Session 14: Financial Regulation

We examine the financial stability implications of deposit insurance using reciprocal deposits, a financial innovation through which banks can break up large deposits and place them with others in an offsetting manner. We show that higher insurance coverage allowed banks to stem deposit outflows during the 2023 banking crisis. Network banks paid lower deposit rates, grew larger, and expanded their local deposit market share, while assuming greater risk exposures. We discuss the trade-offs of deposit insurance and its impact on the banking sector’s industrial organization.

We study competition and pass-through in the market for retail deposits. Federal funds rate increases are associated with only minimal increases in deposit rates. Leveraging new data on offers mailed by banks to households, we show that federal funds rate increases are strongly associated with changes in mail volumes, sign-up bonuses, and offers targeting new customers. These margins and not interest rates are the primary ways in which interest rate changes affect the deposit market. We rationalize the use of these margins and not interest rates in a simple model with active and sleepy depositors. Depositor heterogeneity and adverse selection, as opposed to market power, are the primary reasons why banks offer far less than the full present value of future rate spreads to depositors.

This paper examines deposit stickiness using account-level data from over 10 million retail accounts across 152 U.S. credit unions. We find significant skewness in deposit distributions, with 10% of depositors controlling 70% of total deposits. Low-balance depositors are sensitive to exogenous interest rate changes, but high-balance depositors are not. High-balance depositors are also relatively insensitive to discontinuous rate jumps at specific balance thresholds and are more likely to experience large, sudden withdrawals. Taken together, our evidence suggests that aggregate deposit stickiness is driven by relatively few high-balance accounts that are used as medium-run liquidity stores rather than for long-term savings.

We find that the flightiness of depositors displays pronounced fluctuations over time, reaching unprecedentedly high levels after the Covid-19 crisis. Elevated deposit flightiness coincides with expansions in central bank reserves and low interest rate environments. We rationalize these trends based on heterogeneity in investors’ convenience value for deposits. In our dynamic model, investors in the banking system value the convenience benefits of deposits more than those that choose to invest in non-banks. Following deposit inflows from outside investors, e.g., due to QE’s reserve expansions, the marginal depositor in the banking system becomes more rate-sensitive and the risk of panic runs increases. Our findings imply that the risk of panic runs triggered by policy rate hikes is amplified when the Fed’s balance sheet size is larger, highlighting a novel linkage between conventional and unconventional monetary policy.

Mortgage borrowers are “locked in”: forgoing moves to keep low mortgage rates. We study the general equilibrium effects of mortgage lock-in on housing markets. We provide causal evidence that lock-in increases prices, particularly in expensive areas, because locked-in borrowers would otherwise demand less housing. We design a spatial housing ladder model with long-term mortgages, generating a distribution of locked-in rates and equilibrium effects on mobility and prices consistent with the data. A temporary rate hike causes lock-in, increasing housing demand and prices, especially in expensive areas. A $10k tax credit to starter-home sellers modestly unlocks mobility while increasing trade-up home prices.

This paper examines the impact of access to housing on fertility rates using random variation from housing credit lotteries in Brazil. For 20-25-year-olds, we find that obtaining housing increases the average probability of having a child by 32% and the number of children by 33%, with no increase in fertility for people above age 40. The completed lifetime fertility increase for a 20-year-old is twice as large from obtaining housing immediately compared to obtaining it at age 30. Individuals relocate to areas with lower crime rates, higher per capita income, and higher home-ownership rates. The increase in fertility is stronger for households in areas with lower quality housing and those with lower household income and lower female i come share. These results suggest that easing housing credit and housing adequacy constraints can significantly increase fertility.

This paper shows that households are selectively inattentive to interest rates and examines the macroeconomic implications. Using existing and newly-designed household surveys, we establish that households close to durables purchases actively acquire more information about interest rates and have more accurate, less dispersed, and less uncertain interest rate expectations. We use this evidence to calibrate an incomplete markets model with durable consumption and endogenous information acquisition about interest rates through rational inattention. Using this calibrated model, we quantify how selective inattention changes aggregate consumption responses to interest rates. Relative to exogenous inattention, selective inattention shifts the composition of spending responses to interest rate cuts, accelerates the impact of larger rate cuts, and dampens responses to changes in rate volatility towards empirical evidence.

We use bond-level data to study how US banks manage risk in their securities portfolios, focusing on the period of rapidly-rising interest rates in 2022-23, and examine the role of financial and regulatory frictions in shaping bank behavior. Interest rate risk in bank portfolios increased markedly as rates rose with significant cross-bank heterogeneity depending on ex ante holdings of bonds with embedded options. In response, exposed banks shortened the duration of bond purchases but did not actively sell risky securities or expand “qualified” hedging activity; securities also played a limited role in banks’ responses to deposit outflows. We identify two frictions that can help explain this inertia. First, we find that banks are highly averse to selling underwater bonds at a discount to book value—e.g., banks were 8-9 times more likely to trade bonds with unrealized gains than unrealized losses in 2022-23. This “strategic” trading is more pronounced for banks that do not recognize unrealized losses in regulatory capital and banks facing stock market pressure. Second, frictions in establishing qualified accounting hedges limited hedging activity depending on bond type and accounting classification. Banks did, however, reduce the interest-rate sensitivity of regulatory capital by classifying the riskiest bonds as held-to-maturity.

Several countries now require banks or money market funds to impose state-contingent costs on shortterm creditors to absorb financial stress. We study these requirements as part of the broader prudential toolkit in a model with five key ingredients: banks may face an aggregate stress state with high withdrawals; a fire-sale externality motivates a mix of non-contingent and state-contingent regulation; banks may use shadow technologies to circumvent regulation; parameters of the shadow technologies may be private information; and bailouts may occur. We characterize the optimal policy for various combinations of these ingredients and demonstrate that the threat of shadow activities constrains statecontingent regulation more than noncontingent regulation, especially when imperfect information and limited commitment coexist. The planner triggers shadow activities with positive probability under imperfect information, and shadow activities that deplete resources in the stress state elicit larger bailouts under limited commitment, rendering the requirement of state-contingent costs a weak instrument.

How does banking supervision contribute to financial stability? We document that supervisors tend to be well informed about failing banks’ financial trouble well ahead of failure. Bank closures are almost always a supervisory decision and are conducted in an orderly fashion with low losses for uninsured depositors. Outside of failure, supervisors play a significant role in shaping banks’ financial statements, requiring troubled banks to recognize otherwise unreported losses and subjecting them to enforcement actions. To establish causality, we exploit exogenous variation in supervisory scrutiny at the onset of the 2008 Global Financial Crisis. We find that heightened supervisory scrutiny increases the accuracy of financial reporting, the frequency of public enforcement actions, and the likelihood of bank closure. Taken together, our findings emphasize that a key role of banking supervision is to identify and close failing banks.

Using loan-level regulatory data, this paper finds that banks reduce risk-taking in their loan portfolio after bank-level uncertainty rises. Banks also increase interest rates and require collateral in loan contracts after positive uncertainty shocks, especially among banks with less regulatory capital that are also subject to mark-to-market accounting regulations. In response, public firms borrowing from these banks hold more cash and reduce investment and employment. Riskier private firms turn to shorter duration and higher cost credit, such as credit cards and trade credit, increasing illiquidity. Local employment also declines after bank uncertainty increases. Taken together, uncertainty shocks in the banking system significantly affect the economy.