Public Debt Management and Macroeconomic Stability: An Overview

Recent research suggests that management of the public sector’sdebt can have important effects on a country’s macroeconomicperformance. This article provides an overview of the factorsthat the recent literature has identified as important in determiningthe optimal composition of the public debt. Based on this analysis,it attempts to establish general guidelines for public debtmanagement in emerging economies. To retain market access andpromote domestic financial market development, governments shouldgenerally finance themselves at market rates using a wide varietyof securities. Beyond this general principle, the optimal compositionof the public debt involves a tradeoff between enhancing thegovernment’s anti–inflationary credibility and reducingthe vulnerability of its budget to macroeconomic shocks. Consequently,the optimal composition of the debt depends on a country’scircumstances. Debt should be heavily weighted toward long-termnominal securities for governments that have anti–inflationarycredibility and toward long-term indexed debt for those thatdo not.      

On the importance of retail banking relationships

We use proprietary data to analyze the importance of retail banking relationships to commercial banks and their depositors when banks underwrite securities. We find lead underwriters’ retail customers benefit as they demand and end up with significantly more of the highly underpriced issues. We find it is actual underpricing beyond that predicted by grey markets that drive the differential demand from the lead bank retail clientele, suggesting that banks pass on information about underpriced initial public offerings to their retail depositors. We analyze banks’ incentives for such behavior and find evidence of banks benefiting through retail cross-selling—both brokerage accounts and consumer loans increase significantly.     

Two Modes of Investment Banking: Technocrats,Relationship Managers,and Conflict

Efficient capital allocation in a market economy depends on the exchange of reliable information between providers of capital and companies that seek to put capital to work. One challenge, however, is that information exchange is at most only partly subject to verification and contractual arrangements. Take the case of securities issuance, including IPOs; whereas issuers of the new securities have incentives to overstate their prospects to attract higher bids, prospective investors have incentives to understate their interest. In principle, the counterparties could enter into an agreement that would prevent or discourage misrepresentations by both sides, but failure to perform would be very costly, if not impossible, for a court to verify. Investment banks have traditionally addressed this problem by creating extralegal markets for information whose functioning depends on the reputations of the banks for upholding the interests of both their corporate clients and the providers of capital. But committing to strike the right balance among all of the parties’ interests means that relational investment bankers inevitably face conflicts of interest. The authors of this article argue that such bankers exist to absorb and to manage conflicts of interest in financial markets—and that they do so by exercising judgment in ways that support their reputation for fair dealing. Modern full‐service investment banks, when addressing such conflicts, combine, or braid, such relational functions with technocratic banking activities involving the use of technical skills with advanced information technology. In so doing, however, technocratic bankers substitute formal contracts for the informal judgment exercised by relational bankers; and as a result, they are less dependent on their banks’ reputations for fair dealing. Moreover, technocratic bankers often have powerful incentives to pursue a personal reputation by executing complex transactions that demonstrate their skill, even at the expense of their clients and the bank's reputation for fair dealing. Well‐governed braided banks can benefit from complementarities between relational and technocratic skills. Nevertheless, full‐service banks continue to struggle with governance problems. The authors discuss several market responses to these struggles, such as the growing use of boutique banks offering “unconflicted” sell‐side advice in mergers and acquisitions and securities offerings. But the authors view such responses as at most a first step toward achieving a new understanding of the extent of the challenge facing today's investment banks in carrying out their economic function of bringing together and balancing the interests of companies and their investors.     

Competition and Strategic Information Acquisition in Credit Markets

We investigate the interaction between banks’ use of informationacquisition as a strategic tool and their role in promotingthe efficiency of credit markets when a bank’s abilityto gather information varies with its distance to the borrower.We show that banks acquire proprietary information both to softenlending competition and to extend their market share. As competitionincreases, investments in information acquisition fall, leadingto lower interest rates but also to less efficient lending decisions.Consistent with the recent wave of bank acquisitions, we alsofind that merging for informational reasons with a competitoris an optimal response to industry consolidation.     

Commercial banks in investment banking conflict of interest or certification role?

When commercial banks make loans to firms and also underwrite securities, does this hamper or enhance their role as certifiers of firm value? This paper examines empirically the pricing of bank-underwritten securities as compared to investment-house-underwritten securities over a unique period in the U.S. (pre-Glass-Steagall) when both banks and investment houses were allowed to underwrite securities. The evidence shows that investors were willing to pay higher prices for securities underwritten by banks rather than investment houses. The results support a certification role for banks, which is more valuable for junior and information sensitive securities.     

