the longest U.S. expansions in history may soon come to an end. We know a lot about banks in previous recessions, but we’ve changed the financial system profoundly; will that change the relationship between banks and the economy?

America has transformed its financial system through exacerbates a recession, which forces banks to cut back government action and private sector innovation. further. Economists refer to this spiraling effect as the Banks and their affiliates are now held to much tougher “financial accelerator.” prudential standards – specifically, higher capital requirements and newly minted liquidity requirements, There is every reason to expect this basic interaction to but also mandatory resolution and recovery plans and continue, but there are plenty of questions about whether tougher supervision. For its part, the private sector the transformed financial system is less vulnerable to Wresponded to lessons from the global financial crisis and recessions and less likely to trigger them or is more pro- to opportunities offered by new technology to change the cyclical, increasing fragility. competitive landscape and transform business models.

Question 1: Did new capital and liquidity I will examine two major shifts and consider how they standards reduce recession-related risks may change the relationships between banks and the or add to them? wider economy:

QUESTION 1: Did new capital and liquidity standards Banks are now required to hold much more capital, reduce recession-related risks or add to them? and of better average quality, than before the crisis. For example, the minimum regulatory requirement for the QUESTION 2: Has market-based finance lowered ratio of common equity to risk-weighted assets (RWA) has recession risks by diversification or shifted business to roughly quadrupled since the crisis. more pro-cyclical “shadow banks”? Before the crisis, global standards set by the revised I conclude with a discussion of how banks and Basel Capital Accord (“Basel II”) called for a minimum regulators can reduce risks tied to recessions. ratio of Tier 1 capital to RWA of 4%, of which the majority had to be in the form of common equity, meaning that a BANKS AND THE ECONOMY IN bank could theoretically have common equity to RWA of PAST RECESSIONS just over 2% and still pass the test. Under the latest version The historical record is clear that a sudden stop in of the Basel standards, the minimum ratio of common lending by banks can send the economy into recession equity to RWA is effectively 7% (4.5% absolute minimum or deepen an existing recession. Effects flow in the plus a 2.5% capital conservation buffer). There were also other direction, too. Recessions can do real damage to important definitional revisions that reduce the calculated banks via credit losses, declines in the value of other value of common equity and raise the amount of RWA. investments, reductions in new business revenues, Factoring this in almost certainly increases the new etc. Even worse, the situation can spiral downward as minimum ratio, calculated on a Basel II basis, by at least damage to banks cuts into credit availability, which another point, to 8% or better.

BANKING PERSPECTIVES QUARTER 1 2019 27 Banks and the Next Recession

Similarly, there are new liquidity requirements that as the ability of the financial system to continue to force banks to hold more liquid assets and to cut back provide needed credit and other services to the economy on their reliance on shorter-term funding. The Basel despite external shocks, such as a recession, or internal Accords now include a new liquidity coverage ratio problems within the financial system. intended to ensure that banks can survive 30 days on their own to give time for central banks to ride to THE PESSIMISTIC CASE the rescue in a severe liquidity crisis. There is also a But it’s possible that the key to predicting actions by new calculation for the net stable funding ratio that’s banks and their key constituencies is not the total level of intended to reduce excessive maturity transformation capital and liquidity but the margin of capital and liquidity on bank balance sheets. Before these standards, most above regulatory minimums. If so, the recession-related jurisdictions had very loose or nonexistent quantitative risks have likely become higher, not lower, as a result of standards for liquidity management. the increased requirements.

Prior to the global financial crisis, minimum regulatory The historical record is clear capital requirements were so low that most of the that a sudden stop in lending banking system held considerably more capital. Banks did this in order to meet rating agency requirements by banks can send the economy for management’s targeted credit ratings or to reassure into recession or deepen an existing funders or because their own internal economic models said they needed more to cap their risk of bankruptcy at a recession. Effects flow in the very low level. None of these nonregulatory targets turned other direction, too. out to demand high enough levels of capital in the face of the global financial crisis, but they were still well above pre-crisis regulatory demands.

THE OPTIMISTIC CASE However, the post-crisis regulatory reforms have If the system works as intended, the new prudential dramatically raised capital requirements and generally standards will make us safer by dampening the impacts made them the binding capital constraint for the largest of both banking troubles and recessions. Banks that banks in the system and many smaller banks. To be encounter problems will not need to cut back on lending more precise, the binding constraint is generally the as quickly or sharply because their high levels of capital toughest of the various regulatory requirements plus a and liquidity will reassure their funders and customers safety margin that management chooses to hold on top and allow a gentler slowdown in credit provision or even of that in order to reduce the risk that losses will cause a continuation of previous levels. capital to fall below the regulatory requirement. Those managing banks want a safety margin in order to retain By the same token, recessions won’t translate as quickly some flexibility in how to react to problems rather than or harshly to problems in the banking system because of immediately falling into the zone where regulators are banks’ greater safety margins. In short, our newly resilient telling them what to do. banking system will be less likely to trigger a recession and will be less vulnerable to problems caused by a recession, The new regulatory requirements were deliberately lowering the importance of the financial accelerator. constructed to reduce the risk that banks would suddenly stop lending if capital or liquidity levels This optimistic view is clearly the one held by the fell across the board. On the capital side, the Basel global standard setters and regulators who drove the Committee created a “capital conservation buffer” (CCB) post-crisis reforms. They explicitly intended the new that is not an absolute requirement. Instead, as the CCB prudential rules to increase financial stability, defined is eaten up by losses, progressively tougher restrictions

28 BANKING PERSPECTIVES QUARTER 1 2019 are placed on a bank’s ability to pay dividends or take of 1 to 3 percentage points. For comparison, pre-crisis certain other actions, including paying some types of ratios for common equity to RWA were generally in management compensation. the range of 8%, 6 points more than the 2% minimum regulatory requirement. On the liquidity side, regulators have clearly stated that they would strongly consider lowering the However, there were nonregulatory determinants minimum ratios in a widespread financial crisis to below of capital levels, such as the requirements set by rating 100% in order to allow time for banks and central banks agencies for the rating levels banks generally used as to react in an orderly manner. their targets. It is difficult to know (a) how much excess capital banks had compared with their desired ratings and So, why might banks slam on the credit brakes if they (b) how much of a drop in ratings managers would have come near to crossing these lines? First, neither they nor accepted rather than moving to raise expensive capital in their investors want them to be so vulnerable to regulatory bad times. choices, especially after seeing how adverse the political environment can become. Second, there is the stigma The case is much clearer regarding liquidity effect. The first bank(s) to cross these red lines run the risk requirements. There are now clear and binding regulatory that funders and customers will flee to safer places, whether liquidity requirements, which did not exist pre-crisis. other banks or outside of the banking system altogether. Further, rating agencies and other nonregulatory parties generally did not view liquidity as a serious issue for There is a counterargument that because all banks benefit banks before the crisis, so nonregulatory constraints were from a safety net unavailable to many other institutions, also quite weak. Therefore, liquidity constraints should be funding in a crisis will flow to the banking system, not away much more binding in a recessionary environment than from it. However, many conversations with senior bank was true in the past. executives leave no doubt in my mind that bank managers will strive mightily to avoid falling below the regulatory requirements for capital and liquidity, even when these are It seems very likely that not intended to be absolute. They simply do not want to risk managers and investors view the potential stigma effects, even if banks as a whole may benefit from perceived safety. their safety margins above their most binding capital and liquidity constraints Of course, this logic does not tell us whether the new rules worsen pro-cyclicality compared with pre-crisis as considerably lower than they rules. We need to know not just how banks would did pre-crisis. respond under the new rules but what they would have done under the old. One indication that there may be more pro-cyclicality now is that the margin of actual capital compared with regulatory requirements has All things considered, it seems very likely that declined. It is difficult to pin this down quantitatively managers and investors view their safety margins above because of the profusion of new capital requirements, their most binding capital and liquidity constraints as which go well beyond the simple ratio described earlier. considerably lower than they did pre-crisis. In particular, the largest U.S. banks are generally most constrained by the Comprehensive Capital Analysis BALANCING THE TWO CASES and Review (CCAR) stress tests, created after the crisis, So, is it good news or bad news? There are good rather than the ratio of common equity to RWA. Bank arguments for both views. Having more total capital and managers generally have indicated that they look to hold liquidity will almost certainly provide greater reassurance a safety margin above the full regulatory requirements to the key constituencies for banks and more freedom

BANKING PERSPECTIVES QUARTER 1 2019 29 Banks and the Next Recession

of movement for bank managements than having the business that allow non-banks to compete at least as substantially lower levels that existed before the global effectively as banks in a number of areas. Non-banks financial crisis. There should be less panic and therefore have made substantial inroads into payments that were less economic impact. possible only with new technologies.

At the same time, those managing banks will certainly In some areas, regulatory and market forces pushed in adjust their lending and other risk-taking in order to the same direction – notably, market making. Higher capital stay above regulatory minimums, including the capital and new liquidity requirements, along with the Volcker Rule, conservation buffer. substantially decrease the attractiveness of this business for banks. At the same time, new players that rely on advanced My hunch is that the relative impact of the greater safety software algorithms have stepped forward to provide versus the lesser margin over regulatory minimums will liquidity to the markets, taking share from bank affiliates. vary with the severity of a recession. In a mild recession, banks may act more pro-cyclically than before because of It is difficult to measure the extent to which non-bank their strong aversion to crossing regulatory red lines. But in financing has replaced bank financing in the aggregate in a severe recession, when these lines may be crossed anyway recent years, because it depends heavily on what activities for a number of banks, the balance may be different. The and institutions are included and which starting point is protection and reassurance provided by higher total capital chosen. However, some important traditional core bank and liquidity levels may reduce the impact of the financial credit activities clearly have shifted toward non-banks. accelerator strongly compared with pre-crisis rules. Irani et al. (2018)1 find clear evidence that non-banks have gained a significantly larger share of syndicated Question 2: Has market-based finance corporate loans since the crisis. Further, their analysis of the lowered recession risks by diversification data shows that higher regulatory capital requirements for or shifted business to more pro-cyclical banks play a strong role in this shift. Buchak et al. (2017)2 “shadow banks”? similarly find that non-banks doubled their share of the residential mortgage market from 2007 to 2015, primarily Both regulators and market forces have triggered because of regulatory constraints on traditional banks. an expansion of non-bank activity in many areas that were traditionally dominated by banks. This wasn’t a The big issue is whether these non-bank players will react surprise. Regulators knew that substantially increasing to a recession differently than banks do. There are several capital, liquidity, and other requirements for banks reasons to believe non-banks, in general, will behave more would reduce their competitiveness compared with pro-cyclically than banks. First, in some lines of business, non-banks that were not subject to the same rules. For non-banks rely on “hot money” for their funding, which some types of business, this was viewed as a clear win leaves a distinct risk that it will evaporate in a recession. by regulators because they wanted to insulate the core There has always been a tendency for wholesale funding, of the financial system from certain risky activities. For or other less-stable funding sources, to become more other business lines, it was viewed as an acceptable side important as memories of past crises fade. Banks, on the effect of important safety measures – and in a very few other hand, continue to rely heavily on traditional deposits cases, regulators are actively considering modifying the of one kind or another for much of their funding. post-crisis reforms to diminish undesirable declines in bank competitiveness. Second, banks argue that they operate on a relationship basis to a greater extent than some non- Market forces have played a large role as well – banks do. For example, banks are generally loath to in some cases, a bigger one than regulation has. reduce lending to long-standing customers and often Technological advances opened up new ways of doing profit over time from many non-credit services provided

30 BANKING PERSPECTIVES QUARTER 1 2019 to these clients that may vanish if the customers have DEVELOP A COST MANAGEMENT PLAN FOR THE to turn to another lender. It is a common observation DOWNTURN: Categorize your costs into the minimum that banks are less relationship-oriented than they were needed for survival, those needed to fulfill strategic decades ago, but relationships still play an important objectives, and discretionary activities. Creating a role. Some non-banks may operate in the same way, but cost management plan for each of these categories in generally they are more transactional. advance will both allow a faster and more effective reaction when recession hits and will reveal changes Third, the majority of banking activity comes from large, that could be made now. For example, this may be the diversified banking groups that operate in a wide range of time to replace some fixed costs with variable ones, geographies and multiple differing lines of business. Non- depending on the specific trade-offs. banks are usually smaller and less diversified, which can multiply the pressures on them when their core business INCORPORATE A RECESSION SCENARIO INTO lines hit trouble, leading them to cut back faster on their YOUR STRATEGIC PLANNING PROCESS: Conduct provision of credit or other services or even to go broke. a detailed scenario analysis of a moderate down cycle, which is significantly more likely than the severely There is some empirical evidence that non-bank adverse scenario that CCAR stress testing focuses on. lending is more volatile. Irani et al., for example, found Look for ways to minimize the major factors likely to hurt that higher non-bank shares of syndicated loans had the bank’s capital or earnings, as well as considering the a clear correlation with larger drops in loan prices opportunities that appear with every recession or crisis. during the crisis. That said, it is at least possible that this relationship has changed since the crisis. CONSIDER LIKELY MERGERS AND ACQUISITIONS OPPORTUNITIES THAT MAY ARISE Whatever one’s estimates of the relative riskiness IN A RECESSION: Ensure that the bank is prepared, of non-banks versus banks, we must also recognize and has the financial resources, to move quickly in a that some newer types of non-bank business, such as downturn to pursue strategic targets when they become marketplace lending, have never been through a serious available. In addition to having the financial resources, downturn. This adds unpredictability to the system. management needs to know what they would like to do if the opportunity arose and should try to solidify the All in all, there is clearly a risk that non-banks, taken important personal relationships that will ease eventual as a whole, could either choose or be forced to pull back negotiations. Do not underestimate the advantages on their activities more sharply in a recession than banks of being the one to show up at the right time with the have historically done or would likely do in the future. necessary financing and previously established friendly relationships. REDUCING THE RISKS Regardless of one’s views on whether recession-related MODERNIZE YOUR COLLECTION AND RECOVERY risks have risen or fallen as a result of changes to the FUNCTION: Ensure these functions have been financial system and its regulation, there is clearly more that modernized since the last downturn. Technology has banks and their regulators can do to minimize those risks. changed people’s behavior massively since the last recession and created many new tools to maximize WHAT CAN BANKS DO TO REDUCE RISKS? recoveries and collections. You also need to ensure that Banks can do many things to prepare for the inevitable there will be enough capacity when it is needed. next recession, while keeping an eye on the proper balance between the risk mitigation benefits and the costs, WHAT CAN REGULATORS DO TO both direct and in terms of potential lost opportunities. REDUCE RISKS? Some suggestions from a paper by my colleague, Dan There are three broad types of actions regulators and Rosenbaum, are paraphrased below:3 supervisors can take to cut down on these risks:

BANKING PERSPECTIVES QUARTER 1 2019 31 Banks and the Next Recession

• Fix incentive problems with existing regulation Market liquidity also appears to be unnecessarily handicapped by the degree of regulatory burden banks • Prepare in advance for potential recession- and their affiliates face when conducting market making. related problems This raises the risk of greater market volatility that can move the financial accelerator faster when recession hits • Consider the use of macroprudential tools and markets suffer.

