Balance Sheets Of Financial Intermediaries Research Articles

Wall Street QE vs. Main Street Lending

Monetary and fiscal authorities reacted swiftly to the COVID-19 pandemic by purchasing assets (or “Wall Street QE”) and lending directly to non-financial firms (or “Main Street Lending”). Our paper develops a new framework to compare and contrast these different policies. For the Great Recession, characterized by impaired balance sheets of financial intermediaries, Main Street Lending and Wall Street QE are perfect substitutes and both stimulate aggregate demand. In contrast, for the COVID-19 recession, where non-financial firms faced significant cash flow shortages, Wall Street QE is almost completely ineffective, whereas Main Street Lending can be highly stimulative.

Intermediary Asset Pricing during the National Banking Era

Financial intermediary balance sheets matter for asset returns even when these intermediaries do not directly participate in the relevant asset markets. During the National Banking Era, liquidity conditions for the New York Clearinghouse (NYCH) banks forecast excess returns for stocks, bonds, and currencies. The NYCH banks had little to no direct participation in these markets; their main link to these markets was through securities financing. Liquidity conditions affect asset prices through the credit growth of the NYCH banks, which shapes marginal investors' discount rates. I use institutional features of this era to provide evidence in favor of this mechanism.

Mutual fund flows and fluctuations in credit and business cycles

Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand-based narrative of credit cycles and can be useful for policymakers.

Wall Street vs. Main Street QE

The Federal Reserve has reacted swiftly to the COVID-19 pandemic. It has resuscitated many of its programs from the last crisis by lending to the financial sector, which we refer to as “Wall Street QE.� The Fed is now proposing to also lend directly to, and purchase debt directly from, non-financial firms, which we refer to as “Main Street QE.� Our paper develops a new framework to compare and contrast these different policies. In a situation in which financial intermediary balance sheets are impaired, such as the Great Recession, Main Street and Wall Street QE are perfect substitutes and both stimulate aggregate demand. In contrast, for situations like the one we are now facing due to COVID-19, where the production sector is facing significant cash flow shortages, Wall Street QE becomes almost completely ineffective, whereas Main Street QE can be highly stimulative.

Balance sheet strength and bank lending: Evidence from the global financial crisis

Abstract We use the 2007-2008 financial crisis as a lens to study the link between banks’ financial health and the strength of transmission of financial sector shocks to the real economy. We find that banks with ex-ante stronger balance sheets, in particular higher levels of common equity, were better able to maintain credit supply when faced with liquidity shocks during the crisis. Bank recapitalizations mitigated the lending gap between high and low capital banks, but only in countries with strong sovereigns. These findings support the view that strong financial intermediary balance sheets are key for the recovery of credit and economic performance after large financial sector shocks.

Monetary policy and balance sheets

This paper examines the transmission of monetary policy shocks through private sector balance sheets in the United States over the past three decades. Using a Factor-Augmented Vector Autoregression (FAVAR) model on an expanded dataset, including sectoral balance sheet variables, we show that the balance sheets of various economic agents act as important links in the monetary policy transmission mechanism and affect the impulse response of inflation, output, and unemployment. Balance sheets of financial intermediaries, such as commercial banks, asset-backed-security issuers and, to a lesser extent, security brokers and dealers, shrink in response to monetary tightening, while money market fund assets grow. However, their economic significance in the run-up to the recent financial crisis was small. Furthermore, judging from the magnitude of the interest rate elasticity of house price changes, it seems that large increases in interest rates would have been needed to avert a rapid rise of house prices and an unsustainable increase in leverage. This suggests that financial stability concerns may require some role for other policies such as macroprudential policy.

