Showing papers in "Journal of Money, Credit and Banking in 2004"

Diversification in Banking: Is Noninterest Income the Answer?

Abstract: This paper assesses potential diversification benefits in the U.S. banking industry from the steady shift toward activities that generate fee income, trading revenue, and other types of noninterest income. In the aggregate, declining volatility of net operating revenue reflects reduced volatility of net interest income, not diversification benefits from noninterest income, which is quite volatile and increasingly correlated with net interest income. At the bank level, greater reliance on noninterest income, particularly trading revenue, is associated with lower risk-adjusted profits and higher risk. This suggests few obvious diversification benefits from the ongoing shift toward noninterest income.

Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy*

Abstract: A recent paper by Bernanke, Gertler, and Watson (1997) suggests that monetary policy could be used to eliminate any recessionary consequences of an oil price shock. This paper challenges this conclusion on two grounds. First, we question whether the Federal Reserve actually has the power to implement such a policy; for example, we consider it unlikely that additional money creation would have succeeded in reducing the Fed funds rate by 900 basis points relative to the values seen in 1974. Second, we point out that the size of the effect that Bernanke, Gertler, and Watson attribute to oil shocks is substantially smaller than that reported by other researchers, primarily due to their choice of a shorter lag length than that used by other researchers. We offer evidence in favor of the longer lag length employed by previous research and show that under this specification, even the aggressive Federal Reserve policies proposed would not have succeeded in averting a downturn.

Bank Competition and Access to Finance: International Evidence

Abstract: Using a unique database for 74 countries and for firms of small, medium, and large size we assess the effect of banking market structure on the access of firms to bank finance. We find that bank concentration increases obstacles to obtaining finance, but only in countries with low levels of economic and institutional development. A larger share of foreign-owned banks and an efficient credit registry dampen the effect of concentration on financing obstacles, while the effect is exacerbated by more restrictions on banks’ activities, more government interference in the banking sector, and a larger share of government-owned banks.

Competition and Financial Stability

Abstract: Competition policy in the banking sector is complicated by the necessity of maintaining financial stability. Greater competition may be good for (static) efficiency, but bad for financial stability. From the point of view of welfare economics, the relevant question is: what are the efficient levels of competition and financial stability? We use a variety of models to address this question and find that different models provide different answers. The relationship between competition and stability is complex: sometimes competition increases stability. In addition, in a second-best world, concentration may be socially preferable to perfect competition and perfect stability may be socially undesirable.

Regulations, Market Structure, Institutions, and the Cost of Financial Intermediation

Abstract: This paper examines the impact of bank regulations, market structure, and national institutions on bank net interest margins and overhead costs using data on over 1400 banks across 72 countries while controlling for bankspecific characteristics. The data indicate that tighter regulations on bank entry and bank activities boost the cost of financial intermediation. Inflation also exerts a robust, positive impact on bank margins and overhead costs. While concentration is positively associated with net interest margins, this relationship breaksdownwhencontrolling for regulatory impediments to competition and inflation. Furthermore, bank regulations become insignificant when controlling for national indicators of economic freedom or property rights protection, while these institutional indicators robustly explain cross-bank net interest margins and overhead expenditures. Thus, bank regulations cannot be viewed in isolation; they reflect broad, national approaches to private property and competition.

Dynamics of Growth and Profitability in Banking

Abstract: Dynamic panel and cross-sectional regressions are used to estimate growth and profit equations for a sample of commercial, savings, and co-operative banks from five major European Union countries during the mid-1990s. Methodologically, the paper unifies the growth and profit strands in the previous empirical literature. The growth regressions reveal little or no evidence of mean-reversion in bank sizes. Profit is an important prerequisite for future growth. Banks that maintain a high capital-assets ratio tend to grow slowly, and growth is linked to macroeconomic conditions. Otherwise, there are few systematic influences on bank growth. The persistence of profit appears higher for savings and co-operative banks than for commercial banks. Banks that maintain high capital-assets or liquidity ratios tend to record relatively low profitability. There is some evidence of a positive association between concentration and profitability, but little evidence of a link between bank-level x-inefficiency and profitability.