FIX INCENTIVE PROBLEMS WITH EXISTING PREPARE IN ADVANCE FOR POTENTIAL REGULATION: Some regulations unintentionally RECESSION-RELATED PROBLEMS: Given the many encourage pro-cyclicality, as noted earlier. The new complex changes to the financial system and its regulation liquidity and stable funding requirements create the since the last recession, regulators and the industry would perception of a major stigma problem for any bank be well-advised to analyze recession risks more carefully. that falls below a ratio of 100%, even though the stated In fact, it would be useful to have a series of “war game” regulatory intention is to soften this in practice in the exercises that provide the opportunity to mimic the likely event of a widespread liquidity problem. Ideally, there reactions of important human players in the financial would be a more-nuanced approach without such a system as they respond to unexpected recessionary impacts. strong cliff effect. Regulators and others have benefited from war games simulating financial crises or massive cyberattacks. They Banks can do many things should give similar thought to how a recession would play to prepare for the inevitable out in reality, even if a recession is a slower-moving event than these other situations. It is important to go through next recession, while keeping an eye the thought process of responding to a critical situation on the proper balance between the risk well in advance of it occurring, even though the exact mitigation benefits and the costs, both circumstances always vary from the simulation. direct and in terms of potential CONSIDER THE USE OF MACROPRUDENTIAL TOOLS: More controversially, many regulators, central lost opportunities. bankers, and academics believe that macroprudential tools can work to reduce the damage that financial cycles do to the wider economy. Others in the official and academic sector are more skeptical, and it appears that The aggregate impact of much tougher prudential most executives in the banking industry are opposed. requirements for banks without any significantly expanded regulation of non-banks that operate in The simplest macroprudential tool is the countercyclical similar markets has likely increased pro-cyclicality. capital buffer (CCyB), which is a tool available to U.S. The answer here is easy to describe but difficult to regulators and is part of the Basel Accord. This is an put into practice. Similar activities should face similar additional layer of capital requirements that would be regulatory burdens whether conducted out of a bank put into effect when regulators believed that the financial or a non-bank. This is not precisely accurate because cycle was in a boom phase, creating various risks that were there are reasons to want banks to be more stable inadequately captured in traditional capital requirements. than non-banks that are less central to our financial Done properly, there are two advantages to the CCyB. First, system and payments functions. However, moving it should result in higher aggregate capital levels in the regulation in this general direction, with appropriate banking system when a recession or banking crisis hits, modifications, should increase financial stability and lowering the damage. Second, by making banking activities reduce the impact of recessions. more expensive, it should at least moderately slow the

32 BANKING PERSPECTIVES QUARTER 1 2019 growth in lending and other financial activities during a This topic is too complex to do justice to in this boom, potentially reducing the risk of a crisis. short space, but I believe there should be a more active debate in the U.S. on countercyclical macroprudential One of the great theoretical advantages of the CCyB policy. A number of countries around the globe have is that it provides a buffer that can be used without now implemented such policies, including the U.K., and significant stigma or other negative effects. If regulators believe they are important tools to use going forward. have raised capital requirements by 2 percentage points Even the U.S. took countercyclical macroprudential through the CCyB during a boom, they can drop that actions for decades prior to a disastrous experiment down again to 0 without singling out any particular bank with one version under President Jimmy Carter in and while maintaining perfect intellectual consistency. 1980. (Earlier, less radical efforts had generally had (The CCyB was put in place because of a boom and is the intended counter-cyclical effects to at least some taken away when the boom turns into a bust.) extent.) Readers interested in a long-term view of U.S. macroprudential policies should see a paper I co- If U.S. authorities were to choose to use this tool now, it authored, “The History of Cyclical Macroprudential would mean raising the CCyB from zero to some positive Policy in the United States.”4 level, with the intent of bringing it back down if future conditions warranted. The primary argument for doing CONCLUSION this would be a belief that the credit cycle has moved into Like death and taxes, recessions are a certainty. a late stage where risks are higher than they appear. Bankers and regulators must carefully consider how the many changes in the financial system and its regulation Multiple other countercyclical macroprudential tools could affect us the next time around. It would be even exist, including more targeted approaches, such as raising better if we started taking actions now that would reduce the minimum underwriting standards for mortgages those impacts. n when the housing sector appears to be overheating. ENDNOTES The arguments against countercyclical macroprudential 1 Rustom M. Irani, Raymakal Iyer, Ralf R. Meisenzahl, and Jose-Luis Peydro, “The Rise of Shadow Banking: Evidence from Capital tools are largely the same across the different tools, Regulation,” Finance and Economics Discussion Series 2018-039. including the CCyB, although any specific tool may face Washington: Board of Governors of the Federal Reserve System. some additional technical concerns. The big picture https://doi.org/10.17016/FEDS.2018.039 2 G. Buchak, G. Matvos, T. Piskorski, and A. Seru, “Fintech, questions are: Will regulators know the right time to Regulatory Arbitrage, and the Rise of Shadow Banks,” Working put them in place? Will they have the political will and Paper, University of Chicago, 2017. strength to do so and not be overridden, and can they 3 Dan Rosenbaum, “Thinking Ahead: A Late-Cycle Checklist for US really unwind them appropriately? Regional Banks,” Oliver Wyman, 2018. https://www.oliverwyman. com/our-expertise/insights/2018/nov/thinking-ahead-a-late- cycle-checklist-for-us-regional-banks.html Done badly, the CCyB and other such tools could either 4 Douglas J. Elliott, Gregory Feldberg and Andreas Lehnert, “The be useless, because the authorities never pull the trigger, History of Cyclical Macroprudential Policy in the United States,” Federal Reserve Board Staff Working Paper 2013-29. or even harmful, if bureaucratic or political pressures cause them to be triggered unnecessarily.

BANKING PERSPECTIVES QUARTER 1 2019 33 EXPECTATIONS AND ECONOMICS OF FINANCIAL CRISES

BY NICOLA GENNAIOLI, BOCCONI UNIVERSITY,

AND ANDREI SHLEIFER, HARVARD UNIVERSITY

STANDARD MODELS OF EXPECTATIONS CANNOT EXPLAIN THE 2008 FINANCIAL CRISIS. WE OFFER A MORE REALISTIC ALTERNATIVE.

Editor’s Note: This article is based on the book A Crisis of Beliefs: Investor Psychology and Financial Fragility, Princeton University Press, 2018.

34 BANKING PERSPECTIVES QUARTER 1 2019 BANKING PERSPECTIVES QUARTER 1 2019 35 Expectations and Economics of Financial Crises

THE COLLAPSE of the investment bank Lehman Brothers on Sunday, September 14, 2008, caught almost everyone by surprise. It surprised investors, who dumped stocks and brought the market index down by 500 points on Monday. It surprised policymakers, who rushed to rescue other financial institutions after declaring for months that there would be no government bailouts. It also surprised economic forecasters. Only six weeks before the Lehman bankruptcy, in early August 2008, both the Federal Reserve and professional forecasters predicted continued growth of the U.S. economy. Contrary to that prediction, the U.S. financial system nearly melted down after the Lehman bankruptcy, and the economy slid into a deep recession. Why was the Lehman crisis such a surprise? After all, The relative quiet before the storm, expressed in both fragility had been building up in the financial system for the official and private-sector forecasts of the economy quite some time. In the mid-2000s, the U.S. economy and the speeches of government officials, gives us went through a massive housing bubble. As home important clues as to why Lehman was such a surprise. It Tprices rose, households levered up to buy homes with surely was not the news of Lehman’s financial weakness mortgages. Banks and other financial institutions levered per se, since the investment bank was in trouble and up to hold mortgages and mortgage-backed securities. expected to be sold for several months prior to its As the bubble deflated after 2006, the financial system September bankruptcy. U.S. banks more generally were experienced considerable stress, as reflected in runs on making large losses for several months as the housing financial institutions, followed by bankruptcies, rescues, and mortgage markets deteriorated, and no major and mergers. Yet the system and the economy stayed economic news surfaced that weekend. Nor can the afloat until the fall of 2008, supported by successful surprise be attributed to the government’s reiteration of interventions by the Federal Reserve aimed to avoid a its “no bailout” policy. For if that were the reason for the financial panic. By mid-2008, investors and regulators collapse, the markets would have bounced back as soon expected that, despite the deflating housing bubble, the as it became clear on Monday that bailouts were back in. situation was under control. On May 7, 2008, Treasury In fact, markets bounced around a bit but continued their Secretary Henry Paulson said that “the worst is likely to be slide as the financial system deteriorated over the next behind us.” On June 9, 2008, Fed Chairman Ben Bernanke several weeks, despite all the bailouts. stated that “the danger that the economy has fallen into a ‘substantial downturn’ appears to have waned.” The evidence about the beliefs of investors and policymakers instead tells us that the news in the Lehman demise was the extreme fragility of the financial system The relative quiet before the storm, compared with what was previously thought. Despite consistently bad news over the course of 2008, investors expressed in both the official and and policymakers came to believe that they had dodged private-sector forecasts of the economy the bullet of a major crisis. The pressures building up and the speeches of government officials, from home price declines and mortgage defaults were attenuated by the belief that the banks’ exposure was gives us important clues as to why limited and alleviated by effective liquidity support from Lehman was such a surprise. the Fed. The risks of a major crisis were neglected. The Lehman bankruptcy and the fire sales it ignited showed investors and policymakers that the financial system was

36 BANKING PERSPECTIVES QUARTER 1 2019 more vulnerable, fragile, and interconnected than they research. Expectations in financial markets tend to be previously thought. Their lack of appreciation of extreme extrapolative rather than rational, and this basic feature downside risks was mistaken. The Lehman bankruptcy needs to be integrated into economic analysis. Second, had such a huge impact because it triggered a major we provide an empirically motivated and psychologically correction of expectations. grounded formal model, called diagnostic expectations, that can be used across a variety of domains. Third, we A decade after Lehman’s collapse, economists agree that use this model of expectation formation to account for the underestimation of risks building up in the financial the central features – including both market outcomes system was an important cause of the financial crisis. In and beliefs – of the 2008 crisis both before and after October 2017, the University of Chicago surveyed a panel Lehman and to explain credit cycles and financial of leading economists in the United States and Europe fragility more generally. Getting the psychology right on the importance of various factors contributing to the allows us to shed light on the conditions under which 2008 global financial crisis. The No. 1 contributing factor financial markets are vulnerable to booms and busts. among the panelists was the “flawed financial sector” in terms of regulation and supervision. But the No. 2 factor SURVEY DATA ON EXPECTATIONS among the 12 considered, ranking just below the first in A natural starting point for assessing the significance of estimated importance, was “underestimation of risks” financial “instability from beliefs” is to analyze the beliefs from financial engineering. The experts seem to agree that themselves. This entails not only directly measuring the fragility of a highly leveraged financial system exposed expectations of market participants and systematically to major housing risk was not fully appreciated in the testing whether these beliefs are rational, but also period leading up to the crisis. characterizing the type of mistakes that investors make.

These judgments are made with the benefit of This enterprise is feasible because a wealth of available hindsight. The world, however, has witnessed an extensive survey data reports the beliefs of investors, corporate history of financial bubbles, expanding credit, and managers, households, and professional forecasters. subsequent crises as the bubbles deflated. Errors in beliefs This data offers important insights on whether, in 2008 appear in multiple narratives. Classic studies such as and in other historical episodes, investors appreciated Kindleberger (1978), Minsky (1977), and more recently the risks building up before the crisis or alternatively Reinhart and Rogoff (2009) argue that the failure of failed to see the trouble coming. More generally, survey investors to accurately assess risks is a common thread data helps identify regular patterns in beliefs during of many of these episodes. Rajan (2006) and Taleb (2007) economic fluctuations, needed to develop better theories stressed the dangers from low probability risks to financial of expectation formation and credit cycles. stability. Even before the Lehman bankruptcy, Gerardi et al. (2008) drew attention to expectation errors in the For the period leading to the 2008 crisis, we have a developing subprime crisis. Since the 2008 crisis, a great good deal of data on the expectations of homebuyers deal of new systematic evidence on credit cycles, both for about future home price growth, on investor beliefs the United States and worldwide, has been assembled, about the risk of home price declines and mortgage starting with the pioneering work of Greenwood and defaults, and on forecasts of economic activity made by Hanson (2013). Much of this work points to errors in both private forecasters and the Federal Reserve. We expectations over the course of the cycle. We take this also have a variety of contemporaneous documents and point of view further and put inaccurate beliefs at the speeches of policymakers, as well as discussions at the center of the analysis of financial fragility. Federal Open Market Committee (FOMC) meetings, which shed light on the beliefs of policymakers. We Our argument proceeds in three steps. First, we can then ask directly: What were homebuyers, banks, show that survey expectations data are a valid and investors, and policymakers thinking as the events extremely useful source of information for economic leading up to the crisis unfolded?

BANKING PERSPECTIVES QUARTER 1 2019 37 Expectations and Economics of Financial Crises

The answers to this question cast doubt on the “too big protected from bad shocks by diversification and hedging to fail” theory of the crisis, which holds that the banks before the 2008 crisis. knew the risks but gambled on bailouts. The expectations of bank executives and employees seem to be very similar Looking at beliefs data also sheds light on financial to those of other investors. Bankers were optimistic about fragility more broadly, beyond the financial crisis. A housing markets and made loans as well as personal home great deal of survey data on investor and professional purchases accordingly. There is no evidence that bankers forecaster expectations about not only stock markets, understood the risks better than anybody else. individual stocks, and credit markets, but also the real economy is available and can be examined. We argue that Beliefs are more in line with the classical analyses of extrapolation of past trends is in fact a common feature Kindleberger (1978) and Minsky (1977) that emphasize of expectations held by investors, corporate managers, excessive optimism before crises. Homebuyers were and professional forecasters. The neglect of downside risk unrealistically optimistic about future home price growth. is present in several documented instances of financial Investors in mortgages and in securities backed by these innovation. The kinds of patterns we see in 2008 appear in mortgages, including financial institutions, considered the other financial and economic episodes. possibility that home prices might fall but did not fully appreciate how much and what havoc these declines would DIAGNOSTIC EXPECTATIONS wreak. And macroeconomic forecasters from both the The empirical facts on expectations in the run-up to private sector and the Federal Reserve did not, in forming and during the 2008 financial crisis present a challenge their expectations, recognize the risks facing the U.S. for the standard theory of rational expectations. Nor financial sector and the economy as late as the summer can naive theories of irrational beliefs explain how of 2008. The evidence does not suggest that investors or extrapolation and neglected downside risk are connected policymakers were totally naive or oblivious to the risks in and how they come and go. Adaptive expectations, a the financial system. Rather, they did not fully appreciate theory of mechanical extrapolation of past trends, can tail risks until the Lehman collapse laid them bare. explain the growth of the housing bubble but not why the system stayed afloat after the bubble started deflating in What were homebuyers, banks, 2006 or why a single event such as the failure of Lehman induced such a drastic revision of expectations. investors, and policymakers thinking as the events leading up to the crisis unfolded? We present one psychologically founded theory of expectation formation, which we call diagnostic The answers to this question cast doubt expectations. We have developed this theory over the on the “too big to fail” theory of the crisis, past several years together with Pedro Bordalo and have taken it both theoretically and empirically to a number of different domains with Katherine Coffman, Yueran Ma, and Rafael La Porta. In developing this model The data on beliefs prior to the Lehman crisis point of expectations, we are guided by several principal to two key patterns: the extrapolation of past home considerations. First, we would like a theory of beliefs price growth into the future, and the neglect of unlikely to be biologically and psychologically plausible, and in downside risks. Extrapolation of past home price particular based on the evidence on human judgment growth sheds light on the housing bubble. Neglected obtained in experimental data. Next, we would like downside risk explains how the financial system became the same theory to explain evidence in psychological so leveraged. This levering up of both households and experiments, social judgments individuals make, financial financial institutions was most plausibly supported by markets, and perhaps other domains. Finally, we would the widely shared beliefs that the prices of homes were like a theory in which beliefs are forward-looking and unlikely to collapse and that financial institutions were a theory that can be testable using survey evidence.

38 BANKING PERSPECTIVES QUARTER 1 2019 The theory is surely not the last word in modeling high-growth scenarios to be representative and recessions expectations, but it suggests that one can make some to be unrepresentative, leading investors to both neglect progress in understanding the reality of financial markets. downside risk and to display excess optimism about average conditions. News pointing to reduced volatility Our model of expectations builds on the famous renders extreme shocks unrepresentative, leading investors representativeness heuristic of human judgment under to neglect risk. Diagnostic expectations also generate uncertainty initially proposed by psychologists Daniel systematic reversals of optimism and pessimism in Kahneman and Amos Tversky in 1972. According the absence of news. When trends in news cool off, no to Kahneman and Tversky (1983), “an attribute is particular outcome is representative and expectations revert representative of a class if it is very diagnostic, that is, if the toward rationality. If the corrective news is bad enough, the relative frequency of this attribute is much higher in that left tail becomes representative and investors display excess class than in a relevant reference class.” Representativeness pessimism. These movements in beliefs are entirely due to entails a judgment error of overestimating the likelihood of investors’ overreaction to objectively useful information, representative attributes in a class. not to their mechanical extrapolation of the past.