The Effect of Intermediary Risk Appetite and the Macro Risk Premium: The Great Depression

The consensus among economists is that both monetary and nonmonetary factors played a role in the Great Depression. There is relatively little consensus, however, regarding the specific transmission mechanism through which monetary factors created prolonged non-neutralities. Recent research on the Great Recession sheds light on a new subset of monetary transmission mechanisms that works through constraints on credit supply, rather than the traditional money supply or credit demand. Following the methodology of Adrian, Moench, and Shin (2010a), I document a relationship between changes in financial intermediary balance sheets, i.e. intermediary “risk appetite,” macro risk premia, and real economic activity during the era encompassing the Great Depression (1919-1941). These results suggest that supply-side credit constraints were, in fact, present during the Great Depression, and therefore represent a new explanation for the prolonged non-neutrality of monetary factors.

Balance sheets of financial intermediaries: Do they forecast economic activity?

This paper conducts a real-time, out-of-sample analysis of the forecasting power of various aggregate financial intermediaries’ balance sheets for a wide range of economic activity measures in the United States. I find evidence that the balance sheets of leveraged financial institutions do have out-of-sample predictive power for future economic activity, and this predictability arises mainly through the housing sector. Nevertheless, I show that these variables have very little predictive power during periods of economic expansion, with predictability arising mainly during the financial crisis period.

Balance Sheet Strength and Bank Lending During the Global Financial Crisis

We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. In particular, we exploit variation in banks’ wholesale funding reliance and their capital levels in 2007Q2 to estimate the impact of bank liquidity shocks in 2007-2008 on the supply of large corporate loans and real economic outcomes. We find that banks with ex-ante stronger balance sheets were better able to maintain lending during the global financial crisis. Banks that were more dependent on market funding reduced the supply of credit more than other banks during the crisis but higher levels of better-quality capital mitigated this effect. Reduced credit supply translated into lower economic activity for firms borrowing from thinly-capitalized banks, suggesting there was limited scope for credit substitution across lenders or debt markets. These findings indicate that strong financial intermediary balance sheets are key for the recovery of credit and economic performance after large financial sector shocks. They also support regulatory steps to boost high-quality capital buffers under the Basel III framework.

Monetary Policy and Balance Sheets

This paper evaluates the strength of the balance sheet channel in the U.S. monetary policy transmission mechanism over the past three decades. Using a Factor-Augmented Vector Autoregression model on an expanded data set, including sectoral balance sheet variables, we show that the balance sheets of various economic agents act as important links in the monetary policy transmission mechanism. Balance sheets of financial intermediaries, such as commercial banks, asset-backed-security issuers and, to a lesser extent, security brokers and dealers, shrink in response to monetary tightening, while money market fund assets grow. The balance sheet effects are comparable in magnitude to the traditional interest rate channel. However, their economic significance in the run-up to the recent financial crisis was small. Large increases in interest rates would have been needed to avert a rapid rise of house prices and an unsustainable expansion of mortgage credit, suggesting an important role for macroprudential policies.

140 Years of Financial Crises: Old Dog, New Tricks

Abstract Looking at 140 years of modern financial history, this paper analyses what is new and what is old about the 2008/09 financial crisis. I identify a number of traits common to most financial crises in 19th and 20th century economic history. First, systemic banking crises are typically credit booms gone bust, i.e. they are preceded by periods of marked expansions of the balance sheets of financial intermediaries. Second, despite much more active central bank policies, financial crises have remained costly for the real economy. Third, increases of public debt in the aftermath of banking crisis are nothing new, but there are some indications that the costs have increased over time. However, this time was also different in three respects: first, the dependence of the financial system on wholesale funding markets is a historically new phenomenon with major implications for financial stability and monetary policy. Second, the crisis was closely linked to the emergence of global imbalances and unprecedented reserve accumulation. Third, the global credit boom since the late 1970s did not feed into higher investment rates, which raises questions about the economic benefits of the strong increase in financial intensity in recent years.

