Reprint of: Thawing frozen capital markets and backdoor bailouts: Evidence from the Fed's liquidity programs

During the subprime crisis, the Federal Reserve introduced several emergency liquidity programs as supplements to the discount window (DW): TAF, PDCF, and TSLF. Using data on loans to large commercial banks and primary dealers, we find that the programs were used by relatively few institutions and thus provided limited relief to banks that relied on short-term debt markets. Although usage increased after Lehman's bankruptcy, most commercial banks avoided the DW and TAF. We also find that the programs were more often used by failed European banks than by healthy US banks, likely because these loans are expensive relative to private market funds. Our results also show that usage of PDCF and TSLF programs, while higher, was more often used by primary dealers in weaker financial position.     

Thawing frozen capital markets and backdoor bailouts: Evidence from the Fed's liquidity programs

During the subprime crisis, the Federal Reserve introduced several emergency liquidity programs as supplements to the discount window (DW): TAF, PDCF, and TSLF. Using data on loans to large commercial banks and primary dealers, we find that the programs were used by relatively few institutions and thus provided limited relief to banks that relied on short-term debt markets. Although usage increased after Lehman's bankruptcy, most commercial banks avoided the DW and TAF. We also find that the programs were more often used by failed European banks than by healthy US banks, likely because these loans are expensive relative to private market funds. Our results also show that usage of PDCF and TSLF programs, while higher, was more often used by primary dealers in weaker financial position.     

Discount window borrowing after 2003: The explicit reduction in implicit costs

In 2003, the Federal Reserve introduced primary credit as its main discount window lending program. This program replaced the adjustment credit program, which, subject to a number of restrictions, had generated a stigma associated with borrowing from the Federal Reserve. Lessening the stigma of borrowing was viewed as essential for reducing the reluctance to borrow from the Federal Reserve. We develop a structural model of daily borrowing. Using this model, we estimate the implicit cost associated with borrowing. Our results suggest that the stigma of borrowing is significantly reduced.     

Liquidity Risk,Bank Networks,and the Value of Joining the Federal Reserve System

Reducing systemic liquidity risk related to seasonal loan demand was one reason for founding the Federal Reserve System. Nevertheless, less than 8% of state‐chartered banks joined the Fed in its first decade. Banks facing high liquidity risk from seasonal loan demand were more likely to join the Fed in its first decade. We also find evidence consistent with the notion that banks could obtain some indirect access to the discount window through interbank transfers. Some banks apparently joined the Fed to pass through discount window liquidity to other banks via the interbank network.  Joining the Fed increased member banks’ lending.     

The evolution of the Federal Reserve’s Term Auction Facility and FDIC-insured bank utilization

The Term Auction Facility (TAF) was designed by the Federal Reserve during the financial crisis to inject emergency short-term funds into banks, as a supplement to the lender of last resort discount window offerings. We describe how the Federal Reserve altered the design of the Term Auction Facility (TAF) over the course of the financial crisis and examine the utilization of this stand-alone facility. Most specifically we detail the impact of the greatly increased offering amounts in all auctions after October 2008, which resulted in the facility no longer auctioning scarcely available funds. We also document significantly different usage of the facility by FDIC-insured community and non-community banks, consistent with the notion of a two-tiered banking system in the U.S. Community banks were far less likely to use the facility than larger, non-community banks.     

Federal Reserve financial crisis lending programs and bank stock returns

We use an E-GARCH model to estimate the wealth effects of Federal Reserve lending during the financial crisis to Investment banks (I-Banks), “Too Big to Fail” (TBTF) banks, and “traditional” commercial banks. Borrowing from the Term Auction Facility program has negative wealth effects for all banks and I-banks in particular. We also find that the market view of the liquidity programs changed across the sample sub-periods. I-Bank and TBTF bank borrowing from the discount window is initially viewed positively, however continued use of the discount window and the Term Auction Facility was generally (though not universally) viewed negatively. Commercial Paper Funding Facility program participation is consistently positive only for traditional banks and programs that focus on the purchase of specific securities (e.g., commercial paper) to address specific problems also appear to primarily benefit traditional banks. The inconsistency of results across the time periods of the crisis is telling as market participants struggled to discern what access to these programs meant.     

Banks' Liquidity and the Cost of Liquidity to Corporations

We consider the liquidity shock banks experienced following the collapse of the asset‐backed commercial paper (ABCP) market in the fall of 2007 to investigate whether banks' liquidity conditions affect their ability to provide liquidity to corporations. We find that banks that borrowed more from the Federal Home Loan Bank system or the Federal Reserve's discount window following that liquidity shock passed a larger portion of their borrowing costs onto corporations seeking access to liquidity when compared to the precrisis period. This increase is larger among banks with a bigger exposure to the ABCP market, credit lines that pose more liquidity risk to banks, and borrowers that are likely dependent on the credit‐line provider. Our findings show that the crisis that affected the banking system had a negative effect not only on the price of credit to corporations, but also on the price corporations pay to guarantee access to liquidity.     