To illustrate, suppose someone is asked to predict the most likely hair color of an Irish person. In several The market panic, asset fire sales, informal surveys we conducted, many people said red. runs on financial institutions, mergers It is absolutely the case that red hair is objectively more common among the Irish than among other humans: to avoid bankruptcy, and of course government 10% of the Irish have red hair, compared to 1% of others. rescues can be viewed as reflecting – at least But because red hair is a representative attribute of the in part – the massive revision of Irish, people tend to believe that the Irish are even more likely to have red hair than they actually do. Judgments expectations about financial fragility. by representativeness contain a kernel of truth in that they respond to information in the objectively correct direction. However, they do so excessively. DIAGNOSTIC EXPECTATION AND THE 2008 Applied to expectations in macroeconomics and finance, FINANCIAL CRISIS representativeness has some distinctive implications. Diagnostic expectations provide a useful unifying The kernel of truth principle implies that people tend to account of the 2008 crisis. They can serve as a foundation of overweight future outcomes that become more likely in extrapolative beliefs that characterized the housing bubble, light of incoming data. Just as they overreact to the news which can be seen as updating and overreacting to repeated that a person is Irish in estimating the color of their hair, good news about home prices and general economic they react to macroeconomic news in the correct direction conditions. But they can also account for the neglect of but excessively. Good macroeconomic news makes good downside risk, due to good news both about economic future outcomes more representative, and therefore conditions (which rendered the left tail unrepresentative) overweighted, in judgments about future states of the and about the safety of financial institutions. More world. The converse is true for bad macroeconomic news. subtly, diagnostic expectations can account for the quiet The same principles of belief formation that apply to lab period between the first tremors in housing and financial experiments and social judgments translate one-for-one markets in the summer of 2007, which the Fed contained into our model of diagnostic expectations. so successfully, and the eventual Lehman crisis. Even though the housing bubble was deflating and expectations Under some conditions, diagnostic expectations tie about economic conditions were revised downward, the together extrapolation and neglect of tail risk. News perception of tail risks remained dampened due to Fed pointing to higher likelihood of economic growth causes policies and to the “diversification myth,” an exaggerated

BANKING PERSPECTIVES QUARTER 1 2019 39 Expectations and Economics of Financial Crises

faith in the new insurance mechanisms. Diagnostic model of expectations derived from first principles expectations may thus explain why both Federal Reserve of psychology. Our model of beliefs – diagnostic and private-sector forecasts of future economic activity expectations – can be incorporated into standard made as late as August 2008 point to a widely shared – and macroeconomic analysis. It is testable – and has been exaggerated – belief that, despite the early tremors, the tested – using survey expectations data. We believe it not situation was under control. only fits the evidence on the 2008 financial crisis but also provides the foundation for future work on the role of The theory also accounts for the extreme reaction to beliefs and their impact on economic outcomes. n the Lehman bankruptcy, as the tail risks to the financial system came out into the open and market participants REFERENCES reacted. The Lehman bankruptcy revealed that the Gerardi, Kristopher, Andreas Lehnert, Shane M. Sherlund, and Paul Willen. 2008. “Making Sense of the Subprime Crisis.” Brookings situation was far from being under control, that financial Papers on Economic Activity (Fall 2008): 69-159. institutions were highly interconnected, so that systemic Greenwood, Robin, and Samuel G. Hanson. 2013. “Issuer Quality and risk was much higher than previously expected. As a Corporate Bond Returns.” Review of Financial Studies 26(6): 1483-525. consequence, the previously neglected left tail became Kahneman, Daniel, and Amos Tversky. 1983. “Extensional versus representative, causing beliefs to overweight the black Intuitive Reasoning: The Conjunction Fallacy in Probability Judgment.” Psychological Review 90(4): 293-315. swan of a financial meltdown. The market panic, asset Kindleberger, Charles P. 1978. Manias, Panics, and Crashes: A History fire sales, runs on financial institutions, mergers to of Financial Crises, 1st ed. New York: Basic Books. avoid bankruptcy, and of course government rescues can Manski, Charles F. 2004. “Measuring Expectations.” Econometrica 72(5): 1329-76. be viewed as reflecting – at least in part – the massive Minsky, Hyman P. 1977. “The Financial Instability Hypothesis: An revision of expectations about financial fragility. The Interpretation of Keynes and an Alternative to ‘Standard’ Theory.” Nebraska Journal of Economics and Business 16(1): 5-16. Lehman crisis was a crisis of beliefs. Rajan, Raghuram G. 2006. “Has Finance Made the World Riskier?” European Financial Management 12(4): 499-533. To summarize, we provide a new narrative of the Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: 2008 financial crisis that assigns a central role to beliefs Princeton University Press. in accounting for both periods of quiet and those of Taleb, Nassim N. 2007. The Black Swan: The Impact of the Highly Improbable. New York: Random House. significant volatility. More broadly, we propose a new

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www.debevoise.com THE CECL APPROACH

THE CURRENT EXPECTED CREDIT LOSS APPROACH IS A GOOD IDEA THAT WILL YIELD PROCYCLICALITY.

42 BANKING PERSPECTIVES QUARTER 1 2019 THE CECL APPROACH

BY STEPHEN G. RYAN, STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

BANKING PERSPECTIVES QUARTER 1 2019 43 The CECL Approach

EFFECTIVE IN 2020 for Securities and Exchange Commission registrant banks (and 2022 for private banks), U.S. generally accepted accounting principles (GAAP) will require banks to accrue for credit losses on loans and other financial assets using the current expected credit loss (CECL) approach. Under CECL, banks that make loans of any type will record provisions for loan losses (PLLs) at loan inception that equal the current expected credit losses on the loans over their entire lives. Subsequently, banks will record PLLs only when the current expected credit losses on loans change. Banks will estimate current expected credit losses based on historical loan performance (for example, loss rates), current economic conditions, and reasonable and supportable forecasts of future economic conditions, when they are able to develop such forecasts.

Banks will record considerably higher PLLs at loan as economic conditions change, thereby making banks, inception under CECL than under the current incurred loss bank regulators, and market participants better aware of Emodel (ILM), particularly for certain loan types. Under the changing economic conditions and their implications for ILM, a bank that makes a loan records a PLL at inception banks’ loan losses and overall solvency. Such awareness only for losses that are incurred, probable, and capable of should have beneficial effects on financial stability. reasonable estimation. At the inception of heterogeneous loan types (for example, commercial loans), which banks On the other hand, CECL fits uncomfortably in the evaluate primarily on a loan-by-loan basis, banks typically existing GAAP model for gross loans outstanding and record minimal if any PLLs under the ILM because of the interest revenue, which are based on promised (not difficulty of meeting its three conditions for loss accrual at expected) principal and interest payments. In this essay, the individual loan level. At the inception of homogeneous I explain how this uncomfortable fit yields PLLs that are loan types, which banks primarily evaluate at the portfolio more poorly matched to interest revenue under CECL level, banks typically record PLLs under the ILM and bank than under the ILM. I explain how this worse income regulatory guidance equal to the expected charge-offs statement matching yields more procyclical effects on of the loans over the next 12 months. This amount can banks’ income and capital under CECL than under the be thought of as bank regulators’ rough proxy for credit ILM. I describe the conceptually correct approach that losses that currently meet the ILM’s three conditions for eliminates these procyclical effects while keeping CECL. loan loss accrual. Depending on the type of homogeneous Because accounting standard setters are unlikely to make loan, 12 months may be similar to (for example, credit these changes, I explain an approach that bank regulators card loans), somewhat less than (auto loans), or much could use to approximate the changes. less than (residential mortgages) the remaining lifetime of the loan. Hence, under CECL, banks will record far larger I also explain how CECL likely will yield procyclical PLLs PLLs at inception for both heterogeneous and long-lived after loan inception by expanding the set of loans for which homogeneous loan types than they accrued under the ILM. banks accrue loan losses over the entire remaining lives of the loans. As a consequence of this expansion, banks likely Similar in some respects to fair-value accounting, CECL will record larger PLLs when bad times occur after loan has considerable conceptual attractiveness for both the inception under CECL than under the ILM, despite the management and the evaluation of banks. In particular, fact that CECL requires banks to record larger PLLs at loan CECL requires banks to devote attention and resources inception. While there are no obvious conceptually correct to estimate their current expected credit losses and to ex ways to modify CECL or other accounting requirements to post evaluate (for example, back-test) any forecasts they solve this problem, I provide some guidance regarding how use to make these estimates. These estimates will change bank regulators can best address it.

44 BANKING PERSPECTIVES QUARTER 1 2019 Finally, I explain how the larger PLLs recorded at Similar in some respects to fair-value inception and perhaps subsequently under CECL than under the ILM require bank regulators to rethink accounting, CECL has considerable regulatory capital requirements. conceptual attractiveness for both the THE ILM VS. CECL management and the evaluation of banks. I begin with a brief discussion of the ILM’s three conditions for loan loss accrual. First, loan losses must be “incurred,” which means rooted in the present. Conceptually, CECL substantially weakens the ILM’s conditions both a loss is incurred when the borrower’s ability to pay that losses are incurred and that losses can be reasonably deteriorates unexpectedly after the inception of the loan, so estimated, in part by requiring banks to incorporate that the deterioration could not have been factored into the reasonable and supportable forecasts of future economic loan’s contractual interest rate and other terms. Second, loan conditions into their estimates of expected credit losses, losses must be “probable,” which in practice typically is a high and in part by requiring the accrual of expected lifetime probability threshold, such as 70% or 80%. This condition credit losses for all loans at inception. is difficult to satisfy at the individual loan level (that is, for heterogeneous loans) until loans are close to default but is As described earlier, under CECL, banks will record easy to meet at the portfolio level (for homogeneous loans), much larger PLLs at inception for both heterogeneous even at loan inception. Third, loan losses must be capable loan types and long-lived homogeneous loan types than of reasonable estimation, which means the loss can be they accrued under the ILM. While this is the case in both estimated with adequate accuracy based on historical data or good and bad economic times, it will yield procyclical other evidence. This condition is also much easier to satisfy at effects on bank lending primarily in bad times, when the portfolio level than at the individual loan level. banks will be less willing and able to record such PLLs and thus less willing and able to lend. CECL was motivated by two related allegations,1 neither of which should be viewed as a fact. First, it is alleged that In addition, I predict that banks likely will record the ILM’s three conditions for loan loss accrual delay banks’ larger PLLs when bad times occur after loan inception recording of PLLs in good times when realized credit losses under CECL than under the ILM, even though CECL (for example, loan charge-offs) are low. This allegation makes requires banks to record larger PLLs at loan inception. more sense for heterogeneous loans, for which the three The primary reason is that the lifetime loss rates used conditions are hard to meet, than for homogeneous loans, for under CECL likely will rise more in bad times than which the conditions are easier to meet. Second, it is alleged the 12-month (for homogeneous loans) or other (for that this delay requires banks to accrue excessively large and heterogeneous loans) loss rates used for loans that are unexpected PLLs in bad times when realized credit losses not currently severely delinquent under the ILM. rise. This allegation ignores the fact that the ILM’s three conditions also apply in bad times, particularly for loans that Because of the effects on banks’ PLLs both at and after are not yet severely delinquent. It also ignores the fact that a loan initiation, bank regulators and other policymakers will lot of information about banks’ loan performance other than have increased incentives to provide inducements for banks PLLs (for example, delinquencies) is available to banks, bank to lend in bad times under CECL than under the ILM. regulators, and market participants. Such inducements could include suspending or weakening CECL, reducing regulatory capital requirements, and Regardless of their correctness, CECL addresses these injecting capital, among other possibilities. allegations in two primary ways. First, it eliminates the ILM’s probable condition. Under CECL, banks are THE PROBLEM AT LOAN INITIATION required to accrue for future loan losses that they expect Under U.S. GAAP, banks account for gross loans to occur with any probability, no matter how low. Second, outstanding and interest revenue as follows. At loan

BANKING PERSPECTIVES QUARTER 1 2019 45 The CECL Approach

The conceptually correct solution without reducing their income or their incentive to lend. The effective interest rate should be calculated as the internal rate to the income-matching problem is of return that equates the amount lent to the expected, not not to jettison CECL; it is instead to change promised, principal and interest payments. Interest revenue thus would reflect only the higher expected return on the accounting for gross loans credit-riskier loans, not the benefits of possibly receiving the outstanding and interest revenue. promised payments. Therefore, there would be no potential for mismatching the costs of making credit-risky loans to these benefits. This approach is similar to that currently required under GAAP for acquired credit-impaired loans inception, gross loans outstanding equals the amount lent, (although there is no difference between gross and net loans and the effective interest rate is calculated as the internal outstanding for these loans at acquisition). rate of return that equates the amount lent to the present value of the promised principal and interest payments. A MORE-FEASIBLE (BAND-AID) APPROACH The effective interest rate is higher for credit-riskier loans, Despite the conceptual correctness of the approach holding the promised principal and interest payments described above, the Financial Accounting Standards Board constant, because the amount lent is smaller. The potential (FASB) has shown no inclination to change the accounting benefits of writing credit-riskier loans – for example, the for gross loans outstanding and interest revenue. Assuming (typically quite high) possibility of receiving the promised that this remains the case, bank regulators could approximate payments despite the credit risk – is reflected in higher the conceptually correct approach and eliminate the interest revenue over the life of the loans. disincentive for banks to lend in bad times by adding the (after-tax) PLL recorded at loan inception to bank capital. Under CECL, the expected costs of writing credit-risky This increment would need to be amortized over the life loans are reflected in their entirety in the PLL recorded at of loans to match the interest revenue recorded using the loan inception. In contrast, under the ILM, only a portion of effective interest rate calculated based on the promised these expected costs are reflected in the PLL recorded at loan payments on the loan. Bank regulators would also need to inception. Hence, there will be worse matching of the interest modify capital requirements in the fashion described below. revenue and PLL under CECL than there is currently under the ILM, not that the matching under the ILM is good. THE PROBLEM AFTER LOAN INITIATION The effect of banks’ use of CECL rather than the ILM Relatedly, because gross loans outstanding equals the on their PLLs after loan initiation reflects the net result amount lent at loan inception, under CECL net loans of three effects. First, CECL requires banks to accrue outstanding at loan inception will equal the amount lent for lifetime credit losses on all loans, whereas the ILM less the PLL at inception. Banks thus will write down requires them to accrue for lifetime credit losses only on loans at inception more under CECL than under the ILM, severely delinquent or otherwise impaired loans. Because as if they made worse lending decisions. These write- fewer loans become severely impaired when moving from downs will be larger the higher the credit risk of the loans. bad times to good times, this effect will tend to require larger PLLs under CECL than under the ILM in good THE CONCEPTUALLY CORRECT APPROACH times. Likewise, the reverse is true: Because more loans The conceptually correct solution to the income-matching become severely impaired when moving from good times problem is not to jettison CECL; it is instead to change the to bad times, this effect will tend to require smaller PLLs accounting for gross loans outstanding and interest revenue. under CECL than under the ILM in bad times. This is the Gross loans outstanding should equal the amount lent plus effect that critics of the ILM emphasize. the PLL at inception, so that net loans outstanding equals the amount lent at inception. This approach would enable Second, loss rates rise when moving from bad times to banks to record the increased PLL at inception under CECL good times (and fall when moving from good times to bad

46 BANKING PERSPECTIVES QUARTER 1 2019 times), both for loans that are currently severely delinquent mitigate the procyclical effects of CECL by suspending or and for loans that are not. These changes in loss rates weakening its requirements during bad times, they will naturally are larger for losses over the remaining life of increase bank opacity and thereby reduce the confidence of loans than for losses over any shorter period; for example, market participants in the stability of the banking system. the 12-month horizon over which banks typically accrue for Preferable approaches would be for bank regulators or loan losses on homogeneous loans that are not yet severely the federal government to systematically or in another delinquent is shorter than the remaining life of most transparent fashion reduce regulatory capital requirements types of these loans. Hence, banks’ PLLs will reflect larger or inject capital into banks as early as feasible in bad times. decreases in loss rates when moving from bad times to good times (and increases when moving from good times RETHINKING BANK CAPITAL REQUIREMENTS to bad times) under CECL than under the ILM. This effect Bank regulators should adjust regulatory capital works in the opposite direction of the first effect. Moreover, requirements to reflect the accounting approaches used, all this effect is likely to dominate the first effect unless the else being equal. Capital requirements currently are based third effect described below is sufficiently strong. on the idea that banks reduce capital for recognized credit losses and hold capital against unrecognized credit losses. Third, under CECL, banks are required to incorporate Assuming we retain the current accounting approach for reasonable and supportable forecasts of economic gross loans outstanding and interest revenue, more credit conditions into their PLLs. Historically, the macroeconomic losses will be recognized cumulatively under CECL than cycle has been moderately predictable, with good times under the ILM, thereby reducing bank capital. Therefore, followed by bad times and vice versa, although the bank regulators should reduce capital requirements upon periodicity of the cycle has varied. Most other economic banks’ adoption of CECL, unless bank regulators’ goal is to cycles that affect loan credit losses, such as for real estate exploit this adoption to increase capital requirements. and other asset prices, have been considerably less predictable. Hence, banks have some ability to forecast Even if banks were certain the cycle future good times when times are currently bad, and future bad times when times are currently good. Were this ability will turn (a perhaps rosy premise in sufficiently strong, it would substantially weaken the second today’s world), their ability to develop effect and render the first effect dominant. reasonable and supportable forecasts of There is no evidence of which I am aware that banks the timing and strength of these (or other parties, such as bank regulators) have the ability turns is doubtful. to forecast cycle turns over periods of appreciable length. Even if banks were certain the cycle will turn (a perhaps rosy premise in today’s world), their ability to develop reasonable and supportable forecasts of the timing and On the other hand, in the sadly unlikely event that strength of these turns is doubtful. Hence, I predict that the the FASB adopted the conceptually correct approach second effect will dominate, and banks’ PLLs recorded after to accounting for gross loans outstanding and interest loan initiations will be more procyclical under CECL than revenue described above, banks’ PLLs recorded at loan under the ILM. inception under CECL or any other approach would have no effect on their capital. Only PLLs recorded after loan SOLUTION? inception would affect bank capital. In this event, bank It is not clear that there are any good solutions to this regulators should increase capital requirements. n problem, which results from the unalterable fact that the world is an uncertain place. Bank regulators and other ENDNOTE 1 Remarks by John C. Dugan, Comptroller of the Currency before policymakers can address this problem in better and the Institute of International Bankers, “Loan Loss Provisioning and worse fashions, however. If bank regulators attempt to Pro-cyclicality,” March 2, 2009.

