Depository Institution

Liquidity Risk

In Contemporary Financial Intermediation (Third Edition), 2016

Reducing Liquidity Risk by Dissipating Withdrawal Risk

A depository institution can reduce the variance of its deposit flows by diversifying the sources of funding, that is, having many distinct and dissimilar depositors. This is formally demonstrated in Appendix 6.1. A diverse depositor base results in more predictable deposit flows; the improved predictability reduces the cash needed to service a deposit base to any arbitrary probabilistic standard. That is, the larger and more diverse the depositor base, the smaller the cash holding necessary to achieve any preselected probability of a stock-out (liquidity crisis). This is one way the depository institution produces liquidity. Nevertheless, withdrawals will sometimes exceed the institution's capacity to service them, even though this may happen only with very small probability, and in that sense the system is imperfect. Indeed, this is the system's Achilles' heel. Bank runs are the trauma that illustrates this vulnerability of fractional reserve banking, a vulnerability caused by the illiquidity of bank assets.

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Strategies of Depository Institutions

Rajesh Kumar , in Strategies of Banks and Other Financial Institutions, 2014

Abstract

Depository institutions are broadly classified into commercial banks and thrift institutions. The commercial banking industry provides commercial, industrial, and consumer loans and accepts deposits from individual and institutional customers. Commercial banking covers services such as cash management, credit services, deposit services, and foreign exchange. The explosive growth of secondary loan and credit markets altered the shape of the corporate banking industry. Commercial banks face challenges with respect to additional revenue generation in the event of economic uncertainty, regulatory issues, high liquidity costs, and low demand for loans. The basic functions of commercial banks are to accept deposits and provide loans. Other functions include providing overdraft facilities, discounting bills of exchange, fund investments, and agency functions. A commercial bank's performance can be evaluated along the dimensions of deposit mobilization, quality of lending, capital adequacy analysis, liquidity, earnings, and loan growth. The CAMEL rating system is a supervisory tool for evaluating the soundness of a financial institution. Thrift institutions consist of mutual savings banks, savings and loan associations, and credit unions. These financial intermediaries raise funds through time and savings deposits and invest in residential mortgages and loans. Savings institutions face liquidity, credit, and interest rate risk.

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Housing Finance

J.R. Barth , H. Hollans , in International Encyclopedia of Housing and Home, 2012

Originate-to-Hold Model versus Securitisation

Depending upon the position that a depository institution takes in regard to mortgage-related assets, the role that deposit insurance plays can be significantly different. Depository institutions may take one of two approaches to mortgage-related activity. Institutions can primarily be in the business of underwriting mortgage loans, which are then converted into portfolio assets and become a part of that banking institution's overall asset portfolio. An alternative to this would be a depository institution serving primarily as a mortgage broker; after underwriting mortgages, they are sold to secondary market investors. The structure of the US housing finance system followed this path over the past several decades, as has that in many other countries.

When comparing the US housing finance system of the 1980s to that in 2008, it is clear that the Originate-to-Hold model that was common before the 1980s has been replaced to a significant degree by the Originate-to-Distribute model. During the period of the early 1980s, savings and loan institutions dominated the home mortgage market, holding a 49% share of the source of funding for residential mortgages. By contrast, commercial banks accounted for only 17% of the market with various mortgage pools and private label investment groups accounting for nearly another 20% market share. By 2008, this paradigm had radically shifted. Commercial banks' share had slightly increased to a 19% share, but saving institutions' share declined to only 8% with credit unions' contributing an additional 3% of total funding. However, the largest single source of funding had shifted toward the securitisation market. Government-Sponsored Enterprise mortgage pools, led by Fannie Mae and Freddie Mac, accounted for 41% of funding, with private mortgage pools contributing an additional 18%.

