Financial Institutions/ Consumer Finance

The management and regulation of financial institutions has been at the center of the current crisis. Expert views and research in this area will help shape understanding of financial institutions, their role in the recent crisis and their importance going forward.

As the world observed, a poor understanding of consumer finance in general and sub-prime loans in particular shook the financial world in 2007 and continues to reverberate. One of the outcomes has been the creating of stronger consumer protection laws and a rapid change in the industry.

The financial institutions and consumer finance track of the Smith School's Center for Financial Policy is composed of academic and industry experts. The track provides a forum for the discussion and dissemination of research and policy analysis in both financial institutions and consumer finance.

Addresses & Testimony

State of the Housing Market: Removing Barriers to Economic Recovery
by CFP Academic Fellow Phillip Swagel
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Swagel testifies before the Senate Committee on Banking, Housing, and Urban Affairs on February 9, 2012.

Enhanced Supervision: A New Regime for Regulating Large, Complex Financial Institutions
by CFP Academic Fellow Phillip Swagel
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Swagel testifies before the Committee on Banking, Housing, and Urban Affairs, Subcommittee on Financial Institutions and Consumer Protection in the U.S. Senate on December 7, 2011.

Monetary Policy and Job Creation
by Federal Reserve Governor Sarah Bloom Raskin
Highlights | CSPAN Video | Transcript
Governor Raskin defends the recent Fed policy moves at CFP’s Distinguished Speaker Series on September 26, 2011.

Policy Briefs

February 26, 2013
Increasing the Role of the Private Sector in Housing Finance 
By Phillip Swagel
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This paper proposes reforms of the U.S. housing finance system to increase the role of private capital in funding housing, reduce taxpayer exposure to housing risk, sell off the government stakes in the mortgage finance firms of Fannie Mae and Freddie Mac, and charge appropriate premiums for secondary insurance provided by the U.S. government on housing securities.

February 12, 2011
Reforming the GSEs: Where’s the Beef?
by Cliff Rossi 
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The much anticipated joint report from Treasury and HUD last week on reforming mortgage markets in the end was short on specific recommendations but had a options that would sharply limit government involvement in housing and long-term. The report also offered some introspection into the causes of the GSEs’ demise including a lack of credit discipline, particularly late in the housing bubble administration lost a prime opportunity for laying out a comprehensive strategy for getting the housing market back on track.

October 21, 2010
Bank Supervision: Penny Wise & Pound Foolish?
by Cliff Rossi 
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Seemingly pervasive deficiencies at mortgage servicers and their associated vendors to properly process foreclosure documents point to a serious but little known set of facts…

October 14, 2010
Pulling Back the Veil on Foreclosures
by Cliff Rossi
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Today’s headlines showing that foreclosures have reached record levels punctuate the widening debate over the causes and cures of the ongoing foreclosure crisis…

Consumer Protection and Regulatory Changes in the Dodd-Frank Bill
by Ethan Cohen-Cole
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Summary: On 21 July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank” or “Act”).

White Papers

A Way Forward on the Housing Crisis 
by Clifford Rossi
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Working Papers

Corporate Financial Distress and Bankruptcy: A Survey
By Lemma W. Senbet and Tracy Yue Wang
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Inside Debt, Bank Default Risk and Performance during the Crisis
by Haluk Ünal
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How Your Counterparty Matters: Using Transaction Networks to Explain Returns in CCP Marketplaces
By CFP Faculty Associate Ethan Cohen-Cole, Andrei A. Kirilenko, and Eleonora Patacchini
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Abstract: We study the profitability of traders in two fully electronic, highly liquid markets, the Dow and S&P 500 e-mini futures markets.