BANKING PERSPECTIVES QUARTER 1 2019 47 BALANCING BANKING REGULATION TO DEAL WITH RISKY LENDING AND RUNS 48 BANKING PERSPECTIVES QUARTER 1 2019 WHEN BANKS PERFORM MULTIPLE SERVICES, REGULATING THEM GETS EVEN MORE COMPLICATED. THE FRICTIONS THAT MAKE THE SERVICES VALUABLE WILL DRIVE A WEDGE BETWEEN PRIVATE AND BANKING SOCIAL OBJECTIVES.

BY ANIL KASHYAP,1 UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS, REGULATION BANK OF ENGLAND, NBER, AND CEPR,

DIMITRIOS P. TSOMOCOS, SAÏD BUSINESS SCHOOL AND ST. EDMUND HALL, UNIVERSITY OF OXFORD,

AND ALEXANDROS P. VARDOULAKIS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

BANKING PERSPECTIVES QUARTER 1 2019 49 Balancing Banking Regulation to Deal with Risky Lending and Runs

THERE IS A SURPRISING DISCONNECT between the theory that we teach about financial intermediation and the ongoing debates about how financial institutions ought to be regulated. In this essay, we explore that tension. Throughout, we will refer to these institutions as banks, but understand that non-banks may often also undertake some of these activities, and it is often conceptually hard to explain why regulations are based on organizational form rather than function.

Banking theory suggests that intermediaries arise (and that provide savers with valuable liquidity services. That create value) through various channels. One explanation paper has gone through several revisions, and in the supposes that their purpose is to create claims that course of these alterations, we have experimented with can be traded but are backed by illiquid assets.2 Other different assumptions and found that most plausible ones theories suppose that what makes banks special is their deliver similar implications. In what follows, we stress ability to expand credit to certain type of borrowers, in implications of our framework that are generic in the particular because they can more efficiently monitor them sense of holding across several variants of the model.6 Tand collect on loans granted.3,4 Finally, some theories emphasize the ability of banks to improve risk-sharing by We will see that studying environments where banks creating securities (for example, deposits and equity) that provide multiple services delivers new insights, especially differ in the risk that the owners of the securities face. regarding regulations. The frictions that create a role for banks also naturally create a gap between the choices Yet when we look at the major debates regarding that banks will make on their own (the privately optimal regulatory design, and/or the calibration of regulations, equilibrium) and what a social planner would prefer. The these theories tend to be absent from the discussion. For framework can be used to think about how regulations example, consider two of the most contentious aspects of can interact to close the gap between privately and socially bank capital regulation. One debate regards the level of optimal banking allocations. capital that banks should be required to hold. The other pertains to whether capital ratios should be compared The remainder of this essay is broken into four parts. with a risk-weighted concept of assets or with a simple We will begin by describing the baseline Diamond and sum of assets. In both debates, theory is rarely invoked Dybvig model on which our analysis built. After reviewing and, when it is, the central argument is usually a variant of their classic model, we describe the kind of assumptions the Modigliani and Miller propositions applies to banks.5 that one must make to create the possibility that banks can deliver multiple services to borrowers and savers. Alternatively, consider the new liquidity regulations that are coming into effect. Both the net stable funding We then describe the deviations between the private ratio and the liquidity coverage ratio were designed allocations chosen by the banks, savers, and entrepreneurs from scratch without appeal to any particular theory. and those that a benevolent social planner would choose. We will see that in some cases these two regulations are The planner has to trade off fixing various distortions, and potentially redundant. the choices will depend on how much the planner cares about the different actors in the economy. This essay is based on a paper (Kashyap, Tsomocos, and Vardoulakis [2019]) that explores what happens The third section of the analysis explores how when banks do two things. One is to monitor borrowers regulations can be used to implement the objectives of the to support lending, and the other is to offer deposits social planner. One important finding is that run risk is

50 BANKING PERSPECTIVES QUARTER 1 2019 harmful to banks, savers, and borrowers. However, there liquidated early repays only the principal that was lent. are multiple ways to lower the run risk that differ in the So, direct lending by individuals is a poor way to deal with incidence across the different actors in the model. For uncertain liquidity needs because when the savers need to example, alternative strategies for reducing run risk can consume early, they receive no interest. lower bank profits, reduce deposit services, and/or limit credit extension. Different agents view these outcomes As another alternative, suppose a firm (we will call it differently and hence have different preferences for how a bank) collects deposits from many savers and makes run risk is controlled. Put differently, decreasing run loans to many entrepreneurs. This bank can reduce the risk or eliminating runs altogether is not the primary idiosyncratic risk that each borrower faces. By diversifying social objective; rather, it is a by-product of trying to across many savers, the bank can take some of the interest maximize overall social surplus. The social surplus has that will arrive in two periods and pay part of it out to the two components, the windfall created by reducing run people withdrawing early. This arrangement reduces how risk and the way that the surplus is allocated across much can be paid to the patient savers. However, because agents (because a planner does not necessarily weight savers are not sure whether or not they are patient, they everyone equally). A second important observation is welcome this kind of arrangement. that a regulator will need to use multiple tools jointly to approximate what a planner would like to accomplish. Decreasing run risk or Finally, we offer some concluding remarks about eliminating runs altogether directions for further research. is not the primary social objective; 1. BANKING ENVIRONMENT rather, it is a by-product of trying Our model is a generalization of the classic Diamond and Dybvig (1983) banking model (DD going forward). to maximize overall social surplus. Their setup was initially stark, designed to emphasize one consideration. So, we begin by reviewing their environment and then explain how and why we amend it. The amount promised to the early withdrawers will depend on how many of them there are, relative to the A REFRESHER ON THE DIAMOND-DYBVIG MODEL patient savers and the profitability of loans (that are not In DD, some people (savers) have money that can be called early). Essentially, the bank is a vehicle by which lent but have no investment opportunities. There is an the savers who are patient end up insuring the savers who investment opportunity that requires funding and delivers wind up being impatient. If there is competition between payoffs in two periods. In our rendition of the model, this banks for deposits, it will force bank profits to be very low, investment opportunity will be available to entrepreneurs so essentially all the interest collected from the loans is who have no resources. A saver has uncertain needs to paid out to the savers. The central question is how much consume that are purely idiosyncratic. In particular, some of this interest is offered to earlier withdrawers. of them will need money after one period, while others can wait two periods. The savers do not know whether The banking solution appears to be a better risk- they will need liquidity early or not. sharing arrangement than having each person self- insure via direct lending. However, the bank is fragile Consider two ways to handle the uncertain need for in the following sense. If more people than anticipated access to funds. Suppose a saver were to make a direct request their money back early, the bank may have to loan to an entrepreneur. If the saver learns that she needs liquidate so many loans to satisfy the withdrawals that it the funds after one period, the loan can be recalled. cannot fully meet the promised payments that are due to However, the interest payment in this case is zero; think the patient savers. In that case, the patient savers have to of this as a technological constraint, where a loan that is make a conjecture about what other patient savers might

BANKING PERSPECTIVES QUARTER 1 2019 51 Balancing Banking Regulation to Deal with Risky Lending and Runs

do. If enough of them opt to ask for their money early, We make five modifications to their original setup. We the bank will run out of funds in the course of paying off assume that banks (and savers) can invest in a riskless, the early withdrawals. safe asset (not just loans). We also assume loans have an uncertain payoff, rather than being completely safe, The problem arises because the only way that the early as in DD. This pair of assumptions about the assets that withdrawals are being paid is by liquidating loans, so there are available to the banks introduces a trade-off between may be insufficient remaining loans to fully pay the patient safety and profitability. The banks make more money by depositors. This means that it can be individually rational making loans but are more exposed to run risk when they for a depositor who believes others are going to redeem opt to make more loans and hold fewer safe assets. early to do so also, even if that depositor has no immediate need for funds. In other words, a run can be self-fulfilling. Our third change is to suppose that entrepreneurs and banks are subject to limited liability. This assumption is realistic, and accounting for it opens up two interesting It can be individually rational for possibilities that are absent in DD. First, the banks now have a depositor who believes others a reason to take excessive risk to exploit the limited liability. In DD, it is well known that offering deposit insurance are going to redeem early to do so also, would eliminate run risk without creating any other even if that depositor has no immediate problems. With limited liability for the banks, introducing deposit insurance would exacerbate the temptation of banks need for funds. In other words, a to gamble by extending even more loans. Our extension run can be self-fulfilling. allows us to investigate the idea that banks sometimes excessively gamble at the taxpayers’ expense.

The other by-product of assuming that entrepreneurs GENERALIZING DIAMOND AND DYBVIG have limited liability is that it creates a role for banks to The DD model brilliantly captures the fragility that is monitor borrowers. We assume that banks can audit the inherent in having the bank provide liquidity services by entrepreneurs to see whether they have the ability to repay pooling risk. This is the reason that the model has been the loan or not. The choice to monitor is endogenous, so widely studied and is often used as a basis for policy in that the banks have to expect to receive enough extra discussions. Nonetheless, in making their point as simply in repayment from exerting the effort to undertake as possible, Diamond and Dybvig intentionally left out the auditing. This makes banks the efficient entities to many other important aspects of the financial system and generate loans and means that their presence in the the role banks play in the economy. In particular, the DD economy yields more lending than if individuals, who are model presumes that banks do not contribute to credit not good at auditing, had to make direct loans. extension and so the fragility is disconnected from banks’ capital structure and asset composition. Finally, we assume that banks are funded with equity and debt. This change delivers two benefits. First, it means Therefore, we have experimented with various that the price of equity is endogenously determined, so extensions of their framework that create the possibility that when capital regulation is contemplated, we have to that banks do not only provide liquidity services but also see whether investors are willing to supply more equity improve lending outcomes. The benefit of adding such funding. Often it is just assumed that as much equity is features is that we are able to address a much wider range needed will be available. of issues, while the cost is that the model becomes more complex. Whereas Diamond and Dybvig can solve their The main difficulty with introducing equity is that model analytically, we have to use numerical examples to it significantly complicates the calculation of the characterize the properties. equilibrium. The bank’s solvency is threatened by run

52 BANKING PERSPECTIVES QUARTER 1 2019 risk and the possibility of loans going bad. To simplify the These assumptions mean that the private decisions run decision, we suppose that depositors receive a signal do not fully account for the determinants of a run and about how much the liquidation value of a loan will be if the private equilibrium will not coincide with a socially it is recalled by the bank. The liquidation value is random. optimal equilibrium. A social planner would care about We make technical assumptions about the nature of the how runs directly affect banks, savers, and borrowers and signal so that the depositors follow a threshold rule, and would choose allocations accordingly. whenever the signal about the liquidation value exceeds a cutoff, patient depositors do not run. If the signal is below A natural way to compare private and social banking the threshold, they do run.7 choices is to group the deviations into three types. One reflects the asset mix (that is, the proportion of loans and 2. INEFFICIENCIES liquid assets). A second accounts for the liability mix (the Our modifications to DD not only create more socially proportion of deposits and equity). The third is the overall valuable roles that banks can play but also lead to reasons size of the balance sheet. The scale essentially depends on why private actors following only their own incentives will how many deposits savers are willing to supply and how make choices that a social planner would seek to improve. many loans the entrepreneurs take. These decisions can be summarized by the gap between the loan rate and the PRIVATE VS. SOCIAL EQUILIBRIA interest rate offered to patient depositors. Rich balance sheets allow banks to perform socially useful services but also expose them to run risk. One of There are other ways to categorize the differences, but the main points of our analysis is that private banking this one strikes us as particularly intuitive. Because the choice generates run externalities that adversely affect bank (or planner) can choose investment, liquid assets, the welfare of savers and borrowers. Run risk is harmful deposits, and equity but makes these choices while for all agents in the economy: banks, savers, and respecting the balance sheet identity, we would expect borrowers. But the trade-offs driving their respective there to be three independent choices. The exception to welfare differ. Banks would benefit from low run risk, this rule would be if there is some additional constraint (for but not at the expense of substantially lower profits. example, coming from regulation) that pushes the bank to a Savers would prefer lower run risk and more deposit corner by pinning down one of the margins. More typically, services, while borrowers would benefit from higher the social and private deviations differ according to how the investment accompanied by lower run risk. run risk distorts each of the three margins and by how the planner weighs the different agents. The private choices that the agents make work as follows. Banks are assumed to internalize how savers Correcting some of these distortions involves trade- and borrowers worry about run risk. Therefore, banks offs because the interventions skew allocations that favor choose the amount to lend and the interest rates on borrowers over savers (or vice versa). For instance, if deposits to maximize the value of equity, trading off the bank holds more safe assets and makes fewer loans, the structure of the balance sheet against the risk of a that marginally helps the savers because it makes their run (and accounting for the protection in bankruptcy deposits safer. Conversely, the opposite choice of more afforded by limited liability). Importantly, the bank does loans and fewer safe assets creates more opportunities for not directly care about what a run does to the welfare of the borrowers but reduces the buffer that helps mitigate borrowers and savers. the riskiness of deposits.

Savers and borrowers are small actors that ignore their We have modeled the banks so that they internalize effect on banks’ choices. More specifically, this means all the effects of their choices. This means that the social they take the loan and deposit schedules that a bank offers planner can never make the banks better off. In versions as given, although if they were to coordinate, they could of the model where bank contracts with depositors and influence these choices (and hence the run probability). borrowers are less sophisticated, this need not be true.

BANKING PERSPECTIVES QUARTER 1 2019 53 Balancing Banking Regulation to Deal with Risky Lending and Runs

However, we find it instructive to limit the number There are three ways that the planner can raise the of distortions that a planner is worrying about, so we probability of that depositors are repaid and hence reduce proceed with the assumptions that imply that the banks the risk of a run. One approach is to raise the numerator are also disadvantaged when the planner acts. in the equation by tilting the asset composition to consist of more liquid assets and fewer loans. The second RUN RISK approach is to reduce the denominator of the equation Generically, run risk is different than other types of by shifting the liability composition to consist of more risk from the perspective of the savers and entrepreneurs. equity and less debt. A third, subtler option is to raise When a bank is subject to a run, some of its borrowers the promised return to the patient depositors, so that the will see their loans liquidated to service the withdrawals. gains from not joining a run are higher. Notice that each Likewise, some savers may not be fully paid what they of these options will also affect the way that the gains from were promised. Both borrowers and lenders could be intermediation are divided between the banks, the savers, better off if the run could be prevented unless doing so and the borrowers. requires a dramatic reduction in the provision of deposit services or loan availability. In general, the choices that the planner will make we will depend on the weights that the planner places The externalities generated from runs play a central role on the three agents. Nonetheless, there are a couple in our analysis. Thus, it is essential to understand their basis of generic predictions about how the planner will in order to study ways to mitigate their adverse effect. Savers deviate from the privately optimal choices. First, when decide whether to run based on their conjecture about the the planner cares primarily about savers, then the bank’s ability to repay. The bank has two sources of funds allocations selected will be twisted to make the asset side that can be tapped to service early withdrawals: the liquid of the banks’ balance sheet safer. Raising the percentage assets it holds and the value of loans that can be recovered of assets that are liquid allows the bank to take more upon liquidation. The amount that bank has promised (if deposits, which is the primary thing that savers crave. everyone decides to try to withdraw) is the total value of The size of the banking sector rises. deposits plus the promised interest on those deposits at date one. If we take the ratio of these two figures, we get Second, when the planner cares primarily about the probability for the individual of being repaid. It will be borrowers, the allocations are tipped to generate more helpful to write out this expression for future reference: lending. This preference means the planner reduces the percentage of liquid assets that the bank holds. There is a limit on how far the planner can go in this direction Probability of payment because as the bank cuts back on liquid assets holdings, the savers will stop making deposits. In this case, the size Total funds available in a run = of the banking sector shrinks. Total promised payments In arranging allocations, if the planner wants banks to Liquid assets + Liquidated loans = monitor the entrepreneurs, the banks have to conclude Deposits + Interest that lending is sufficiently profitable to justify the effort. This constraint limits how far the lending can As mentioned earlier, the model has to be solved be cut because if lending becomes too low, the profits numerically – that is, picking values for the main from lending are not sufficient to justify monitoring parameters and then solving for the agent’s optimal borrowers. In this setup, the planner typically does not choices conditional on those values. To gauge the guarantee that borrowers always be repaid because doing robustness of our findings, we experimented with so would limit the banks’ profitability so much that they different parameter values, and statements that follow are would stop monitoring. Hence, runs may still occur even indicative of the results for many parameter sets. when the planner is determining allocations.