Financial Development, Financial Fragility, and Growth

Abstract: The authors study the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (for example, Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (for example, Kaminski and Reinhart 1999). The authors account for these contrasting effects based on the distinction between the short- and long-run impacts of financial intermediation. Working with a panel of cross-country and time-series observations, they estimate an encompassing model of short- and long-run effects using the Pooled Mean Group estimator developed by Pesaran, Shin, and Smith (1999). Their conclusion from this analysis is that a positive long-run relationship between financial intermediation and output growth coexists with a mostly negative short-run relationship. The authors further develop an explanation for these contrasting effects by relating them to recent theoretical models, by linking the estimated short-run effects to measures of financial fragility (namely, banking crises and financial volatility), and by jointly analyzing the effects of financial depth and fragility in classic panel growth regressions.

Bank Concentration and Competition: An Evolution in the Making

Abstract: The consolidation of banks around the world in recent years is intensifying public policy debates on the influences of concentration and competition on the performance of banks. In light of these developments, this paper first reviews the existing literature on the impact of bank concentration and competition. Second, the paper summarizes the main findings of the papers in this special issue of the JMCB within the context of this active literature. Finally, the paper suggests some directions for future research.

Home is Where the Equity Is: Mortgage Refinancing and Household Consumption

Abstract: Applying a permanent income model with exogenous liquidity constraints and mortgage behavior, household refinancing when mortgage interest rates are historically high and rising, a persistent empirical puzzle, is explained. Using data from the Panel Study of Income Dynamics, households experiencing an unemployment shock and having limited initial liquid assets to draw upon are shown to have been 25% more likely to refinance, 1991-94. On average, such liquidity-constrained households converted over two-thirds of every dollar of equity they removed into current consumption as mortgage rates plummeted, 1991-94, producing an estimated expenditure stimulus of at least $28 billion.

Expectations, Heterogeneous Forecast Errors, and Consumption: Micro Evidence from the Michigan Consumer Sentiment Surveys

Abstract: The household data underlying the Michigan Index of Consumer Sentiment are used to test the rationality of consumer expectations and their usefulness in forecasting expenditure. The results can be interpreted as characterizing the shocks that hit different types of households over time. Expectations are found to be biased and inefficient, at least ex post. People underestimated the disinflation of the early 1980s and the severity of recent business cycles. People's forecast errors are also systematically correlated with their demographic characteristics, in part because of time-varying, group-level shocks. Further, sentiment helps forecast consumption growth. Some of this rejection of the permanent income hypothesis is due to the systematic demographic components in forecast errors.

Taking Stock: Monetary Policy Transmission to Equity Markets

Abstract: This paper analyses the effects of U.S. monetary policy on stock markets.We present evidence that individual stocks react in a highly heterogeneous fashion to U.S. monetary policy shocks and relate this heterogeneity to financial constraints and Tobin's q. First, we show that there are strong industry-specific effects of U.S. monetary policy. Second, we also find that for the 500 individual stocks comprising the S&P500 the firms with low cash flows, small size, poor credit ratings, low debt to capital ratios, high price-earnings ratios, or a high Tobin's q are affected significantly more by monetary policy.

How Foreign Participation and Market Concentration Impact Bank Spreads: Evidence from Latin America

Abstract: Increasing foreign participation and high concentration levels characterize the recent evolution of banking sectors' market structures in developing countries. The authors analyze the impact of these factors on Latin American bank spreads during the late 1990s. Their results suggest that foreign banks were able to charge lower spreads relative to domestic banks. This was more so for de novo foreign banks than for those that entered through acquisitions. The overall level of foreign bank participation seemed to influence spreads indirectly, primarily through its effect on administrative costs. Bank concentration was positively and directly related to both higher spreads and costs.

Money's Role in the Monetary Business Cycle

Abstract: A small, structural model of the monetary business cycle implies that real money balances enter into a correctly-specified, forward-looking IS curve if and only if they enter into a correctly-specified, forward-looking Phillips curve. The model also implies that empirical measures of real balances must be adjusted for shifts in money demand to accurately isolate and quantify the dynamic effects of money on output and inflation. Maximum likelihood estimates of the modelOs parameters take both these considerations into account, but still suggest that money plays a minimal role in the monetary business cycle.

Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy

Abstract: Hamilton and Herrera (HH) have provided an interesting comment on our 1997 paper (Bernanke, Gertler, and Watson 1997 [BGW]). We take the opportunity offered to us by the editors to respond briefly. The goal of BGW was to show that the magnitude and shape of the economy’s response to a particular exogenous shock will typically depend critically on how monetary policy makers choose to react to the shock. As a consequence, we argued that assessments of the importance of monetary policy for real activity should take into account the systematic portion of policy (i.e., the policy rule) as well as the unsystematic component (i.e., monetary policy shocks.) The specific type of exogenous shock that we considered in BGW was a sharp increase in the price of oil, of the magnitude observed during several episodes in the 1970s. Using a modified VAR framework, we considered counterfactual scenarios in which monetary policy (represented by the level of the federal funds rate) does not respond to an oil price shock. We found that the adverse effects of an oil price shock on output are reduced considerably when the endogenous response of the funds rate is “shut off.” Indeed, our point estimates suggested that the endogenous response of monetary policy accounted for virtually all the negative impact of the oil shock on This research was funded in part by NSF grants to each of the authors. We thank Michele Cavallo for research assistance.

Bank Competition and Firm Creation

Abstract: We investigate the effects of competition in the financial sector on the creation of firms in the nonfinancial sector, explicitly allowing for heterogeneous effects across borrowers characterized by different degrees of asymmetric information. We find evidence of a bell-shaped relationship between bank competition and firm creation. In addition, consistently with theories arguing that competition may reduce the availability of credit to informationally opaque firms, we find that bank competition results less favorable to the emergence of new firms in industrial sectors where informational asymmetries are more important.

Rule-of-thumb consumers and the design of interest rate rules

Abstract: We introduce rule-of-thumb consumers in an otherwise standard dynamic sticky price model, and show how their presence can change dramatically the properties of widely used interest rate rules. In particular, the existence of a unique equilibrium is no longer guaranteed by an interest rate rule that satisfies the so-called Taylor principle. Our findings call for caution when using estimates of interest rate rules in order to assess the merits of monetary policy in specific historical periods.

The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time

Abstract: A stable predictive relationship between inflation and the output gap, often referred to as a Phillips curve, provides the basis for countercyclical monetary policy in many models. In this paper, we evaluate the usefulness of alternative univariate and multivariate estimates of the output gap for predicting inflation. Many of the ex post output gap measures we examine appear to be quite useful for predicting inflation. However, forecasts using real-time estimates of the same measures do not perform nearly as well. The relative usefulness of real-time output gap estimates diminishes further when compared to simple bivariate forecasting models which use past inflation and output growth. Forecast performance also appears to be unstable over time, with models often performing differently over periods of high and low inflation. These results call into question the practical usefulness of the output gap concept for forecasting inflation.

Real Effects of Bank Competition

Abstract: Does banking market power contribute to the formation of nonfinancial industries populated by few, large firms, or does it instead enhance industry entry? Theoretical arguments could be made to support either side. The banking industry of European Union (EU) countries has been significantly deregulated in the early 1990s. Under the old regime, cross-border expansions were heavily constrained, while after deregulation, banks from EU countries have instead been allowed to branch freely into other EU countries. Concurrently to the process of deregulation, European banking industries have also experienced a significant process of consolidation. Exploiting such significant innovations affecting the banking industries of EU countries, this paper explores whether changes in bank competition have in fact played a role on the market structure of nonfinancial industries. Empirical evidence is derived from a panel of manufacturing industries in 29 OECD countries, both EU and non-EU members, adopting a methodology that allows controlling for other determinants of industry market structure common across industries, across countries or related to time passing. The evidence suggests that the overall process of enhanced competition in EU banking markets has led to markets in nonfinancial sectors characterized by lower average firm size.

The Transitional Dynamics of Fiscal Policy: Long-Run Capital Accumulation and Growth

Abstract: This paper analyzes the effects of fiscal policies in a non-scale growing economy with public and private capital. The equilibrium dynamics are characterized and we contrast the dynamic effects of government expenditure on investment and expenditure on consumption under four alternative modes of tax financing. Most of our attention focuses on the numerical simulations of a calibrated economy. The results emphasize the lengthy transition periods, which implies that policies have sizeable level effects, leading to substantial welfare effects, even though long-run growth rates are unaffected. The paper highlights the intertemporal dimensions of fiscal policy and the tradeoffs these involve for economic performance, especially growth and welfare.