The monumental shift away from depository institutions holding the lion's share of residential loans to large-scale securitisation significantly impacted the capital structure of these institutions. Historically, institutions that pursued an originate-to-hold strategy gained a steady and acceptable rate of return on capital from mortgage investment. The period of the mid-to-late 1980s fuelled significant changes in this strategy as savings and loan institutions gave way to commercial banks in terms of market share. This transition also impacts the public's perceived risk of deposits in depository institutions that rely heavily upon investment in housing finance as a primary source of revenue. These institutions are somewhat insulated from market downturns in regard to mortgage portfolio value losses, given that a significant portion of the mortgages they create are sold in the secondary market. This behaviour by deposit institutions serves to weaken the rationale for linking housing finance activity with deposit insurance requirements, as the risk of holding mortgage assets is shifted to investors in securities backed by pools of mortgages.

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The Deposit Contract, Deposit Insurance, and Shadow Banking

In Contemporary Financial Intermediation (Third Edition), 2016

General Background

We have now reviewed both the theory and some empirical evidence about the effects of deposit insurance on depository institutions' risk-taking behavior. In trying to understand the great deposit insurance debacle of the 1980s, it is important to remember that until the mid-1970s deposit insurance worked remarkably well. But, two developments undermined federal deposit insurance. One is the lowering of bank charter values, which increased managers' incentives to take more asset risk and to also engage in fraud. The other is the decline in regulatory vigilance over the same period; this simply exacerbated the moral hazard problem of federally insured depository institutions.

The waste that resulted from the collapse of the thrift industry and the many banking failures in the 1980s can be classified into three categories: excessive risk-taking, excessive consumption of perquisites by top executives, and outright fraud. Moreover, these diversions/destructions of wealth were possible due to three factors working in concert: deposit insurance with risk-insensitive pricing, low charter values due to deregulation, and lax monitoring by regulators. This laxity in monitoring, caused by a lowered commitment of resources to supervision, was also compounded by cozy relationships between some regulators and the institutions they were supposed to be watching over. In Figure 12.7, we have provided a simple schematic to summarize these effects.

Figure 12.7. Schematic of Effects Responsible for Problems in Banking and Thrift Industries.

It is not as if S&L and bank managers woke up one morning in the 1980s and decided to change the way they made decisions in order to "rip off" the taxpayers.

The point is that their incentives were altered. Their decision rule was still the same, but the altered incentives changed their behavior. The reasons for the deposit insurance crisis can therefore be traced not just to the managers of depository institutions, but also to the politicians and regulators who pursued myopic and hasty policies. In what follows, we briefly discuss the causes and effects depicted in Figure 12.7.

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Milestones in Banking Legislation and Regulatory Reform

In Contemporary Financial Intermediation (Third Edition), 2016

Title VI – Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions

Title VI provides for a variety of measures to strengthen the regulation of BHCs, saving and loan holding companies and depository institutions to ensure that these will not threaten the stability of the U.S. financial system. Title VI contains the Volcker Rule, which prohibits banks and BHCs from engaging in proprietary trading, and from investing in private equity funds and hedge funds (see Chapter 15 for a more detailed discussion of the Volcker Rule). It also contains other measures that give the Federal Reserve the power to evaluate mergers and acquisitions based on their impact on stability, and to prescribe countercyclical capital buffers when deemed necessary.

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Securitization

Gary Gorton , Andrew Metrick , in Handbook of the Economics of Finance, 2013

8.2 The Federal Reserve and Asset-Backed Securities during the Crisis

Asset-backed securities were at the core of the financial crisis of 2007–2008 because they were, to a large extent, used as collateral in sale and repurchase agreements (repo) and as the assets held by asset-backed commercial paper (ABCP) conduits. Moreover, repo and ABCP were sizeable. ABCP peaked at about $1.2   trillion in July 2007. Repo was around $10   trillion (see Gorton and Metrick (2012) for a discussion of the size of the repo market). These markets are two of the larger money markets, that is, short-term debt obligations that serve essentially like demand deposits in the wholesale market.

In a repo transaction one party deposits/lends money overnight and receives the repo rate. In addition, bonds are provided as collateral to the depositor/lender. The collateral is valued at market rates and is returned to the borrower when the repo matures, if it is not rolled over. This collateral was often ABS, although there are no data to measure the extent of this. Asset-backed commercial paper conduits are managed vehicles which issue short-term debt to finance longer term ABS. Conduits have sponsors, which are financial intermediaries, and the sponsors manage the conduits.