54 BANKING PERSPECTIVES QUARTER 1 2019 When the planner cares equally about the savers and sheet. The other alternative is to also include the value of borrowers, then we get a result that is a combination of loans that could be used to meet outflows in the very worst the more extreme possibilities. Run risk is reduced via all case regarding potential liquidation values. It turns out that three potential channels. In particular, the asset mix is either definition leads to similar findings. safer because there is a higher percentage of liquid assets. Deposit rates rise to deter runs and the banks increase The net stable funding ratio is essentially the mirror their percentage of equity financing so that the liability image of liquidity coverage ratio. It requires that illiquid side of the balance sheet is also safer. The combined assets are funded with stable liabilities. In our setup, the changes improve the welfare of borrowers and savers. numerator of the ratio is the combination of equity and the expected amount of patient deposits – though one 3. REGULATION could include a parameter to use to translate the expected The results regarding the planning solution follow from amount of patient deposits into an equity equivalent. The letting the planner simply pick the levels of loans, liquid denominator – that is, the illiquid assets – will be loans. assets, deposits, and equities subject to the constraints that savers, borrowers, and banks are voluntarily willing to hold these quantities. For example, the promised Once banks perform multiple return on deposits for the patient savers has to be higher services, regulating them becomes than on liquid assets; otherwise, they would just invest directly in liquid assets. The final step in the analysis is to more complicated. The frictions that make investigate what happens when there is no social planner the services valuable will drive a wedge but a regulator can choose requirements for capital and liquidity ratios to try to mimic what a planner might do. between private and social objectives.

REGULATORY TOOLS There are four potential regulatory tools that we focus on: two capital requirements and two liquidity requirements. In seeking to approximate the planning solution, a We view it as a strength of the modeling approach that we regulator must use multiple tools. It is possible to make can use it to analyze regulations that are similar in spirit the asset side of the balance sheet safer using liquidity to the main banking ratios that were recommended by the regulation. However, in shifting toward liquid assets and Basel Committee on Bank Supervision. away from lending, the entrepreneurs are made worse off. It is possible to raise the proportion of equity financing One of the capital regulations is the ratio of equity to using either of the capital regulations, which makes the total assets. There are no off-balance-sheet assets in our liability side of the balance sheet safer. Increasing the setup, and loans are the only risky, on-balance-sheet asset, leverage ratio creates an incentive to shift out of liquid so this leverage ratio is very simple. The other capital assets and toward lending, so the asset side of the balance ratio compares equity to loans, and this is akin to a risk- sheet becomes riskier. Using this tool helps the borrowers weighted capital ratio, where liquid assets are given a zero because so much more credit is extended, but it reduces risk weight and loans are given a weight of 1. the welfare of savers. The risk-weighted capital ratio limits the lending, so it helps savers but hurts borrowers. The liquidity coverage ratio is aimed at insuring that deposit outflows over a certain period (30 days, in practice) Mimicking the planner’s allocations requires using at are backstopped with funds that are readily available. In least one capital regulation and one liquidity regulation. our two-period setup, all deposits could potentially run, so These kinds of combinations can move both the liability the definition of outflows is clear. To decide on the available side and the asset side of the bank toward the planners’ funds, there are two potential choices. One would be to desired outcome. Importantly, some combinations, such count only liquid assets that are currently on the balance as using both a liquidity coverage ratio and a net stable

BANKING PERSPECTIVES QUARTER 1 2019 55 Balancing Banking Regulation to Deal with Risky Lending and Runs

funding ratio, do not work better as a pair because they try to move some of their risk-taking off of their balance operate on the same margins. Any improvements require sheets. The actual Basel regulatory ratios recognize the tools be distinct enough to fix different distortions. that banks have off-balance-sheet activities and seek to account for their presence. Nevertheless, understanding Given that there are three distortions in the private how multiple regulations interact in this environment equilibrium, one might conjecture that the regulator would be interesting. would need to have three tools to fix the three distortions. Our numerical analysis confirms this hunch. However, Alternatively, we could permit the arbitrage by allowing none of the capital and liquidity regulations are well suited for additional intermediaries, “shadow banks,” that could to deal with the distortion in the scale of intermediation. partially or perhaps fully evade bank regulations. Obviously, For instance, when the planner weights the savers and these entities have to be less efficient at banks at some borrowers equally, the planner wants a larger-balance functions; otherwise, they would drive the banks out of banking system (that has a safer mix of both assets and business. Exploring how the substitutability of activities liabilities). In this case, there are other tools that can be across organizations changes the efficacy of regulations also used to encourage the banks to expand their balance seems like a promising direction for future work. sheet to the level that the planner prefers. For example, a deposit subsidy (say, through the tax deductibility of Finally, because our model was derived from Diamond interest payments) would work. Likewise, a program and Dybvig’s work, it is not well suited for analyzing that subsidizes certain type of credit extension, such as dynamic issues. Working out what happens in a more a funding for lending program, could also be used to dynamic version of the model would also be valuable. change the level of intermediation. When a tool like one For example, in a more dynamic model, we could study of these is combined with a capital and liquidity tool, the the efficacy of both ex ante regulations and ex post ones, regulations can deliver outcomes that mimic the planner’s. such as bailouts. n CONCLUSION ENDNOTES Once banks perform multiple services, regulating them 1 This material is based on our paper, “Optimal Bank Regulation in the Presence of Credit and Run Risk.” All views are our own and becomes more complicated. The frictions that make the do not necessarily reflect the views of the Federal Reserve Board, services valuable will drive a wedge between private and the Federal Reserve System, or the Bank of England. social objectives. In our framework, banks take more 2 D.W. Diamond and P.H. Dybvig, “Bank Runs, Deposit Insurance and Liquidity,” Journal of Political Economy 91, no. 3 (1983), 401-419. lending risk and prefer to operate with higher leverage 3 D.W. Diamond, “Financial Intermediation and Delegated than a social planner would prefer. Both considerations Monitoring,” 51, no. 3 (1984): 393-414. make the risk of runs higher. A regulator can use a 4 D.W. Diamond and R.G. Rajan, “Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking,” Journal of Political combination of a capital and a liquidity regulation to Economy 109, no. 2 (2001), 287-327. correct these two distortions. The regulator will need 5 The appeal to Modigliani and Miller is somewhat puzzling since an additional tool to adjust the overall level of banking the standard theories of intermediation, such as the ones cited in the prior paragraph, do not satisfy the assumptions required for activity. Typically, that level will also be distorted. So, the capital structure invariance propositions to apply. to fully replicate a planner’s preferred outcomes, the 6 For instance, in prior versions, we also considered how allowing savers access to bank equity and deposits could offer insurance regulator would need to deploy three tools. against aggregate risk. This service is not unique to financial intermediaries and abstracting from this makes the model more There are two obvious directions of future research that tractable. See the following for a version of the analysis that includes this channel: A.K. Kashyap, D.P. Tsomocos, and A.P. seem particularly promising. One is to extend the analysis Vardoulakis, “How Does Macroprudential Regulation Change Bank so that some form of regulatory arbitrage is possible. This Credit Supply?” revision of National Bureau of Economic Research working paper 20165 (2017). could be modeled in several ways. One approach would 7 This approach was initially proposed by Goldstein and Pauzner, be to give banks access to off-balance-sheet assets. In this who assumed that the signal concerned the value of the loans in the final period. See I. Goldstein and A. Pauzner, “Demand– case, the liquidity and capital regulations that we have Deposit Contracts and the Probability of Bank Runs,” The Journal studied would be less potent because the banks could of Finance, 60 (2005): 1293-1327.

56 BANKING PERSPECTIVES QUARTER 1 2019 Banks Regulators and Digital Giants-Who Has the Consumers Trust.pdf 1 11/1/18 11:23 AM

Banks, Regulators, and Digital Giants: Who Has the Consumer’s Trust?

As retailers, banks, and other financial institutions grapple with the consequences of protecting customers’ private information, the question of who should be responsible for data privacy and security is more important than ever. Recent A.T. Kearney research finds that Americans are divided about how their data should be used and whether

C digital providers’ use of that data is an invasion of privacy. Furthermore, many Americans lack confidence in US data

M privacy and security regulations. Yet through it all, banks remain in a position of trust when it comes to personal

Y data, especially in comparison to digital service providers.

CM

MY Consumers look ƒirst to banks to exercise leadership in addressing data privacy and CY security concerns.

CMY Consumer views on parties responsible for protecting data privacy and security K who selected each option as an institution that should exercise leadership in addressing concerns related to data privacy and security among banked consumers †% ˆ‰% Š‹% Œˆ% Ž‹%

Banks Regulatory Government/ Retailers Digital service providers (e.g., agencies Congress Twitter, Facebook, Instagram) Question: If actions were required to protect your interest as it relates to data privacy and security, which of the following institutions would you look to, to exercise leadership to address any concerns on the topic you may have? Select all that apply. Source: A.T. Kearney Qƒ „ †‡ Consumer Digital Behavior Study (N=‡, ‘ƒ)

The key question is whether banks can find ways to operationalize their trust advantage and address consumers’ data privacy concerns and needs. Where is consumer data privacy on your strategic agenda? To learn more about the consumer data privacy marketplace and opportunities to help your customers manage data privacy, email [email protected] or visit www.atkearney.com/financial-services.

www.atkearney.com FRB AND FDIC CAST A CRITICAL EYE ON RESOLUTION PLANS

BY NEIL BLOOMFIELD AND KATE WELLMAN, MOORE & VAN ALLEN

WHILE THE LIVING-WILL PROCESS CONTINUES TO EVOLVE, IT IS LIKELY THAT MANY OF THE CENTRAL TENETS AND REQUIREMENTS WILL REMAIN IN PLACE FOR THE FORESEEABLE FUTURE.

58 BANKING PERSPECTIVES QUARTER 1 2019 BANKING PERSPECTIVES QUARTER 1 2019 59 FRB and FDIC Cast a Critical Eye on Resolution Plans

ON DECEMBER 20, 2018, the Federal Reserve Board (FRB) and the Federal Deposit Insurance Corporation (FDIC; together with the FRB, the Agencies) released their determinations regarding the 2018 resolution plans of four foreign banks and announced they had finalized resolution plan guidance applying to the eight U.S. global systemically important banks (G-SIBs).1

BACKGROUND ON RESOLUTION PLANS reduction of the size of their U.S. operations and adoption Resolution plans – or living wills, as they are of a regional single-point-of-entry (SPOE) strategy, under commonly called – are a product of Section 165(d) of which only a single U.S. subsidiary would enter bankruptcy the Dodd-Frank Act, which was passed in the wake of proceedings. The firms’ adoption of the SPOE strategy the 2007–2008 U.S. financial crisis. Section 165(d) and mirrors the approach taken by most major U.S. firms. its implementing rule2 (Resolution Plan Rule) require certain financial companies to develop and submit The shortcomings cited by the Agencies related to the on an annual basis the plan of each such company firms’ escalation triggers, which are intended to lead to Oto resolve itself in a quick and orderly manner in the increased communication and coordination between event of another financial crisis. For foreign banking foreign and U.S. entities during times of financial stress organizations (FBOs), the Resolution Plan Rule is focused if the triggers are breached. Under prior guidance on ensuring the reorganization or liquidation of an FBO’s released by the Agencies, triggers must be linked to U.S.-domiciled subsidiaries and operations in order to each firm’s methodology for forecasting the capital mitigate the risk that the failure of the entire company and liquidity needed to facilitate its U.S. resolution could negatively impact the U.S. financial system. strategy. The Agencies found that, while certain of the firms utilized liquidity-based escalation triggers, none AGENCIES IDENTIFY SHORTCOMINGS of the firms had capital-linked triggers, and one of the IN FOREIGN BANK PLANS WHILE firms exclusively relied on management discretion. The RECOGNIZING PROGRESS Agencies further identified shortcomings in the model The Agencies identified shortcomings in the 2018 plans and process behind one firm’s liquidity forecasting of the four FBOs – Barclays, Credit Suisse, Deutsche Bank, and in its mapping of shared critical services from its and UBS – which the firms will have to address in their foreign service entities to its U.S. subsidiaries. next resolution plan submissions, due by July 1, 2020. The Agencies stopped short of labeling the shortcomings Quantitative triggers – thresholds based on financial as “deficiencies.” Importantly, the Agencies did not find targets that require the board or senior management that any of the plans were not credible, which would to make decisions or take actions – continue to be an have resulted in additional prudential requirements if important element of recovery and resolution planning not corrected, including more stringent capital, leverage, for U.S.-based regulators. The prevailing view is that or liquidity requirements and restrictions on the firm’s management discretion is considered to be insufficient activities, growth, and operations. The foreign firms will because discretion can, in the regulators’ minds, lead need to submit project plans in April 2019 describing to a slow or inadequate response to a quantitative in detail how each one intends to address the identified event. Discretion does not need to be eliminated shortcomings in its 2020 resolution plans. because it creates flexibility, but it must be combined with hard triggers to generate attention and activity. In their determination, the Agencies also acknowledged improvements in the firms’ plans from their prior The Agencies’ letters suggest a larger point – growing submissions in July 2015, including the foreign firms’ interest in cross-border cooperation among global

60 BANKING PERSPECTIVES QUARTER 1 2019 regulators. Given that the financial institutions based process and resources could be extended to U.S. internal outside of the U.S. seamlessly provide services across recovery and resolution-planning management. multiple borders, the Agencies acknowledge that the best strategy for reducing risks to the financial stability The specific findings for the FBOs may not be of the U.S. is the successful resolution of the global particularly relevant to the U.S. G-SIBs. The findings operations of a foreign firm, not simply by attempting largely relate to concerns regarding communication to preserve assets for creditors in the U.S. The Agencies between the foreign parent and U.S. subsidiaries, which suggested they will proactively engage with foreign are not directly applicable to financial institutions that regulators and identified firms to support the joint are based in the U.S. The Agencies identified similar regulatory objectives. While it’s still early, it is possible shortcomings and deficiencies in the U.S. G-SIBs’ 2015 that the level of expressed expectation may signal some resolution plans related to their triggers, capital and lessening interest in ring-fencing, the holdings of bank liquidity forecasting methodology, and mapping of assets at a country level. As a word of caution, however, shared services and the financial institutions.7 On the the emerging direction of cross-border cooperation other hand, U.S. firms would be prudent to continue in recovery and resolution planning may wane if the to clearly structure and document the communication current favorable economic conditions subside. plans with their foreign operations and subsidiaries. RELEVANCE TO U.S. G-SIBS 2019 GUIDANCE CONTINUES TO FOCUS There are a few takeaways from the Agencies’ findings ON PCS AND DERIVATIVES AND for the U.S. G-SIBs as they prepare their 2019 resolution TRADING ACTIVITIES plans, which are due to the Agencies by July 1, 2019. Thefinal 2019 guidance for the U.S. G-SIBs largely mirrors proposed guidance released by the Agencies in June 2018, First, the findings are most instructive in showing the which adapted many aspects of the Agencies’ April 2016 Agencies’ continuing attention to and critical analysis guidance and added content regarding derivatives and of resolution plans. Since the beginning of the Trump trading activities and payment, clearing, and settlement administration, whether and in what form the living- (PCS) activities.8 The new rules continue to build on the will process will continue has been a subject of much feedback letters for the U.S. G-SIBs’ 2017 resolution plan debate. In a June 12, 2017, report, the U.S. Department submissions, which identified four areas that required work of the Treasury recommended numerous reforms, to improve resolvability, including PCS activities. including increasing the asset threshold triggering the requirement to submit resolution plans and adjusting the frequency of submission from annual to every The shortcomings cited by the other year.3 Congress and the Agencies have already Agencies related to the firms’ taken steps to implement a number of those reforms, including through the Agencies’ one-year extension escalation triggers, which are intended of the U.S. G-SIBs’ next filing deadline from July 1, to lead to increased communication and 2018, to July 1, 2019, in September 2017.4 Although the Agencies have signaled that they are considering further coordination between foreign and U.S. changes to both the 165(d) plans5 and the separate entities during times of financial resolution plans6 the FDIC requires from insured depository institutions (IDIs), the latest findings stress if the triggers are breached. send a strong message that the Agencies continue to value the resolution-planning process for the world’s largest financial institutions and to take seriously their Other than minor modifications, the remaining responsibility to review and critique these plans. The guidance remains similar to that released by the regulators’ learnings about the lack of communication Agencies in prior years. The final guidance consolidates