Another Perspective on the Effects of Inflation Uncertainty

Abstract: This paper examines the effects of inflation uncertainty on real economic activity by utilizing a flexible, dynamic, multivariate framework that accommodates possible interaction between the conditional means and variances. The empirical model is based on a familiar identified vector autoregressive framework, modified to accommodate multivariate generalized autoregressive conditional heteroskedasticity. Our empirical model is preferred to the baseline VAR by likelihood based information criteria, and it retains the important dynamics of the underlying VAR. We find that an average shock to inflation uncertainty has tended to reduce output growth over three months by about 22 basis points.

Crises in Competitive versus Monopolistic Banking Systems

Abstract: We study a monetary, general equilibrium economy in which banks exist because they provide inter-temporal insurance to risk-averse depositors. A "banking crisis" is defined as a case in which banks exhaust their reserve assets. This may (but need not) be associated with liquidation of a storage asset. When such liquidation does occur, the result is a real resource loss to the economy and we label this a "costly banking crisis." There is a monetary authority whose only policy choice is the long-run, constant rate of growth of the money supply, and thus the rate of inflation. Under different model specifications, the banking industry is either a monopoly bank or a competitive banking industry. It is shown that the probability of a banking crisis may be higher either under competition or under monopoly. This is shown to depend on the rate of inflation. In particular, if the nominal rate of interest (rate of inflation) is below (above) some threshold, a monopolistic banking system will always result in a higher (lower) crisis probability. Thus, the relative crisis probabilities under the two banking systems cannot be determined independently of the conduct of monetary policy. We further show that the probability of a costly banking crisis is always higher under competition than under monopoly. However, this apparent advantage of the monopoly banking is strictly due to the fact that it provides relatively less valuable inter-temporal insurance.

Commercial Lending and Distance: Evidence from Community Reinvestment Act Data

Abstract: A number of large banking organizations have substantially broadened the distances at which they are willing to extend commercial loans, but there is also evidence to suggest that this has occurred primarily at the high side of the distribution of lending distances. In this paper, we employ a new source of data to examine the relationship between lending decisions and distance between lender and borrower for that part of the distance distribution where, arguably, most of the competitive interactions among lenders still occur.We report three basic findings: (1) distance operates as a deterrent to lending, even within areas traditionally defined as local markets, (2) distance is more of a deterrent for small banks than for larger organizations, even within these areas, and (3) for those commercial loans made within areas currently treated by regulators as markets, distance has not been declining in importance. Indeed, a preponderance of the evidence suggests that it is becoming, if anything, more of a factor. Possible explanations and policy implications are discussed.

Why are prices sticky? the dynamics of wholesale gasoline prices

Abstract: The menu-cost interpretation of sticky prices implies that the probability of a price change should depend on the past history of prices and fundamentals only through the gap between the current price and the frictionless price. We find that this prediction is broadly consistent with the behavior of nine Philadelphia gasoline wholesalers. Nevertheless, we reject the menu-cost model as a literal description of these firms' behavior, arguing instead that price stickiness arises from strategic considerations of how customers and competitors will react to price changes.

Tobin's Imperfect Asset Substitution in Optimizing General Equilibrium

Abstract: In this paper, we present a dynamic optimizing model that allows explicitly for imperfect substitutability between different financial assets. This is specified in a manner which captures Tobin's (1969) view that an expansion of one asset's supply affects both the yield on that asset and the spread or "risk premium" between returns on that asset and alternative assets. Our estimates of this model on U.S. data confirm that some of the observed deviations of long-term rates from the expectations theory of the term structure can be traced to movements in the relative stocks of financial assets. The richer aggregate demand and asset specifications imply that there exists an additional channel of monetary policy. Our results suggest that central bank operations exercise a modest influence on the relative prices of alternative financial securities, and so exert an extra effect on long-term yields and aggregate demand separate from their effect on the expected path of short-term rates.