Dynamic Portfolio Choice with Parameter Uncertainty and the Economic Value of Analysts' Recommendations

We derive a closed-form solution for the optimal portfolio ofa nonmyopic utility maximizer who has incomplete informationabout the alphas or abnormal returns of risky securities. Weshow that the hedging component induced by learning about theexpected return can be a substantial part of the demand. Usingour methodology, we perform an "ex ante" empirical exercise,which shows that the utility gains resulting from optimal allocationare substantial in general, especially for long horizons, andan "ex post" empirical exercise, which shows that analysts’recommendations are not very useful. (JEL C61, G11, G24)     

Competing for underwriting market share: The case of commercial banks and securities firms

This study analyzes changes in the underwriting market share of securities firms and commercial banks over a 20-year period that encompasses the deregulation period of 1989–1999. The study finds that, after controlling for firm combination effects, there is no evidence that commercial banks gained share at the expense of ranked traditional underwriters. There is strong evidence that market breadth helps both securities firms and commercial banks to gain market share, whereas greater share in the underwriting of a specific security has the opposite effect on next year's market share. There is supportive but limited evidence that high-volume years favor commercial banks, whereas low-volume years favor prestigious underwriters. The influence of firm-specific factors is limited to a few markets, which may explain the stickiness of underwriting market share of ranked firms over time.     

Tainted portfolios: How impairment accounting rules restrict security sales

Contrary to claims that fair value accounting exacerbated banks’ securities sales during the recent financial crisis, we present evidence that suggests – if anything – that the current impairment accounting rules served as a deterrent to selling. Specifically, because banks must provide evidence of their ‘intent and ability’ to hold securities with unrealized losses, there are strong incentives to reduce, rather than increase, security sales when market values decline to avoid ‘tainting’ their remaining securities portfolio. Validating this concern, we find that banks incur greater other‐than‐temporary impairment (OTTI) charges when they sell more securities. We then find that banks sell fewer securities when their security portfolios have larger unrealized losses (and thus larger potential impairment charges), and these results are concentrated in banks with homogenous securities portfolios, expert auditors, more experienced managers, and greater regulatory capital slack. Overall, our results suggest that – contrary to critics’ claims – the accounting rules appear to have reduced banks’ propensity to sell their securities during the financial crisis.     

Bank valuation and accounting discretion during a financial crisis

This paper shows that banks overstate the value of distressed assets and their regulatory capital during the US mortgage crisis. Real estate-related assets are overvalued in banks' balance sheets, especially those of bigger banks, compared to the market value of these assets. Banks with large exposure to mortgage-backed securities also provision less for bad loans. Furthermore, distressed banks use discretion over the classification of mortgage-backed securities to inflate their books. Our results indicate that banks' balance sheets offer a distorted view of the financial health of the banks and provide suggestive evidence of regulatory forbearance and noncompliance with accounting rules.     

Participation in WTO Dispute Settlement: Complainants, Interested Parties, and Free Riders

What affects a country’s decision of whether to formallyengage in a trade dispute directly related to its exportinginterests? This article empirically examines determinants ofaffected country participation decisions in formal trade litigationarising under the World Trade Organization (wto) between 1995and 2000. It investigates determinants of nonparticipation andexamines whether the incentives generated by the system’srules and procedures discourage active engagement in disputesettlement by developing country members in particular. Thoughthe size of exports at stake is found to be an important economicdeterminant affecting the decision to participate in challengesto a wto-inconsistent policy, the evidence also shows that measuresof a country’s retaliatory and legal capacity as wellas its international political economy relationships matter.These results are consistent with the hypothesis of an implicit"institutional bias" generated by the system’s rules andincentives that particularly affects developing economy participationin dispute settlement.     

Bank earnings and regulatory capital management using available for sale securities

Based on a large sample of publicly listed and non-listed US commercial banks from 1996 to 2011, we find robust evidence consistent with banks using realized available for sale (AFS) securities gains and losses to smooth earnings and increase low regulatory capital. We also find that (i) banks with positive earnings smooth earnings, and banks with negative earnings generally take big baths; (ii) regulatory capital constrains big baths; (iii) banks with more negative earnings and more unrealized beginning-of-quarter losses (gains) take big baths (smooth earnings); and (iv) banks with low regulatory capital and more unrealized gains realize more gains. Also, banks with negative earnings take big baths (avoid or reduce the earnings loss) if their unrealized gains are insufficient (sufficient) to offset the negative earnings. Our inferences apply to listed and non-listed banks, which indicates that the earnings management incentives do not derive solely from public capital markets. Our findings reveal that the accounting for AFS securities gains and losses enables banks to manage regulatory capital and earnings in a variety of ways.     

A Model of QE,Reserve Demand,and the Money Multiplier

Quantitative easing (QE) programs have driven unprecedented expansions in the supply of central bank reserves around the world over the past two decades, fundamentally changing the implementation of monetary policy. The collapse in money multipliers following QE episodes has often been interpreted as implying banks are happy to passively hold most of the reserves created by QE. This paper develops a simple microsimulation model of the banking sector that adapts the traditional money multiplier model and allows for bank reserve demand to be inferred from monetary aggregates. The model allows the use of unwanted reserves by banks to play out over time alongside QE purchases and incorporates both significantly higher reserve demand after 2008 and capital constraints. With these additions, the model explains the persistently lower money multipliers seen in the United States following QE, as well as the growth in commercial bank deposits. The model suggests the demand from banks for reserves has increased substantially since the introduction of QE but not to the point where banks are passively absorbing all newly created reserves.     