When there was a run on repo and on ABCP conduits, the demand for cash led these intermediaries to sell assets, depressing their prices, leading to further sales, and so on. This is why the prices of ABS completely unrelated to subprime mortgages fell dramatically. Covitz et al. (2009), Gorton (2010), and Gorton and Metrick (2012, c) describe these dynamics of the crisis.

The financial intermediaries at the center of the crisis were dealer banks (the old investment banks), not regulated depository institutions. 28 The short-term liabilities of dealer banks are not insured by the government and dealer banks do not have access to the discount window of the Federal Reserve System. Consequently, the US Treasury Department and the Federal Reserve System introduced a number of programs, involving hundreds of billions of dollars, in response to the financial crisis. Several of these programs were either specifically aimed at asset-backed securities or ABS were eligible to be part of the program. In this subsection we briefly discuss these programs and their effectiveness. Table 11 lists some of the lending facilities related to ABS adopted by the Federal Reserve System during the Crisis. Johnson (in press) provides some detail about each facility.

Table 11. Selected forms of federal reserve lending adopted during the financial crisis

Term Securities Lending Facility Primary Dealer Credit Facility ABCP Money Market Fund Liquidity Facility Commercial Paper Funding Facility Term Asset-Backed Securities Facility
Announcement Date March 11, 2008 March 16, 2008 September 19, 2008 October 7, 2008 November 25, 2008
Eligible borrowers Primary dealers Primary dealers Funds Eligible CP issuers All US persons that own eligible collateral
Facility type Auction Standing Standing Standing Standing
Operation frequency Weekly As requested As requested As requested Twice a month, alternating between non-mortgage backed ABS and CMBS collateral types
Type of borrowing US Treasuries Funds Funds Funds Funds
Eligible collateral US Treasury securities, agency debt, agency MBS, investment grade debt Tri-party repo system collateral First-tier ABCP Newly-issued 3-month unsecured and asset-backed CP from eligible US issuers Recently originated US dollar-denominated AAA ABS, CMBS and legacy CMBS

Source: Federal Reserve Bank of New York, http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf.

The Term Securities Lending Facility (TSLF) was adopted on March 11, 2008 to specifically address the problems that dealer banks were having with ABS that had become difficult to use as collateral. The haircuts on this type of collateral were rising. A "haircut" refers to a situation where the depositor in repo demands overcollateralization for the deposit. For example, if a deposit of $90   million requires collateral worth $100   million, there is said to be a 10% haircut. Gorton and Metrick (2012, c) document the increases in haircuts. This facility is unique in that the dealer borrows US Treasury bonds from the Fed, posting agency bonds, ABS, or investment-grade corporate bonds as collateral. The exchange is one type of bond for another. Fleming, Hrung, and Keane (2010a, 2010b) and Hrung and Seligman (2011) describe and analyze the TSLF.

All the other facilities involve posting collateral in exchange for cash (funds). The Primary Dealer Credit Facility (PDCF) was adopted on March 16, 2008 during the extremes of the Bear Stearns failure and takeover by JP Morgan. The PDCF allows the primary dealers to borrow cash from the Federal Reserve System on a collateralized basis. The PDCF is akin to the Federal Reserve's discount window, which was not available to dealer banks, the institutions at the heart of the financial crisis. The PDCF exchanges eligible bonds as collateral for cash funds. See Adrian, Burke, and McAndrews (2009) for further details.

The remaining two facilities listed in the table were aimed at alleviating the problems that arose for the holders of ABCP and the issuers of CP. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) was created to provide collateralized loans to depository banks and bank holding companies allowing them to buy ABCP from money market mutual funds (MMMFs). The AMLF was intended to increase the liquidity of the ABCP market and also to provide a way for MMMFs to sell their ABCP holdings as they faced runs following the failure of Lehman Brothers—to avoid "breaking the buck". See the discussion in Duygan-Bump, Parkinson, Rosengren, Suarez, and Willen (2010).