Comment on "What Drives Bank Competition? Some International Evidence"

Abstract: The question of bank competition is vitally important for a number of reasons. The essential role of bank credit and other financial services as an input in the production of most other goods and services places banks in a unique and influential position, such that any allocative inefficiency or other market distortions in banking are almost certain to be felt throughout the economy. Moreover, recent history has provided numerous instances where the textbook paradigm of atomistic competition has proven inadequate as a policy guide for efficient banking-either because there are simply too few banks to rely on sheer numbers as a guarantee of vigorous competition, as in Canada; or because of evidence that there can be such a thing as "too much competition" in banking, as suggested by several studies; or because of instances where nearly competitive pricing has been observed in markets containing only one or two banks; or because, conversely, substantially noncompetitive pricing has sometimes been deduced in banking products-such as credit cardswith thousands of suppliers. Thus, the study of bank competition remains an urgent field of research. Claessens and Laeven (2004, this issue of JMCB) make two key contributions here. First, they extend a proven empirical method to an unprecedentedly large and varied crosscountry sample. Second, they offer the logical and policy-relevant additional step of seeking to identify factors associated with variations in measured conduct. This step is needed to assess the empirical validity of the traditional structure-conductperformance paradigm in their sample and is especially important where that paradigm is found lacking as a predictor of bank conduct. Indeed, although the authors

Is There a Positive Relationship between Stock Market Volatility and the Equity Premium

Abstract: This paper investigates whether evidence for a positive relationship between stock market volatility and the equity premium is more decisive when the volatility feedback effects of large and persistent changes in market volatility are taken into account. The analysis has two components. First, a log- linear present value framework is employed to derive a formal model of volatility feedback under the assumption of Markov-switching market volatility. Second, the model is estimated for a variety of assumptions about information available to economic agents. The empirical results suggest the existence of a negative and significant volatility feedback effect, supporting a positive relationship between stock market volatility and the equity premium.

The Response of Term Rates to Fed Announcements

Abstract: In February 4, 1994 the Federal Reserve began the practice of announcing changes in the targeted level for the federal funds rate immediately after such decisions were made. This paper investigates to what extent the policy of "the announcement" affected a key ingredient in the monetary transmission mechanism: the term structure of nominally risk-free, Treasury securities. We find that term rates react much more in unison during announcement days than at any other time. Moreover, the practice of circumscribing almost all changes in the federal funds rate target to Federal Open Market Committee (FOMC) meeting dates regiments the formation of market expectations in the overnight rate and the price discovery process of term rates, thus facilitating the Fed's goal of controlling long-term rates.

The Nonlinear Phillips Curve and Inflation Forecast Targeting: Symmetric Versus Asymmetric Monetary Policy Rules

Abstract: We study a simple, small dynamic economy that a policymaker is attempting to control via use of a monetary policy rule. The model features a convex Phillips curve, in that positive deviations of aggregate demand from potential are more inflationary than negative deviations are disinflationary. Using dynamic optimization techniques, we find that the form of the optimal monetary policy reaction function is asymmetric. We show that in the optimal rule the interest rate is a nonlinear function of the deviation of inflation from its target and of output from potential. With asymmetry, optimal monetary policy becomes more active as uncertainty about the impact of policy increases.We thus provide an important and novel theoretical reason why increased uncertainty can lead to more aggressive rather than toward more cautious optimal policies.

The Role of Bank Advisors in Mergers and Acquisitions

Abstract: This paper looks at the role of commercial banks and investment banks as financial advisors. In their role as lenders and advisors, banks can be viewed as serving a certification function. However, banks acting as both lenders and advisors face a potential conflict of interest that may mitigate or offset any certification effect. Overall, we find evidence of a net certification effect for target firms but conflicts of interest for acquirers. In particular, target firms earn higher abnormal returns when the target's own bank is hired as merger advisor, consistent with the bank's role as certifier of the (more informationally opaque) target's value to the acquirer. In contrast, we find no net certification role for acquirers. There are at least two possible reasons for this. First, certification of value may be less important for acquirers because it is the target firm that must be priced in a merger. Second, acquirers may utilize commercial bank advisors in order to obtain access to bank loans to finance activities in the postmerger period. Thus, an acquirer may choose its own bank (with whom it has had a prior lending relationship) as an advisor in a merger. However, this choice weakens the certification effect and creates a potential conflict of interest because the advisor's merger advice may be distorted by considerations related to the bank's past and future lending activity.

The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations

Abstract: We use forecast errors made by the Federal Reserve while preparing open market operations to identify a liquidity effect at a daily frequency in the federal funds market. We find a liquidity effect on most days of the reserve maintenance period in addition to settlement day. The effect is nonlinear; large changes in supply more consistently have a measurable effect than do small changes. In addition, a higher aggregate level of reserve balances in the banking system is associated with a smaller liquidity effect during the maintenance period but a larger liquidity effect on the last days of the period.