BANKING PERSPECTIVES QUARTER 1 2019 61 FRB and FDIC Cast a Critical Eye on Resolution Plans

all prior relevant guidance, indicates that any such a user or provider of PCS services and allowing a firm guidance not included has been superseded, and adds to identify key clients, FMUs, and agent banks from a new section outlining expected plan format and its own perspective rather than that of the client. The structure. The Agencies also preview in their comments Agencies’ comments preceding the final guidance also preceding the guidance that they intend to address provide some flexibility to firms in developing their firms’ capital and liquidity capabilities in future cycles. PCS playbooks by allowing a firm to tailor playbook content to the specific relationships with its key FMUs and agent banks, clarifying that content related to the The emerging direction of firm’s role as both a user and provider of a specific cross-border cooperation in PCS service may be provided in a single playbook, and endorsing the use of cross-references to other sections recovery and resolution planning may of the resolution plan if appropriate when discussing wane if the current favorable PCS-related liquidity capabilities. economic conditions subside. AGENCIES INCORPORATE COMMENTS SEEKING CLARIFICATION ON DERIVATIVES CAPABILITIES Building on prior guidance, the final 2019 AGENCIES CLARIFY PCS-RELATED TERMS guidance contains five subsections of derivatives- AND BUILD SOME FLEXIBILITY INTO related expectations that are intended to mitigate PCS PLAYBOOKS the risk posed to a dealer firm’s resolvability by its Consistent with the proposed guidance, the final derivatives and trading activities. The Agencies call guidance focuses on ensuring a firm’s continued access for development of resolution capabilities, including during resolution to PCS services, which facilitate booking practices and interaffiliate risk monitoring and a broad range of U.S. financial transactions. The controls, that are commensurate with the size, scope, guidance requires each firm to (i) identify key clients, and complexity of a firm’s derivatives portfolio, as well financial market utilities (FMUs), and agent banks as analysis of the firm’s strategy to stabilize and de-risk using quantitative and qualitative criteria; (ii) map its derivative portfolio in a resolution scenario. As in its material entities, critical operations, core business the PCS area, the Agencies have acknowledged the lines, and key clients to key FMUs and agent banks; significant progress dealer firms have made in this area and (iii) develop a playbook for each key FMU and and note that many of the expectations set forth in the agent bank reflecting the firm’s role(s) as a user and/ guidance reflect those improvements. or provider of PCS services. Among other things, those playbooks – which all of the U.S. G-SIBs began The final guidance also incorporates a number of the developing as part of their 2017 plan submissions – derivatives-related comments the Agencies received. must analyze the financial and operational impact to The final guidance clarifies that a dealer firm is only material entities and key clients in the event of adverse expected to provide information on compression action by an FMU or agent bank, describe contingency strategies – a method for managing interaffiliate risk – arrangements, and, for PCS users, discuss PCS-related if it anticipates relying on such strategies in resolution. liquidity sources and uses during business-as-usual Addressing the stabilization and de-risking strategy, conditions and in escalating financial stress. the final guidance gives a dealer firm the choice not to model its operational costs for executing that strategy In response to comments the Agencies received, the at the level of specific derivatives activities while final guidance adjusts the definition of certain PCS- specifying that such analyses should be more granular related terms and concepts, including by clarifying the than the material entity level. The final guidance circumstances under which a firm will be considered further clarifies certain derivatives-related terms and

62 BANKING PERSPECTIVES QUARTER 1 2019 expectations, including by confirming that “material other-year submission requirement for 165(d) derivatives entities” means a dealer firm’s material plans to future proposed rulemaking. entities that engage in derivatives activities. Overall, the final guidance reinforces the theme AGENCIES DECLINE TO INCORPORATE shown in the Agencies’ FBO plan determinations that CERTAIN REQUESTS FROM COMMENTERS while the living-will process continues to evolve, it IN FINAL GUIDANCE is likely here to stay, notwithstanding elections and Although the PCS and derivatives areas of the administration changes, and many of the central final guidance reflect feedback from commenters, tenets and requirements will remain in place for the the Agencies rejected or declined to address other foreseeable future. n comments, including:

• SPOE AS PREFERRED RESOLUTION Consistent with the proposed STRATEGY. Some commenters asked that the guidance, the final guidance Agencies acknowledge SPOE – which entails focuses on ensuring a firm’s continued the parent company sustaining its material entity subsidiaries with capital and liquidity access during resolution to PCS before entering bankruptcy proceedings services, which facilitate a broad itself – as a credible resolution strategy and eliminate any non-SPOE-related guidance. range of U.S. financial transactions. In response, the Agencies disavowed any single preferred strategy and noted that SPOE remains untested and has inherent challenges and difficulties. ENDNOTES 1 “Federal Reserve and FDIC Announce Resolution Plan Determina- tions for Four Foreign-Based Banks and Finalize Guidance for Eight • RECONSIDERATION OF PREPOSITIONING Domestic Banks,” press release, December 20, 2018. https://www. REQUIREMENTS. Other commenters asked federalreserve.gov/newsevents/pressreleases/bcreg20181220c.htm that the Agencies reconsider requiring 2 Electronic Code of Federal Regulation. https://www.ecfr. gov/cgi-bin/retrieveECFR?gp=&SID=745f36bbc567b55fbe- local prepositioning of capital and liquidity 7525379a8bb3d6&r=PART&n=12y4.0.1.1.13#se12.4.243_16 at material entities given firms’ adoption 3 “A Financial System That Creates Economic Opportunities: Banks of secured support agreements. Secured and Credit Unions,” U.S. Department of the Treasury, June 2017. https://www.treasury.gov/press-center/press-releases/Docu- support agreements, the commenters ments/A%20Financial%20System.pdf asserted, eliminate the need for prepositioning 4 “Agencies Extend Next Resolution Plan Filing Deadline for Certain by ensuring the availability of resources Domestic and Foreign Banks,” press release, September 28, 2017. https://www.federalreserve.gov/newsevents/pressreleases/bcre- in financial stress and providing for their g20170928a.htm distribution according to each entity’s specific 5 “Agencies Announce Joint Determinations for Living Wills,” press needs. The Agencies indicated that while release, December 19, 2017. https://www.federalreserve.gov/ newsevents/pressreleases/bcreg20171219a.htm they continue to consider the benefits and 6 “Keynote Remarks by Jelena McWilliams, Chairman, Federal Deposit drawbacks of secured support agreements, Insurance Corporation, to the 2018 Annual Conference of The they do not view these agreements as a Clearing House (TCH) and Bank Policy Institute (BPI),” November 28, 2018. https://www.fdic.gov/news/news/speeches/spnov2818.pdf substitute for local prepositioning. 7 “Agencies Announce Determinations and Provide Feedback on Resolution Plans of Eight Systemically Important, Domestic Banking • REFORMS TO IDI AND 165(D) PLAN PROCESS. Institutions,” press release, April 13, 2016. https://www.federalre- serve.gov/newsevents/pressreleases/bcreg20160413a.htm The Agencies also left calls for elimination of 8 Final guidance from the Board of Directors of the Federal Reserve the IDI plan requirement for firms that have Board. https://www.federalreserve.gov/newsevents/pressreleas- adopted SPOE and formalization of an every- es/files/bcreg20181220c5.pdf

BANKING PERSPECTIVES QUARTER 1 2019 63 A RECENT CONFERENCE SERVED AS AN OPPORTUNITY TO CATCH UP ON SOME OF THE ADVANTAGES AND POTENTIAL PROBLEMS OF FINTECH LENDERS. FINTECH AND THE NEW FINANCIAL LANDSCAPE

BY ITAY GOLDSTEIN, THE WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA,

JULAPA JAGTIANI, FEDERAL RESERVE BANK OF PHILADELPHIA,

AND AARON KLEIN, THE BROOKINGS INSTITUTION

64 BANKING PERSPECTIVES QUARTER 1 2019 FINTECH AND THE NEW FINANCIAL LANDSCAPE

Editor’s Note: The opinions expressed in this paper are the authors’ own views and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. FinTech and the New Financial Landscape

THE FEDERAL RESERVE BANK of Philadelphia, the Wharton School, the Bank Policy Institute, and the FDIC jointly held a conference called “Fintech and the New Financial Landscape” this past November that focused on potential disruption that FinTechs could cause and their impact on the financial landscape.1 This article provides an overview of the broad issues facing the financial industry in light of comments made during the conference discussions, broadly encapsulated as the “FinTech revolution.”

We want to understand how disruptive FinTech One population especially served by FinTechs are people lending affects the financial services industry and, more with thin credit files – those who have few pieces of data generally, the overall financial landscape and consumer on their traditional credit report and hence are frequently behavior. The optimistic scenario is clear: FinTech could assigned low or no composite credit score. FinTech benefit underserved consumers around the globe by lenders have been able to utilize nontraditional data to allowing approximately 2 billion unbanked consumers make more-informed decisions, sometimes providing to be connected to the financial system.2 It can also make credit to borrowers who otherwise would not have access Tprocesses more efficient for currently served borrowers. to loans.4 However, there is no specific target population However, FinTech’s potential could face substantial for FinTechs; different types of FinTech lenders aim at barriers. The regulatory structure built around the different populations. provision of financial services includes many assumptions, both stated and unstated, that new technologies are We also discuss some of the legal challenges that challenging. Moving to a new market equilibrium between FinTech lending faces. Consumer advocates have had established financial institutions and new FinTech lenders concerns about the use of alternative data in predicting will cause regulatory and market-based frictions that could a consumer’s ability and willingness to pay back a loan. result in unintended consequences. These concerns involve privacy and discrimination. One must balance them against the opportunity of expanding When we describe FinTech lending, we are not referring access to credit, which is valuable because many people to all online lending. After all, technology is not new have been left out of the financial system. in finance. Most credit card applications are online and decisions can be reached in seconds. We define lending We conclude with general thoughts about future as FinTech only if it involves advanced technology and challenges and the need for active debate involving nontraditional processes in credit decision-making, such academics, practitioners, and regulators. as utilizing alternative data about consumers (including utility payments, medical payments, rent, etc.). Below, we 1. HOW ALTERNATIVE DATA, ARTIFICIAL review the types of data that FinTech lenders use as well as INTELLIGENCE (AI), AND MACHINE their advantages and potential disadvantages. LEARNING (ML) HAVE TRANSFORMED LENDING LANDSCAPES We also review the target population of FinTech FinTech lenders use technology to obtain new kinds lenders. A common assumption is that FinTech lenders of data that can make lending decisions more efficient target younger borrowers, particularly millennials. and informed. However, data shows that about 60% of consumers who borrow from FinTech lenders are over 40 and that the age CASH-FLOW DATA: FinTech lenders utilize distribution of consumers who take loans from FinTech additional (that is, nontraditional) data such as cash lenders is similar to that of borrowers from traditional flows and bank transactions for credit decisions, lenders (banks, credit unions, and finance companies).3 unlike the traditional approach. For example, Petal

66 BANKING PERSPECTIVES QUARTER 1 2019 relies heavily on cash-flow data analysis for its credit The optimistic scenario is clear: decision-making, which is easy to understand because cash flows are a close proximate of a consumer’s ability FinTech could benefit underserved to pay back a loan, perhaps more illustrative than consumers around the globe by allowing backward-looking data on a consumer’s repayment of prior loans. Hence, this new technology has substantial approximately 2 billion unbanked opportunity to improve upon the industry-dominant consumers to be connected to model of credit report underwriting. the financial system.

Cash flows could serve as (almost) a real-time update of a consumer’s financial situation through salary as well as utility and medical payments, alimony, and BIG DATA, ALTERNATIVE DATA, AND ADVANCED other fixed expenses. Unlike data from rating agencies AI TECHNOLOGY: Alternative data tells a lot about a or consumer credit panels (CCPs) (such as the Equifax, consumer’s life, such as wealth (assets, equity, loan to Experian, and TransUnion), cash-flow data would value, tax payments, cars [brand, age, how many]), cash immediately reveal any gaps between income and flow (salary, rental, utility, alimony, medical payments), expenses while the traditional CCP data would become lifestyle (education major, grade point average, school available after a lag. attended, occupation, appearance [weight/height], number of dependents), digital footprints and web tracking (where In addition, consumer behaviors observed through the consumer has visited, shopping habits), device tracking bank transactions could reveal additional information (how fast the consumer scrolls as well as typing speed about the type of the consumer and the patterns of and accuracy), and social profiles (network, topics that a behavior. For example, some people spend quickly and person is engaged in). Over time and with technological never save, while others spend money slowly and put development, an increasing amount of information what they can into savings. becomes available and could potentially be used for credit decisions with rich-enough models. More data is needed to build a robust credit- risk model that accounts for changes in economic SOCIAL MEDIA DATA: Most FinTech lenders claim circumstances. CCP data could be useful to understand not to use social media information in credit decisions, how consumers behaved in the past recession. A long instead using this type of information for marketing history of data would allow for a deeper understanding and fraud-detection purposes. One concern about of trends and a consumer’s behavior. social media data is that the relationships are likely to be unstable, and thus models would likely fail to predict We need a broader ecosystem to facilitate deeper default, especially during or after economic contractions. and more liquid markets for cash-flow-based loans. The potential use of social media footprints as they relate Secondary market structures to securitize consumer to protected classes, including race, gender, and age, is credit have been defined by FICO scores: Market another concern. participants broadly understand a securitization of loans from consumers who have FICOs in the 720s or RECENT DEVELOPMENTS AT RATING AGENCIES: 660s. Could similar structures exist for consumers with Traditional credit rating agencies like FICO and $300+ excess cash per month? Part of this ecosystem VantageScore recently have attempted to incorporate involves financial regulators. Regulatory rules, guidance, some additional data into the ratings, using bank and and experience often have been based on credit scores. non-bank data such as utility and rent payments. For Regulators could incorporate a broader set of credit example, FICO, through its financial inclusion initiative, risk factors in defining rules and guidance to adapt to a has explored more-advanced modeling techniques potential cash-flow underwriting system. often used by FinTech lenders. These complex models,

BANKING PERSPECTIVES QUARTER 1 2019 67 FinTech and the New Financial Landscape

however, often present their own set of challenges and identify the “invisible prime.” While cash flows and bank limitations in terms of interpretability.5 Recognizing transactions are closely related to a consumer’s ability to AI’s challenges, an AI tool could be used to build better pay, the data has not yet been factored into mainstream models if used with appropriate controls. In addition, credit ratings. Petal pulls and aggregates all financial VantageScore is incorporating some trend data (rather information across several sources and institutions. than status at a point in time) as well as utility payments.6 Through this automated process, FinTech lenders could The new approach would explore trends and look back at prequalify those “invisible prime” consumers in seconds through a consumer’s history trying to learn more about and at significantly lower cost. periods where some are rated as prime but have been deteriorating, or others are rated nonprime but have been Another firm, Urjanet, performs this task using data improving in credit ratings. on $70 billion of utility payments for consumers in 43 countries. It argues that 100 million more consumers have been able to access credit through its utility payment Tying small business lending to information. Overall, these FinTech lenders claim to make payment processing allows greater loans to the “invisible prime” at a lower interest rate than alternatives currently available to them (for example, security for the lender; while the loan is still payday loans and subprime credit cards) and have losses technically unsecured by a physical or financial below industry average.8

asset, the lender can be repaid directly Students, recent graduates from universities, and through the gross receipts processed immigrants usually have thin credit files. Given that some for the business. are likely to have high and stable earnings, particularly graduates of top universities or immigrants with established high-income jobs, they are a natural target of FinTech lenders. However, this category represents only a small fraction of thin-file consumers who have been 2. FINTECH IMPACT ON CONSUMER served by FinTech firms. ACCESS TO CREDIT FinTech lenders focus on diverse sets of consumers. MIDDLE-INCOME CONSUMERS: Some FinTech Some FinTech companies chase prime consumers while lenders, including Avant and Amount, do not focus on others look to serve near-prime and subprime consumers. prime or subprime customers but look to serve those in between – so-called middle-income consumers. These are BELOW PRIME AND THE “INVISIBLE PRIME” not people with thin credit files; instead, they have longer CONSUMERS: A presentation by Upstart’s Paul Gu histories and thicker files but do not always get access to shows that 33% of borrowers with FICO scores below 620 credit easily and not usually at a good rate. Through their default, suggesting that the other 67% did not default. partnership with traditional banks, these FinTech firms Using alternative data and AI algorithms, FinTech provide white-label service and technology solution to lenders promise to identify from the subprime pool those bank partners – helping large and small banks digitize consumers who are less risky. In other words, FinTech their lending processes. Due to banks’ legacy structures lenders could identify those who will perform as prime and products, it is argued that they often could not easily customers but who are not identified as such.7 build their own platforms.