MMMFs are a very important set of buyers of commercial paper, so when these funds faced massive redemptions following Lehman Brothers' demise, issuers faced a problem: there were few buyers when it came time to roll over their commercial paper. The Commercial Paper Funding Facility was intended to address this liquidity problem by extending the discount window to issuers of commercial paper. A special purpose vehicle was created (CPFF LLC) to purchase 90-day commercial paper from highly rated US issuers and essentially pledge it to the Federal Reserve System for cash. See Adrian, Kimbrough, and Marchioni (2011).

An important issue concerns whether these special liquidity facilities were effective or not. There is a small, but burgeoning literature on this topic. The most common approach is a time-series approach that tries to determine if spreads changed when a program was initiated; see, e.g. Fleming et al. (2010a, 2010b), Christensen, Lopez, and Rudebusch (2009), and Taylor and Williams (2009). An alternative uses cross-sectional variation. For example, Duygan-Bump et al. (2010) have rich micro data to evaluate the AMLF, and find that it was successful.

The most relevant study is Hrung and Seligman (2011), who study the TSLF in the context of other programs that increased the amount of US Treasuries outstanding. The TSLF increases the amount of Treasuries outstanding because it allows other bonds to be used as collateral to borrow Treasuries. Open market operations exchange cash for Treasuries or vice versa. In addition, there was the Supplementary Financing Program (SFP) introduced on September 17, 2008—two days after Lehman's collapse. The SFP was designed to help the Federal Reserve manage bank reserves. Reserves had to be drained as cash was building up in the banking system. The Treasury was also selling debt for budgetary purposes.

Hrung and Seligman focus on the unique feature of the TSLF, in the context of all the various programs that are changing the overall amount of Treasuries in the economy. The unique feature of the TSLF is that it did not just provide a way to get cash into the system. It was very specific, in that instead of cash it allowed high-quality collateral to be substituted for low-quality collateral, i.e. Treasuries for ABS. Hrung and Seligman look at the effect on the spread between the repo rate when Treasuries are used for collateral (the "general collateral" or GC rate) and the federal funds rate, using daily data and the daily changes in the TSLF amounts, conditional on all other programs. Federal funds are uncollateralized transactions while repo is collateralized; collateralized rates are lower, so this spread is negative.

Their main finding is that an increase in collateral due to the TSLF narrows the fed funds-repo spread. An increase of $1   billion of Treasury collateral via the TSLF narrows the fed funds-repo spread by 12 basis points. This is consistent with the notion that the problem was a run-on repo and that dealer banks needed higher quality collateral. The TSLF was a success in this sense.

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Introduction

Allen N. Berger , Christa H.S. Bouwman , in Bank Liquidity Creation and Financial Crises, 2016

Shadow banks are financial institutions that engage in the same or similar activities as commercial banks, but are not highly regulated depository institutions such as commercial banks, thrifts, or credit unions. They include the finance companies, investment banks, mutual funds, insurance companies, and pension funds already discussed, as well as hedge funds, private equity funds, and other financial firms. i Shadow banks are usually only lightly regulated and supervised or unregulated and unsupervised because they do not accept traditional deposits. As a result, many shadow banks do not have regulatory-imposed capital requirements and are riskier. Since the subprime lending crisis of 2007:Q3–2009:Q4, shadow banks have come under increased scrutiny and regulation. For example, a few shadow banks in the United States are now classified as systemically important financial institutions (SIFIs), and are now prudentially regulated and supervised by the Federal Reserve. j

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Financial Markets, Trading Processes, and Instruments

John L. Teall , in Financial Trading and Investing (Second Edition), 2018

Money Market Issues of Financial Institutions

Nongovernment financial institutions are obviously significant issuers and borrowers in the primary markets for debt instruments. For example, the federal funds markets allow banks and other depository institutions to borrow from one another to meet Federal Reserve requirements. Essentially, this market provides that excess reserves of one bank may be loaned to other banks for satisfaction of U.S. central bank reserve requirements. The rate at which these loans are extended is referred to as the federal funds rate.