The effect of the Federal Reserve’s lending facility on PPP lending by commercial banks

We investigate whether the Federal Reserve’s Paycheck Protection Program Liquidity Facility (PPPLF) boosted commercial bank Paycheck Protection Program (PPP) lending. To determine whether this facility had a causal effect, we use pre-existing familiarity with the Federal Reserve’s discount window as an instrumental variable. We show that the PPPLF materially bolstered bank PPP lending and provided a meaningful funding backstop for banks that did not use the facility. Our paper is one of the first to quantitatively illustrate the effectiveness of a central bank facility as a funding backstop.     

Reserve regulation and recourse as a source of risk premia in the federal funds market

In this paper we demonstrate that there is a pronounced and persistent daily pattern of returns in the federal funds market, centered on Wednesday. We present evidence that explains this phenomenon as a reflection of the optimal behavior of banks operating in an environment in which there are effective reserve requirements and a penalty cost for recourse to discount borrowing. In particular, we report empirical evidence that shows there was a significant upward shift in the amplitude of this pattern of daily returns that resulted from (1) the increase in uncertainty associated with the change in Federal Reserve operating procedures during the 1979–1982 period, and (2) the imposition of a surcharge on discount borrowing instituted by the Federal Reserve. Our results demonstrate that what otherwise might be regarded as anomalous interest-rate behavior is consistent with the optimal response of banks to the regulatory environment within which they operate.     

Interventions in Markets with Adverse Selection: Implications for Discount Window Stigma

I study the implications for central bank discount window stigma of a workhorse model of adverse selection in financial markets. In the model, firms (banks) need to borrow to finance a productive project. There is limited liability and firms have private information about their ability to repay their debts, which gives rise to the possibility of adverse selection. The central bank can ameliorate the impact of adverse selection by lending to firms. Discount window borrowing is observable and it may be taken as a signal of firms' credit worthiness. Under some conditions, firms borrowing from the discount window may pay higher interest rates to borrow in the market, a phenomenon often associated with the presence of stigma. I discuss these and other outcomes in detail and what they suggest about the relevance of stigma as an empirical phenomenon.     

A note on discount rate policy and the variability of discount window borrowing

The purpose of this note is to evaluate the appropriate discount rate policy rules consistent with minimization of the variability of borrowing at the Federal Reserve discount window. In the context of Goodfriend's (1983) model of the bank borrowing decision, it is demonstrated that either a penalty rate or a subsidy rate policy will produce minimized variability of borrowing, so long as the subsidy rate adjusts point for point to changes in the value of the Federal funds rate. These policy rules are compatible with a policy procedure designed to target borrowed or non-borrowed reserves. If the Fed does not adhere to one of these specific rules, minimization of borrowing variability requires an open market procedure in which the Fed pegs the Federal funds rate.     

A note on the valuation of asset management firms

Market capitalization relative to assets under management is often used to value asset management firms. Huberman’s (2004) dividend discount model implies that cross-sectional variations in this metric are explained by cross-sectional differences in operating margins, and yet we find no evidence of this in our data set. We show that a superior model—inspired by the work of Berk and Green (2004)—includes also the level of fees as an explanatory variable. This approach dramatically increases the fit of our valuation model and casts doubt on the relevance of the so-called Huberman puzzle.     

Option listing: market quality revisited

We test for changes in liquidity around LEAPS option introduction and find two results that address important disputes in the literature. First, we find that the impact of LEAPS upon share liquidity does not occur until 23 days after the LEAPS are introduced. Our findings are in conflict with Danielsen et al.’s (J Financ Quant Anal 42:1041–1062, 2007) findings that liquidity improves before option introduction, and are consistent with the findings of Kumar et al. (J Finance 53:717–732, 1998). Second, we find that share volume increases before option introduction and so the volume increase can be predictive of option listing, but the shift in volume does not occur early enough to drive the exchange’s introduction decision.     

Bank regulatory capital and liquidity: Evidence from US and European publicly traded banks

The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital and bank liquidity measured from on-balance sheet positions for European and US publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks decrease their regulatory capital ratios when they face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009). However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, our findings also shed light on the need to further clarify how to define and measure illiquidity and also on how to regulate large banking institutions, which behave differently than smaller ones.     

How do global banks scramble for liquidity? Evidence from the asset-backed commercial paper freeze of 2007

We investigate how banks scrambled for liquidity following the asset-backed commercial paper (ABCP) market freeze of August 2007 and its implications for corporate borrowing. Commercial banks in the United States raised dollar deposits and took advances from Federal Home Loan Banks (FHLBs), while foreign banks had limited access to such alternative dollar funding. Relative to before the ABCP freeze and relative to their non-dollar lending, foreign banks with ABCP exposure charged higher interest rates to corporations for dollar-denominated syndicated loans. The results point to a funding risk manifesting as currency shortages for banks engaged in maturity transformation in foreign countries.     