140 Years of Financial Crises: Old Dog, New Tricks

Looking at 140 years of modern financial history, this paper analyses what is new and what is old about the 2008/09 financial crisis. I identify a number of traits common to most financial crises in 19th and 20th century economic history. First, systemic banking crises are typically credit booms gone bust, i.e. they are preceded by periods of marked expansions of the balance sheets of financial intermediaries. Second, despite much more active central bank policies, financial crises have remained costly for the real economy. Third, increases of public debt in the aftermath of banking crisis are nothing new, but there are some indications that the costs have increased over time. However, this time was also different in three respects: first, the dependence of the financial system on wholesale funding markets is a historically new phenomenon with major implications for financial stability and monetary policy. Second, the crisis was closely linked to the emergence of global imbalances and unprecedented reserve accumulation. Third, the global credit boom since the late 1970s did not feed into higher investment rates, which raises questions about the economic benefits of the strong increase in financial intensity in recent years.

Financial Intermediaries and Monetary Economics

We reconsider the role of financial intermediaries in monetary economics, and explore the hypothesis that the financial intermediary sector is the engine that drives the financial cycle through fluctuations in the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and, hence, for the risk-taking channel of monetary policy. We document evidence that balance sheets of financial intermediaries provide a window on the transmission of monetary policy through capital market conditions. Short-term interest rates are found to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and suggest the importance of tracking balance sheet quantities.

The Adverse Feedback Loop and the Effects of Risk in Both the Real and Financial Sectors

Recessions that are accompanied by financial crises tend to be more severe and are followed by slower recoveries than ordinary recessions. This paper introduces a new Keynesian model with financial frictions on both the demand and supply side of the credit markets that can explain this empirical finding. Following a shock that leads to a decline in economic activity, an adverse feedback loop arises where falling profits and asset values lead to increased defaults in the real sector, and these increased defaults lead to increased loan losses in the banking sector. Following this increase in loan losses, financial frictions in the banking sector imply that the banking sector itself may face difficulty obtaining funds. This disruption in the intermediation process leads to a further decline in output and asset prices in the real sector. In simulations of the model it is found that this feedback loop operating through the balance sheets of financial intermediaries can lead to as much as a 20% increase in business cycle volatility, and impulse response analysis shows that in the presence of financial frictions the path back to the steady state after a shock is much slower.

Risk Appetite and Exchange Rates

We present evidence that fluctuations in the aggregate balance sheets of financial intermediaries forecast exchange rate returns—at weekly, monthly, and quarterly frequencies, both in and out of sample, and for a large set of countries. We estimate prices of risk using a cross-sectional, arbitrage-free asset pricing approach and show that balance sheets forecast exchange rates because of the latter’s association with fluctuations in risk premia. We provide a rationale for an intertemporal equilibrium pricing theory in which intermediaries are subject to balance sheet constraints.

Financial Intermediaries, Financial Stability, and Monetary Policy

In a market-based financial system, banking and capital market developments are inseparable. We document evidence that balance sheets of market-based financial intermediaries provide a window on the transmission of monetary policy through capital market conditions. Short-term interest rates are determinants of the cost of leverage and are found to be important in influencing the size of financial intermediary balance sheets. However, except for periods of crises, higher balance-sheet growth tends to be followed by lower interest rates, and slower balance-sheet growth is followed by higher interest rates. This suggests that consideration might be given to a monetary policy that anticipates the potential disorderly unwinding of leverage. In this sense, monetary policy and financial stability policies are closely linked.

Financial Restructuring In East Asia: Halfway There?

Resolving systemic banking and corporate distress is no easy task. This paper reviews bank and corporate restructuring efforts in the four East Asian crisis countries. Indonesia, Republic of Korea, Malaysia, Thailand, and identifies remaining priorities for reform. The analysis indicates that two years into the process, much has been done,but much remains to be accomplished. Although governments have spent substantial resources to clean up the balance sheets of financial intermediaries, restructuring is incomplete, much new capital is still needed, and for most intervened financial institutions new private owners have yet to be found. Progress on corporate restructuring is less advanced, and many corporations remain overindebted. Durable economic recovery depends on further progress in both areas. In particular, decisive improvements in the allocation of investible funds will require better-capitalized banking systems and deeper institutional reforms in financial regulation and supervision, corporate governance, and bankruptcy procedures.