Normally, bank accounts are not regarded as marketable securities. One exception to this is the negotiable certificates of deposit (a type of jumbo CD). This is a tradable depository institution CD account with a denomination or balance exceeding $100,000. The amounts by which jumbo CDs exceed $250,000 are not covered by FDIC insurance. Negotiable CDs are often purchased by wealthy individual investors, financial institutions, corporate treasuries, and by money market mutual funds, which are created by banks and investment institutions for the purpose of pooling together depositor or investor funds.

Banker's acceptances are originated when a bank accepts responsibility for paying a client's loan or assuming some other financial responsibility on behalf of a client. Because the bank is likely to be regarded as a good credit risk, these acceptances are usually easily marketable as securities.

Repurchase agreements (repos) are issued by financial institutions (usually securities firms and banks) acknowledging the sale of assets (typically treasuries and fixed-income instruments) and a subsequent agreement to repurchase at a higher price in the near term. This agreement is essentially the same as a collateralized short-term loan; the securities (collateral) reduce credit risk, and the ability of the buyer to be the seller in subsequent repo agreement reduces liquidity risk. Both reductions in risk serve to reduce the cost of the loan to the original repo seller. The repo rate is determined by the price at termination relative to the price at the initiation of the agreement, then adjusted for time. The counterparty institution buying the securities with the agreement to resell them is said to be taking a reverse repo.

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Links to Websites Containing Data, Documents, and Other Information Useful for US Bank Performance Benchmarking, Research, and Policy Work

Allen N. Berger , Christa H.S. Bouwman , in Bank Liquidity Creation and Financial Crises, 2016

16.16 Federal Reserve's monetary policy tools

The Federal Reserve's website discusses its current and expired monetary policy tools:

http://www.federalreserve.gov/monetarypolicy/policytools.htm

1.

Its current tools include, among others, the discount rate, that is, the rate charged to depository institutions including commercial banks on funds received from the discount window. Historically, only quarterly data aggregated at the Federal Reserve district level are available. In response to a Freedom of Information Act request, the Federal Reserve released daily discount window usage at the institution level from Aug. 20, 2007 – March 1, 2010. These data are largely in pdf format and can be found here:

https://publicintelligence.net/federal-reserve-financial-crisis-discount-window-loan-data/

Following the enactment of Dodd-Frank on July 21, 2010, the Federal Reserve releases daily discount window usage at the institution level quarterly with approximately a two-year lag. The data are in Excel format and can be found here:

http://www.federalreserve.gov/newsevents/reform_discount_window.htm

Current tools also include open market operations in which the Federal Reserve Bank of New York buys and sells treasury securities and engages in repurchase agreements for the purpose of influencing the federal funds rate, the main overnight interbank lending rate in the US. Data are available on open market operations starting with transactions conducted after the date of enactment of the Dodd–Frank Act, July 21, 2010, through September 30, 2010. Information for subsequent periods will be published quarterly, approximately two years after the transaction is conducted, and can be found here:

http://www.newyorkfed.org/markets/OMO_transaction_data.html

2.

The Federal Reserve's expired policy tools include the tools used during the subprime lending crisis of 2007:Q3–2009:Q4, such as the Term Auction Facility (TAF) and the Term Asset-Backed Securities Loan Facility (TALF). A helpful overview site with links to the transaction data (in Excel format):

http://www.federalreserve.gov/newsevents/reform_transaction.htm

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Industrial Organisation of the US Residential Mortgage Market

W.S. Frame , L.J. White , in International Encyclopedia of Housing and Home, 2012

Funding

Instead of depositors, the ultimate funding for a securitised mortgage comes from the purchasers of/investors in the MBS. These can be pension funds, insurance companies, bond mutual funds, hedge funds, individual investors, depository institutions, and Fannie Mae and Freddie Mac. It is worth noting that some of these institutions, such as life insurance companies and pension funds, have long-lived payout obligations and thus would seemingly want to match those obligations with long-lived assets, like MBS.

Also, as was noted earlier, investors in private-label MBS would likely want a credit rating agency to evaluate the creditworthiness of the securities, including the credit enhancement arrangements. This, then, introduced another new element into the vertically dis-integrated structure.

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