One example is Elevate, which has reported that it has PRIME CONSUMERS: Some other FinTech lenders, served 2 million nonprime consumers in the U.S. and such as Marlette Funding, focus on prime consumers who U.K., using electronic platforms and nontraditional data. have mature credit histories and documented histories of Another is Petal, which uses cash-flow underwriting to good incomes. This segment of consumers may be viewed

68 BANKING PERSPECTIVES QUARTER 1 2019 as currently being well served by traditional lenders. leading to California passing the historic Small Business The focus of these lenders is on a more-efficient lending Borrowers’ Bill of Rights.9 process, providing consumers with more convenience and transparency. Some prime consumers prefer to deal with 3. HOW TO PROTECT CONSUMERS AND FinTech lenders and may be willing to pay a premium PROMOTE FINTECH INNOVATIONS for convenience – loan applications can be completed in Fast technological development has led to many minutes and funding can be obtained within 24 hours for challenges involving the legal framework and the three- to five-year terms. FinTech lenders apply innovative boundaries delineating how lending should be conducted. tools to consumer banking as they leverage their ability to tap into dozens of data sources (with thousands more CHALLENGES WITH DATA AGGREGATORS AND AI items of data) through the API protocol and Amazon Web VENDORS: The amounts of data generated raise major Services cloud base. Partner banks, such as Cross River questions about the future use, storage, and aggregation Bank and WebBank, could originate the loans so that the of this vast amount of new information. In the keynote FinTech lenders do not need to obtain their own license in speech that opened the conference, Federal Reserve each state. FinTech lenders could utilize technology to more Governor Lael Brainard noted that “the world is creating accurately or more efficiently perform risk-based pricing. data to feed those models at an ever-increasing rate. Whereas in 2013 it was estimated that 90% of the world’s SMALL-BUSINESS OWNERS: Several firms conduct data had been created in the prior two years, by 2016, small-business lending, including PayPal, OnDeck, IBM estimated that 90% of global data had been created LendingClub, Funding Circle, and Kabbage. They all have in the prior year alone. The pace and ubiquity of AI unique advantages and specialize in different small- innovation have surprised even experts.”10 business products – for example, loan amounts range from $5,000 to $400,000, maturities range from 30 days to seven years, and the annual percentage rate (APR) This is an opportune time for academics, ranges from less than 10% to over 200%. FinTech lenders such as PayPal, Amazon, and Square have a comparative practitioners, and regulators to engage advantage with access to cash-flows data (through their in debate over the landscape of the financial own payment platforms) allowing for additional insights into how a borrower’s business performance compares industry’s future. What will the market with other similar business owners. structure become?

Tying small-business lending to payment processing also allows a greater security for the lender; while the loan is still technically unsecured by a physical or financial Indeed, this vast amount of data and advanced asset, the lender can be repaid directly through the gross technology have presented the possibility for enhanced receipts processed for the business. Hence, access to credit-risk models that would allow more consumers on credit can be expanded to those small-business owners the margins of the current credit system to be included who may have a short credit history but are not likely in the financial system because of their improved credit to default. Unlike the situation for consumers, there are standing. FinTech lenders could build and utilize more- fewer legal or regulatory protections for small-business complex models for better credit decision-making and owners engaging in small-business borrowing. Some more-accurate risk-pricing as well as bringing greater small-business owners had to take very short-term loans speed to credit decisions. Several data aggregators and at extremely high rates, and they may not be aware of AI vendors have also emerged to serve as white-label the actual APRs that they are getting. Absent federal platforms for traditional lenders to enhance their action, state governments have attempted to increase credit decision-making process. But there exist several transparency to protect small-business borrowers, data consortiums that contain a gigantic amount of

BANKING PERSPECTIVES QUARTER 1 2019 69 FinTech and the New Financial Landscape

consumer data and are currently not regulated. It is not in her speech, AI can unknowingly incorporate gender clear who owns the data. Consumers may not be aware factors, such as attendance at an all-woman’s college, as of what information about them is being used, for what part of the ML process. Incorporation of such a factor purpose, and by whom – thus potentially having their in a credit algorithm would be highly problematic. privacy violated. However, gender is an allowable factor for underwriting in the business of insurance. Car insurance premiums Protecting consumer information is clearly an explicitly differ for men and women, with substantial important goal. Recently, data aggregators and AI price differences for teenagers based on gender. Legal vendors have considered blockchain technology as and regulatory protections differ even within what a way to provide decentralized permission access to constitutes a protected class within financial services. consumer data so that lenders could use the data for These differences will translate into different adoption credit decisions without actually seeing the data – and, challenges for FinTech firms and financial institutions therefore, with little or no chance of losing data and incorporating AI, ML, and big data. allowing for more protection to consumers. One concern around this approach (when consumers start limiting 4. LOOKING AHEAD data access to FinTech lenders) is that it might limit FinTech activities are progressing fast and penetrating lenders’ ability to train the models. It is important for all all areas of the financial system. Recent developments the regulatory agencies to work together to find the right reflect increased collaboration and partnerships between balance between protecting consumers and encouraging traditional lenders and FinTech platforms. The use of AI/ more FinTech innovations. ML and data collection has been growing exponentially. While consumers could send their data to specific lenders/ DEFINING FAIR LENDING AND PROTECTED providers, the automation through AI/ML processes and CLASSES: According to the Fair Credit Report Act data aggregation could enhance efficiency, reduce costs, (FCRA), the use of social media data in credit decision- and further expand credit access – within regulatory making may not be legal. While there has been a lot of compliance. Several AI/ML vendors (including traditional talk about lenders using social media data for credit firms such as IBM Watson and Promontory, its consulting decisions, most lenders argue that they do not really use firm) have also been serving lenders in this space. the data because of FCRA regulation.11 Other online data Partnership opportunities between banks and FinTech such as online footprints and shopping habits have been firms have been increasing. used in credit decisions. Overall, FinTech lenders have serious concerns about AI and big data are necessary to expand credit access the lack of clarity under the current regulatory and legal but not sufficient. FinTech lenders need policy guidance regime, as well as question about where we are headed. related to the use of ML techniques – what determines There are also concerns regarding compliance with too disparate impact; whether it is all right to use bank many different sets of rules. Although some aspects and other payment transactions; whether to use data of the market are marching ahead, others are delayed from households versus individual accounts; use of pending regulatory approval. FinTech approaches a consumer’s character and other non-credit data to expose issues with basic assumptions of our entire decline credit applications. system: 1) the dual charter and regulatory regime of federal and state governments; 2) where the line is The application of AI, ML, and big data is particularly drawn between banking and commerce; 3) the ability challenging given the unique and differing laws of credit providers to comply with legal and regulatory covering protected classes from illegal discrimination. requirements (knowing why credit is denied, disparate For example, gender is a protected class, and its impact, what is/isn’t a protected class); 4) incorporating consideration in providing access to credit or the terms new technology that probes the boundaries of acceptable of credit is illegal. As Fed Governor Brainard remarked behavior while offering possibilities of benefits to many.

70 BANKING PERSPECTIVES QUARTER 1 2019 There is room for concerted effort involving scholars, What will the market structure become? Will the new policymakers, and regulators to clarify the framework FinTech players threaten the existence of established going forward. financial institutions? What will be the response of these institutions to such threats? What are the effects of In addition to the AI/ML algorithms, there has FinTech on the well-being of different participants, and been a lot of hype about how blockchain technology will it ultimately lead to better outcomes for borrowers could potentially disrupt the entire financial service and consumers? These are all questions that need to be industry. Blockchain platforms have been used in several evaluated using empirical and theoretical analysis that applications, most notably for cryptocurrencies and could be conducted by academics and relying on the initial coin offerings. However, there may have been hands-on experience of practitioners and regulators. The misunderstandings about the blockchain applications conference was a great opportunity to catch up on some and their potential as a mainstream technology for of these issues, and we are sure that much more debate the future. For example, the conference highlighted will follow in future events and writings. n that smart contracts can exist independently without a blockchain.12 In addition, a speaker from Cambridge ENDNOTES Quantum Computing explained that current encryption 1 More information about the conference (including papers, presentation slides, speaker bios, and videos) are available technology might no longer be effective because from the conference website: https://philadelphiafed.org/bank- quantum computing will be fast enough to hack even resources/supervision-and-regulation/events/2018/fintech the blockchain platforms; the only effective encryption 2 This has been documented in Julapa Jagtiani and John Kose, “Fintech: The Impact on Consumers and Regulatory Responses,” process of the future would require quantum computing Journal of Economics and Business 100 (2018): 1-6. technology. There are many uncertainties regarding the 3 See TransUnion (TU) study by John Wirth (2018), “Fact Versus rapid advance in technology. Fiction: Fintech Lenders,” presentation slides and video are available through the conference website. 4 See Julapa Jagtiani and Cathy Lemieux (2018a), “The Roles A final issue to consider relates to financial stability. of Alternative Data and Machine Learning in Fintech Lending: Evidence from the LendingClub Consumer Platform,” Federal Unlike banks, FinTech firms do not take deposits, and Reserve Bank of Philadelphia, Research Working Paper #18-15. thus they need to rely on private investors (through 5 See FICO study by Gerald Fahner (2018), “Developing Transparent peer-to-peer or marketplace lending) and capital Credit Risk Scorecards More Effectively: An Explainable Artificial Intelligence Approach,” presentation slides and video are available market funding through securitization or loan sale through the conference website. to financial institutions. Through securitization, they 6 See VantageScore study by Nick Rose and Jeff Richardson (2018), are also required to self-fund part of the loan pools on “Impacts of Trended Data on Consumer Risk Scores,” presentation slides and video are available through the conference website. their balance sheets (as required by the Dodd-Frank 7 See Jagtiani and C. Lemieux, op cit. Act). Like any new business model, there are concerns 8 See Upstart’s presentation by Paul Gu (available on the that FinTech lending has not gone through an entire conference website) and see Knowledge@Wharton (2018) “How Fintech Serves the ‘Invisible Prime’ Borrower,” interview of Ken economic cycle. During a recession, FinTech funding Rees, CEO of Elevate (November 27, 2018). Available at this link: could dry up – thus potentially driving most of the http://knowledge.wharton.upenn.edu/article/fintech-serving- invisible-prime-borrower/ FinTech lenders out of business. Another concern is 9 For more detail, see presentation by Louis Caditz-Peck (Director that risks are sent off the balance sheet for the FinTech of Public Policy, LendingClub) on “Responsible Small Business and into the capital markets, and so the impact of a Lending,” available on the conference website. 10 See Governor Lael Brainard’s speech titled “What Are We Learning downturn on FinTech firms themselves may be limited, about Artificial Intelligence in Financial Services?” given at the but the effects will spill over to other players who have conference on “Fintech and the New Financial Landscape,” at the purchased the loans. Technology can improve lending, Federal Reserve Bank of Philadelphia, PA (November 13, 2018). Link: https://www.federalreserve.gov/newsevents/speech/ but risk cannot be completely eliminated. brainard20181113a.htm 11 Facebook, for example, has an agreement with all users to not use Facebook data for credit decisions. This is an opportune time for academics, 12 See Hanna Halaburda (2018), “Blockchain Revolution Without the practitioners, and regulators to engage in debate Blockchain,” Bank of Canada Staff Analytical Note 2018-5; video over the landscape of the financial industry’s future. of the discussion is also available from the conference website.

BANKING PERSPECTIVES QUARTER 1 2019 71 Bank Conditions Index

The Bank Conditions Index (BCI), which provides a Exhibit 2 depicts the heat map of the BCI for each summary measure of the condition of the U.S. banking of the six categories that make up the aggregate index. system, shows an extremely resilient system, reflecting in Values near 100 (higher resiliency) are shown in blue; large part the very strong capital and liquidity positions of values near 0 (higher vulnerability) are shown in red. banks as well as a prudent stance on loan originations. The capital, liquidity, and risk aversion categories exhibit very high levels of resiliency in the third quarter The index rose in the third quarter of 2018, as shown of 2018, in part because of the post-crisis regulatory in Exhibit 1. Over the last two quarters improvements in reforms. The remaining three components – asset the BCI were widespread across almost all categories of quality, interconnectedness, and profitability – show the index. Specifically, in the third quarter the increase levels of resiliency that are close to historical standards. in resilience in the BCI was driven by improvements In addition, five of the six subcomponents of the BCI – in profitability, liquidity, and asset quality. Overall, capital, liquidity, asset quality, interconnectedness, and the BCI remains well above the level that maximizes profitability – became more resilient in the third quarter of the contribution of the index in tracking future GDP 2018. Of those, the liquidity, asset quality, and profitability growth, suggesting that risk aversion by banks or categories showed significant improvements in their degree banking regulations continue to be holding back of resiliency. Only the risk aversion category experienced a economic growth somewhat. decline in the degree of resiliency this quarter.

The increase in the resiliency observed in the liquidity EXHIBIT 1: AGGREGATE INDEX OF RESILIENCE category was driven by an increase in BPI’s proxy for OF THE U.S. BANKING SYSTEM the net stable funding ratio (NSFR) and a decrease in the maturity mismatch between assets and liabilities. 100 The share of liabilities financed by short-term wholesale funding was about unchanged. The NSFR is a measure of bank liquidity over a one-year horizon, and it is 75 defined as the ratio of a bank’s available stable funding to its required stable funding. The former includes the sum of weighted capital and liabilities, while the latter is B 50 made up of assets that have different weights meant to measure the illiquidity of the assets. The increase in the RESILIENCE estimated NSFR in the third quarter of 2018 was driven by a decrease in the amount of required stable funding. 25 Overall, U.S. banks continued to have highly liquid balance sheets and sizable liquidity buffers, and banks’ share of high-quality liquid assets remained very elevated. 0 1995Q1 2000Q1 2005Q1 2010Q1 2015Q1 Bank profitability continues to recover, as measured QUARTER Souce ccutions by improvements in banks’ return on assets and return

Note: BPI* denotes the estimate of the optimal level of the BCI, that is the value of the index that on equity, which are now close to historical standards. maximizes the contribution of the BCI in tracking future GDP growth. Net interest margins and noninterest income edged up as well. These components of the profitability category

72 BANKING PERSPECTIVES QUARTER 1 2019 EXHIBIT 2: HEAT MAP OF ALL CATEGORIES OF THE BANK CONDITIONS INDEX

AGGREGATE 100.0 MORE RESILIENT

CAPITAL

LIQUIDITY

RISK AVERSION 50.0 LESS RESILIENT

ASSET QUALITY

INTERCONNECTEDNESS

PROFITABILITY 0.0

1995 2000 2005 2010 2015

Note: Values near 100 (higher resiliency) are shown in blue while values near 0 (higher vulnerability) are shown in red. Source: BPI calculations

have increased steadily since the first quarter of 2018. Lastly, the risk aversion category fell in the third The improvement in the asset quality category was also quarter, driven by an easing in lending standards, a widespread across all series of the index, including a rise in average risk-weights, and a modest increase in decline in the ratio of nonperforming loans to loans ratio of loans to deposits. This was partly offset by a and an increase in the ratio of loan loss reserves to decline in the loan-to-GDP gap. Currently, the gap is nonperforming loans. The recent reports on rising well below its long-run trend and declined further in delinquency rates on consumer loans are driven by a the third quarter, signaling a lackluster growth rate of deterioration of loans held by non-banks. The delinquency loans relative to the size of the economy. The softness rate on consumer loans held by banks was about in bank lending is in part due to competition from unchanged in the third quarter. the non-bank sector, and based on the loan-to-GDP gap, it would be a bad idea to raise the countercyclical The capital and interconnectedness categories rose capital buffer. In addition, headwinds arising from slightly in the third quarter. Under the capital category, tighter banking regulations have likely continued to the market leverage ratio under stress rose, while put downward pressure on loan growth, particularly on regulatory capital ratios remained roughly unchanged. loans to small businesses and loans to borrowers with The slight rise in resiliency in the interconnectedness less-than-pristine credit histories.1 n category was driven by a decrease in exposures to financial entities, defined as the ratio of loans made to ENDNOTE other depository institutions, repos, and federal funds 1 “Bank Regulations as a Tax on Lending” https://bpi.com/bank- regulations-as-a-tax-on-lending/ sold to total assets.