Aspects of insurance,intermediation and finance

This paper is concerned with the role of the insurance company as a financial intermediary which offers securities to uninformed retail investors. The search costs of retail investors cause the demand for the securities offered by intermediaries to be inelastic, making possible an intermediary spread, the difference between the returns on primary securities and the rates offered on the secondary securities sold by intermediaries. It is argued that the intermediary spread is economically significant, and a simple model of its determination is offered: the spread is shown to be an increasing function of interest rates. The bonus policy of life insurance companies is analyzed and is shown to be inefficient under simple assumptions about asset returns.     

Consolidation and universal banking

Banks in the US have been competing with investment banks through newly created “Section 20” subsidiaries. The evidence to date suggests that banks entry into securities activities via these subsidiaries has been pro-competitive. Recently, however, banks have been allowed to enter securities activities via acquisitions. This may not result in the same competitive effects as “new bank” entry.     

Pricing,operating efficiency,and profitability among large commercial banks

This study uses statistical cost accounting techniques to examine the relationship between bank profitability and two dimensions of operating performance — pricing and operating efficiency. The traditional statistical cost accounting model, which relates a firm's income to its asset and liability mix, is expanded to account for differences in market structure, regional demand and supply conditions, and macroeconomics factors. The study focuses on large (above $500 million in domestic deposits) banks, comparing a sample of relatively profitable banks against a matched group of much less profitable banks over the period 1970–1977. After allowing for regional supply and demand factors, the high and low-profit banks are estimated to earn equal market rates of return on individual assets and liabilities. There is virtually no evidence that differential prices are an important discriminator between the two bank groups. Some evidence is found that the high-earnings banks experience lower operating costs on some liabilities, but the opposite is true with respect to selected asset items. After taxes are taken into account, however, any such cost differentials virtually disappear. Overall, there is no compelling evidence that high-profit banks are characterized by greater operating efficiency than their low-earnings counterparts. This finding is consistent with the view that over time, and especially among relatively large banks, information flows and competitive pressures act to reduce operating efficiency differences that may appear in the short run.     

The Behavior of the Interest Rate Differential Between Tax-exempt Revenue and General Obligation Bonds: A Test of Risk Preferences and Market Segmentation

This paper presents evidence that the yield differential between revenue bonds and similar general obligation bonds varies contracyclically with the level of economic activity. The evidence also indicates that significant investor-borrower induced market segmentation exists in the municipal bond market. An increase in the relative demand by commercial banks for tax-exempt securities and/or an increase in the supply of revenue bonds relative to the supply of general obligation bonds increase the yield spread between the two classes of debt. These findings were the result of a series of empirical tests with both macroeconomic and microeconomic data.     

Negative Monetary Policy Rates and Systemic Banks' Risk-Taking: Evidence from the Euro Area Securities Register

We show that negative monetary policy rates induce systemic banks to reach-for-yield. For identification, we exploit the introduction of negative deposit rates by the European Central Bank in June 2014 and a novel securities register for the 26 largest euro area banking groups. Banks with more customer deposits are negatively affected by negative rates, as they do not pass negative rates to retail customers, in turn investing more in securities, especially in those yielding higher returns. Effects are stronger for less capitalized banks, private-sector (financial and nonfinancial) securities and dollar-denominated securities. Affected banks also take higher risk in loans.     

Raising rival's costs in the securities settlement industry

The competition between a central securities depository (CSD) and a custodian bank is analyzed in a Stackelberg model. Investor banks decide whether to use the services of the CSD or of the custodian bank, depending on the prices and their preferences for their inhomogeneous services. Since the custodian bank uses services provided by the CSD as input, the CSD can raise its rival's costs. The CSD's equilibrium market share is higher than socially optimal, unless the CSD is not allowed to charge negative prices. This result has important policy implications that are related to a discussion currently taking place in the securities settlement industry.     

What's different about banks?

Negotiable certificates of deposit (CD's) trade in the capital market in competition with other securities like commercial paper and bankers' acceptances. If CD's must pay lenders competitive monetary interest, the reserve tax on CD's is borne by bank borrowers. Viability of the tax means there must be something special about bank loans that makes some borrowers willing to pay higher interest rates than those on other securities of equivalent risk. Moreover, there must be something special about banks that prevents other intermediaries from competing to assure that it never pays to finance loans with CD's.     

Distance Still Matters: Evidence from Municipal Bond Underwriting

Using a sample of municipal bond offerings, I find that "local"investment banks have substantial comparative and absolute advantagesover nonlocal counterparts-–locals charge lower fees andsell bonds at lower yields. Local investment banks’ strongestcomparative advantage is at underwriting bonds with higher creditrisk and bonds not rated by rating agencies. These findingssuggest that high-risk bonds and nonrated bonds are more difficultto evaluate and market, and that investment banks with a localpresence are better able to assess "soft" information and placedifficult bond issues.