Adaptive basket liquidation

We consider the infinite-horizon optimal basket portfolio liquidation problem for a von Neumann–Morgenstern investor in a multi-asset extension of the liquidity model of Almgren (Appl. Math. Finance 10:1–18, 2003) with cross-asset impact. Using a stochastic control approach, we establish a “separation theorem”: the sequence of portfolios held during an optimal liquidation depends only on the (co-)variance and (cross-asset) market impact of the assets, while the speed with which these portfolios are reached depends only on the utility function of the trader. We derive partial differential equations for both the sequence of portfolios reached during the execution and the trading speed.     

The future and dynamics of global systemically important banks

The purpose of this paper is to analyse some of the issues associated with supervision and regulation of global systemically important banks, G-SIB. The paper highlights the importance of managing liquidity risk and creating a global financial system that can minimise regulatory arbitrage by large financial institutions. The paper argues that, unlike some industries such as the airline industry in which risk has been contained and yet the size and capacity of aircrafts have increased, in the banking system, less progress has been made to contain financial risk and allow large banks to expand their global activities. The paper argues that G-SIB are able to continue remaining large provided that a globally integrated financial system ensures effective global supervision of these large banks. The paper compares the US banking crises in the 19th century and the subsequent emergence of the US Federal Reserve System to the possibility of establishing a world central bank and a global supervisory board. Such new global institutions will have the capacity to reduce regulatory arbitrage, increase effective supervision, reduce systemic and liquidity risk and create a more stable global financial system.     

Modeling the inconsistency in intertemporal choice: the generalized Weibull discount function and its extension

The aim of this paper is to obtain the family of the so-called generalized Weibull discount functions, introduced by Takeuchi (Game Econ Behav 71:456–478, 2011), by deforming the q-exponential discount function by means of the Stevens’ “power” law. The obtained discount functions exhibit different degrees of inconsistency and so they can be classified according to the value of their characteristic deforming parameters. Moreover, we extend the construction of the generalized Weibull discount function starting from any discount function instead of the q-exponential discounting. In any case, the value of the parameter \(\theta \) of these new discount functions is extended from (0, 1] to the union of the intervals \((-\,\infty ,0) \cup (0,+\,\infty )\).     

A BSDE approach to fair bilateral pricing under endogenous collateralization

Nie and Rutkowski (Int. J. Theor. Appl. Finance 18:1550048, 2015; Math. Finance, 2016, to appear) examined fair bilateral pricing in models with funding costs and an exogenously given collateral. The main goal of this work is to extend results from Nie and Rutkowski (Int. J. Theor. Appl. Finance 18:1550048, 2015; Math. Finance, 2016, to appear) to the case of an endogenous margin account depending on the contract’s value for the hedger and/or the counterparty. Comparison theorems for BSDEs from Nie and Rutkowski (Theory Probab. Appl., 2016, forthcoming) are used to derive bounds for unilateral prices and to study the range for fair bilateral prices in a general semimartingale model. The backward stochastic viability property, introduced by Buckdahn et al. (Probab. Theory Relat. Fields 116:485–504, 2000), is employed to examine the bounds for fair bilateral prices for European claims with a negotiated collateral in a diffusion-type model. We also generalize in several respects the option pricing results from Bergman (Rev. Financ. Stud. 8:475–500, 1995), Mercurio (Actuarial Sciences and Quantitative Finance, pp. 65–95, 2015) and Piterbarg (Risk 23(2):97–102, 2010) by considering contracts with cash-flow streams and allowing for idiosyncratic funding costs for risky assets.     

Change of numeraire in the two-marginals martingale transport problem

In this paper, we apply change of numeraire techniques to the optimal transport approach for computing model-free prices of derivatives in a two-period setting. In particular, we consider the optimal transport plan constructed in Hobson and Klimmek (Finance Stoch. 19:189–214, 2015) as well as the one introduced in Beiglböck and Juillet (Ann. Probab. 44:42–106, 2016) and further studied in Henry-Labordère and Touzi (Finance Stoch. 20:635–668, 2016). We show that in the case of positive martingales, a suitable change of numeraire applied to Hobson and Klimmek (Finance Stoch. 19:189–214, 2015) exchanges forward start straddles of type I and type II, so that the optimal transport plan in the subhedging problems is the same for both types of options. Moreover, for Henry-Labordère and Touzi’s (Finance Stoch. 20:635–668, 2016) construction, the right-monotone transference plan can be viewed as a mirror coupling of its left counterpart under the change of numeraire.