BANKING PERSPECTIVES QUARTER 1 2019 73 Research from Around the Industry: ACADEMICS, THINK TANKS, AND REGULATORS Research Rundown provides an overview of the most groundbreaking and noteworthy research on critical banking and payments issues and seeks to capture insights from academics, think tanks, and regulators that may well influence the design and implementation of the industry’s regulatory architecture.

74 BANKING PERSPECTIVES QUARTER 1 2019 CAPITAL, LIQUIDITY, AND LENDING OF THE ALLOWANCE FOR LOAN LOSSES IN UNCONDITIONALLY CANCELABLE CREDIT CARD WHEN LOSSES TURN INTO LOANS: THE COST OF PORTFOLIOS (Canals-Cerda) UNDERCAPITALIZED BANKS (Blattner, Farinha & Rebelo) This working paper investigates the effects of two different credit card payment allocation assumptions on This paper provides evidence that a weak banking sector allowances for loan and lease losses under CECL. Under contributed to low productivity following the European one assumption, all future monthly payments and net sovereign debt crisis. To establish this result, the paper finance charges are allocated to the initial balance. Under exploits a regulatory intervention by the European the other assumption, all future monthly payments, net Banking Authority in 2011 that induced exogenous finance charges, and incurred expenses are allocated to variation in banks’ capital adequacy, enabling comparison the initial balance. The choice of payment allocation rule of the changes in credit from exposed and nonexposed plays an important role in the definition of loan default, banks. Using Portuguese data, the authors find that and the authors find that differing rules give diverging banks exposed to the higher capital requirements not cumulative default curves. only reduced lending but also reallocated credit toward keeping distressed corporate customers afloat to forestall THE COSTS AND BENEFITS OF LIQUIDITY having to take losses. The authors then trace how such REGULATIONS: LESSONS FROM AN IDLE credit misallocation distorts firm-level use of production MONETARY POLICY TOOL (Curfman & Kandrac) factors and, in turn, significantly reduces aggregate productivity. Based on partial equilibrium estimates, the This paper investigates the response of banks to EBA intervention accounts for over 50% of the decline in regulation-mandated changes in liquid assets. Liquidity aggregate productivity in 2012. regulations have only been adopted since the global financial crisis, but the reserve requirement that has been LOCAL BANKS, CREDIT SUPPLY, AND HOUSE in place since the pre-crisis era serves as a simple, de facto PRICES (Blickle) liquidity rule. The authors find that regulation-imposed increases in high-quality liquid assets reduce lending This paper studies the effect of an increase in the supply (with the least liquid loans decreasing the most) and bank of mortgage credit on house prices and employment. profits. However, increased HQLA also decreases the The author builds a natural experiment around the 2008 likelihood of failure. exodus of Swiss retail customers from UBS, a large, universal bank, to smaller, local banks that specialize DYNAMISM DIMINISHED: THE ROLE OF HOUSING in mortgage lending. Exploiting the fact that mortgage MARKETS AND CREDIT CONDITIONS lenders near UBS branches received a larger influx of (Davis & Haltiwanger) deposits, the author finds that banks invest strictly in their area of specialization in response to the exogenous This paper assesses the effects of housing prices and positive funding shock. Further, increases in house prices credit supply on the activity of young firms. The authors around the affected banks were more than 50% greater find that local house-price changes have a large effect on than other neighborhoods. Employment at small firms employment growth and employment shares at young reliant on real estate collateral located in the affected firms; bank lending supply has a smaller effect. They neighborhoods also increased. determine that house prices affect new firm formation and young-firm expansion through the wealth, liquidity, FROM INCURRED LOSS TO CURRENT EXPECTED and collateral channels. At the national level, movements CREDIT LOSS (CECL): FORENSIC ANALYSIS in the housing markets are a driving force of medium-

BANKING PERSPECTIVES QUARTER 1 2019 75 Research Rundown

run fluctuations in young-firm employment shares. The banks and each bank’s position in the interbank network. contraction in bank loan supply reinforced this collapse. Based on data on linkages between banks from 1929 to 1934, the paper estimates the effect of the failure of 9,000 WHAT CAUSED THE POST-CRISIS DECLINE IN banks during the Great Depression. Results indicate that BANK LENDING? (Hogan) systemic risk was evenly distributed in 1929, but the banking crisis of 1930–1933 increased systemic risk per This brief explores why bank lending has failed to bank and increased the riskiness of the largest banks. respond to expansionary monetary policy in the wake of the recent recession. The authors find that not only has FINANCIAL STRUCTURE AND INCOME INEQUALITY lending failed to recover to the level expected, but banks (Brei, Ferri & Gambacorta) seem to have permanently decreased lending relative to total assets. They compare lending growth during This paper empirically investigates the relationship between the recovery to other economic activity and find that income inequality and the development and structure lending has lagged behind GDP and job growth, loan of financial systems. Using a panel of 97 developing and demand as surveyed by the Fed Board of Governors, advanced economies from 1989 to 2012, the authors find and a measure of banks’ uncertainty about the future. the relationship is nonlinear. Up to a point, more finance The authors find that increasing regulation of banks in correlates with lower inequality. After that point, however, the response to the Dodd-Frank Act and higher excess the relationship depends upon the structure of the financial reserve holdings better explain the subdued pace of system, with more market-based financing increasing bank lending. inequality but more bank lending having the opposite effect.

BANK STRUCTURE, SYSTEMIC RISK, AND MARKETS, BANKS, AND SHADOW BANKS MACROPRUDENTIAL POLICY (Martinez-Miera & Repullo)

MACROPRUDENTIAL FX REGULATIONS: SHIFTING This paper examines the effect of bank capital regulation THE SNOWBANKS OF FX VULNERABILITY? on the structure and risk of the financial system using (Ahnert et al.) a model that includes regulated banks, direct market finance, and shadow banks. The authors find that when This paper evaluates the effectiveness and unintended shadow banks are included, tightening risk-insensitive consequences of macroprudential foreign exchange capital requirements lead to a market equilibrium in which regulations. Borrowing in foreign currency is often cheaper, direct market finance funds the safest projects and shadow though it introduces the risk of local currency depreciating banks fund intermediate-risk projects, and regulated banks against the foreign currency. This makes debt-servicing fund the riskiest. Tightening risk-sensitive requirements more expensive and has the potential to lead to default. gives an equilibrium in which banks and shadow banks The authors find that while foreign exchange regulations are transposed, with banks taking on intermediate-risk may successfully discourage banks from borrowing in investments and shadow banks taking the riskiest. foreign currency, they cause firms to increase their foreign exchange borrowing from non-banks. GLOBAL BANKS AND SYSTEMIC DEBT CRISES (Morelli, Ottonello & Perez) SYSTEMIC RISK AND THE GREAT DEPRESSION (Das, Mitchener & Vossmeyer) This paper analyzes the role of global banks in systemic debt crises. Global banks hold a large portion of the This paper examines systemic risk before and after the external debt of emerging market (EM) economies, and Great Depression, using both credit risk of individual this debt constitutes a significant share of global banks’

76 BANKING PERSPECTIVES QUARTER 1 2019 total assets. Banks highly exposed to EM debt amplify the models. First, the authors propose an operational systemic shocks that originate in EMs, while banks with a definition of fairness that both excludes explicit low exposure to EM debt transmit shocks from other risky discrimination on the basis of sensitive features such as assets in developed economies to debt markets in EMs. The race or gender while providing a means for detecting role of global banks also explains the synchronization of latent discrimination. They show that eliminating latent debt prices within EMs and the sensitivity of bond prices discrimination requires that the sensitive features to systemic income shocks. be included when the algorithm is trained but then excluded when the algorithm is used. DIGITAL CURRENCY RUNS (Skeie) GOING THE EXTRA MILE: DISTANT LENDING AND This paper explores the potential impact of digital CREDIT CYCLES (Granja, Leuz & Rajan) currency on the stability of the banking system. It develops a model of an economy where the introduction This paper proposes a novel method of measuring risk- of digital currency competes with traditional fiat money. taking by lenders: the average distance from the borrower The author shows that privately issued digital currency, to the bank. Average distances are greater during times of such as bitcoin, will be held if the inflationary risk of easy credit and shorter when credit is tight. The usefulness fiat money is sufficiently large. This dynamic does not of the lending distance as a measure of risk-taking lies in necessarily displace the banking system, as consumers the ease with which it is calculated. The authors use this may hold deposits of digital currency at banks. However, measure to assess the interaction of lending competition this allows for a banking crisis equilibrium as banks are with the credit cycle, finding that finding that greater vulnerable to withdrawal runs on digital currency. competition pushes banks to take greater risks, lending to borrowers farther from bank locations. BANK PROFITABILITY AND FINANCIAL STABILITY (Xu, Hu & Das) THE FHA AND THE GSES AS COUNTERCYCLICAL TOOLS IN THE MORTGAGE MARKETS This paper analyzes the relationship between bank (Passmore & Sherlund) profitability and financial stability. First, empirical results indicate that bank profitability and price-to-book ratios This paper analyzes the relationship between federal are negatively related to systemic and idiosyncratic mortgage-market programs and the economic shocks risks. Second, an elevated share of non-interest income felt by households during and after the financial crisis. is associated with higher systemic and idiosyncratic The article uses county-level data on the penetration risks. Third, lower competition is associated with lower of programs from the Federal Housing Administration idiosyncratic risk but higher systemic risk. Finally, asset (FHA), the U.S. Department of Veterans Affairs (VA) quality and funding costs help determine bank profitability. and Fannie Mae and Freddie Mac (GSEs). The authors find a strong correlation between a greater use of these BANK REGULATION, INNOVATION, AND OTHER programs and better real economic outcomes like lower unemployment. In addition, the analysis shows that the ELIMINATING LATENT DISCRIMINATION: TRAIN FHA was a more effective countercyclical tool than GSE THEN MASK (Ghili, Kazemi & Karbasi) lending, possibly because the FHA was more willing to lend to marginal borrowers. These results suggest that Machine learning algorithms are used in a variety a tight link between a government-backed insurer and of decision-making tasks, including lending and the GSE would mitigate tighter underwriting standards credit scoring. This paper investigates how latent and higher securitization costs during a crisis, which the discrimination can be removed from these predictive authors encourage future GSE reforms to consider. n

BANKING PERSPECTIVES QUARTER 1 2019 77 Featured Moments THE 2018 CLEARING HOUSE ANNUAL CONFERENCE

James D. Aramanda of The Clearing House welcomes attendees to the 2018 TCH + BPI Annual Conference before the conference opening dinner. During the “CEO Roundtable on the Business of Banking” session, Bank of America’s Brian Moynihan responds to a question from moderator Kausik Rajgopal of McKinsey & Co. (far left). Also pictured (L to R) are René F. Jones from M&T Bank; Kelly King, BB&T Corp.; and Nandita Bakhshi, Bank of the West and BNP Paribas USA.

William S. Demchak from PNC Financial Services Group speaks to the audience before the Greg Baer of the Bank Policy Institute introduces TCH + BPI Chairs’ Dinner. authors Amy Goldstein and J.D. Vance for their discussion, “Appalachia and Janesville: Two Richard Clarida, Vice Chairman of the Federal American Crises and Prospects for Renewal.” Reserve Board, speaks to the audience during his keynote presentation at the TCH + BPI Annual Conference.

78 BANKING PERSPECTIVES QUARTER 1 2019 Susan Roth-Katzke from Credit Suisse discusses how changing consumer demands impact the banking industry during the “Outside Perspectives on the Banking Industry” panel, while (L to R) Mitchell S. Eitel, Sullivan & Cromwell; Eugene Ludwig, Promontory Financial Group; Gary D. Howe, Lazard LLC; Michael E. Martin, Warburg Pincus; and Thomas B. Michaud, Keefe, Bruyette & Woods listen.

General Stanley McChrystal (right), author of Leaders: Myth and Reality, sits down for a Q&A Near the end of the “Fraud Experience and Controls in Real- session with BPI’s Greg Baer following McChrystal’s keynote remarks during the TCH + BPI Time Systems” panel, audience members asked questions Chair’s Dinner. of the panelists during the Q&A session.

Authors Amy Goldstein and J.D. Vance (R) deliver their remarks on “Appalachia and Janesville: Two American Crises and Prospects for Renewal” during the TCH + BPI Annual Conference opening dinner. Greg Baer (L) of BPI moderated the session.

BANKING PERSPECTIVES QUARTER 1 2019 79 Featured Moments

General Stanley McChrystal, author of Leaders: Myth and Reality, signs copies of his book following his keynote remarks during the TCH + BPI Chair’s Dinner.

Attendees at the 2018 TCH + BPI Annual Conference network after the TCH + BPI Chair’s Dinner. Carolyn Criscitiello, Head of Digital Payments, Retail Banking and Wealth Management Group at HSBC Bank, discusses RTP during the session, “A One-Year Assessment of Faster Payments: Your Life Is in Real Time — Is Your Bank?”

Jennifer Burns, from the Board of Governors of the Federal Reserve System, speaks to the audience during the “Supervision 2.0: Adapting Supervisory Priorities and Examination Approaches to the David Tao, Senior Manager, Payments, at Uber Digital Age” session, as Meredith Fuchs, Capital discusses how Uber plans to use the RTP network One, listens. to speed payments to drivers during the “A One- Year Assessment of Faster Payments: Your Life Is Mastercard’s Sherri Haymond speaks to the audience in Real Time — Is Your Bank?” session. during the “Tokenization: Authenticating, Provisioning Secure Credentials In The Digital Ecosystem” panel during the Payments Systems Risk Symposium.

80 BANKING PERSPECTIVES QUARTER 1 2019 Clients appreciate our unique insight into issues relating to the financial services industry, gained through our extensive experience and deep knowledge of the complex and changing regulatory framework. Our Financial Institutions Practice Group integrates transactional work across a broad spectrum of mergers and acquisitions and capital markets and financing transactions with a depth of regulatory, compliance and litigation experience that we believe is unrivaled. Our broad experience gives us an invaluable perspective to address our clients’ needs with practical and creative solutions in light of prevailing commercial realities.

NEW YORK BEIJING HONG KONG HOUSTON LONDON LOS ANGELES PALO ALTO SÃO PAULO SEOUL TOKYO WASHINGTON, D.C. Featured Moments

Richard Dzina from the Federal Reserve Bank of New York delivers his keynote remarks during the opening session of the Payments Systems Risk Symposium.

Attendees listen intently during the “Fraud Experience and Controls in Real-Time Systems” panel. Speakers include (L to R) Dan Larkin, PNC Bank; Donna Turner, Early Warning Services; Mary Ann Miller, Varo Money; Steve Ledford, The Clearing House; and Cyrus Bhathawalla, KPMG U.S.

Antony Phillipson, British Consul General in New York and HM Trade Commissioner for North America, Her Majesty’s Treasury, delivers his remarks during a special session prior to the beginning of the TCH + BPI Annual Conference.

Julapa Jagtiani, the Federal Reserve Bank of Attendees at the 2018 TCH + BPI Annual Conference mingle before the General Stanley McChrystal’s Philadelphia, listens to Anna Gincherman, keynote presentation. Women’s World Banking, during the “Considering Correlations Between Bank Regulation and Inequality” panel session.

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