We document and seek to explain the fact that traders that transact with each other in this market have highly correlated returns. While traditional least squares regressions explain less than 1% of the variation in trader-level returns, using the network pattern of trades, our regressions explain more than 70% of the variation in returns. Our approach includes a simple representation of how much a shock is amplified by the network and how widely it is transmitted. It provides a possible short-hand for understanding the consequences of a fat-finger trade, a withdrawing of liquidity, or other market shock. In the S&P 500 and DOW futures markets, we find that shocks can be amplified more than 50 times their original size and spread far across the network. We interpret the link between network patterns and returns as reflecting differences in trading strategies. In the absence of direct knowledge of traders’ particular strategies, the network pattern of trades captures the relationships between behavior in the market and returns. We exploit these methods to conduct a policy experiment on the impact of trading limits.

Systemic Risk and Network Formation in the Interbank Market
By Ethan Cohen-Cole, Eleonora Patacchini, and Yves Zenou
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Abstract: We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default.

Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

The Cost Effectiveness of the Private-Sector Reorganization of Failed Banks
by Rosalind L. Bennett and Haluk Ünal
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Abstract: In this paper, we examine how the cost to the FDIC of resolving bank failures differs between two types of resolution methods of failed banks: liquidation and a private-sector reorganization.

An FDIC liquidation is analogous to a Chapter 7 bankruptcy and a private-sector reorganization is analogous to a Chapter 11 bankruptcy. Our findings show that private-sector reorganizations do not deliver the expected cost-savings prior to the passage of FDICIA in 1991, a period of industry distress. We obtain this result when we control for the selection bias that arises from the resolution process. In contrast, during the post-FDICIA period, we observe that private-sector reorganizations yield significant cost savings over FDIC liquidations. We also find that the direct costs are lower for private-sector reorganizations over the sample period. When compared to nonfinancial bankruptcy costs, FDIC resolution methods appear to be less costly than Chapter 7 and Chapter 11 bankruptcies.

The Financial Sector and the Real Economy During the Financial Crisis: Evidence from the Commercial Paper Market
by Ethan Cohen-Cole, Judit Montoriol-Garriga, Gustavo Suarez, Jason Wu
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Abstract: Shocks to the financial sector led credit spreads to widen to unprecedented levels in many markets during the 2007-2008 financial crisis.

The rise in spreads attracted attention because it could signal a disruption in financial markets, which has been widely linked to an increased burden on non-financial firms. This paper disentangles the relative contributions of credit and liquidity risk in explaining the widening of commercial paper spreads. In doing so, we find that liquidity risk was isolated to the financial sector throughout the first two major shocks to the system (August 2007 and March 2008). Indeed, controlling for credit risk, non-financial corporations saw little or no change in the cost of funding during this time period. After the bankruptcy of Lehman Brothers, for the first time, liquidity problems in the commercial paper market spilled out of the financial sector into the spreads of low credit quality non-financial firms. This effect had a disproportionately larger impact on those low credit-quality non-financial firms that placed paper exclusively through financial sector dealers. High credit quality firms remained unaffected throughout. Our interpretation of the results is that markets were able to differentiate not only between safe and imperiled firms in the midst of the crisis, but also to isolate where liquidity effects were most likely to be salient.

Pay for Performance? CEO Compensation and Acquirer Returns in BHCs
by Haluk Unal, Kristina Minnick, Liu Yang
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Abstract: We examine how managerial incentives affect acquisition decisions in the banking industry.

We find that higher pay-for-performance sensitivity (PPS) leads to value-enhancing acquisitions. Banks whose CEOs have higher PPS have significantly better abnormal stock returns around the acquisition announcements. On average, acquirers in the High-PPS group outperform their counterparts in the Low-PPS group by 1:4% in a three-day window around the announcement. Ex ante, higher PPS helps to prevent value-destroying acquisitions, while at the same time promote value-enhancing acquisitions. The positive market reaction can be rationalized by post-merger performance. Following acquisitions, banks with higher PPS experience greater improvement in their operating performance.

Monetary Policy and Capital Regulation in the US and Europe
by Ethan Cohen-Cole and Jonathan Morse
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Abstract: From the onset of the 2007-2009 crisis, the Federal Reserve and the European Central Bank have aggressively lowered interest rates.

Both sets of changes are at odds with an anti-inflationary stance of monetary policy; indeed, as the crisis began in August 2007 inflation expectations were high and rising, particularly in the United States. We have two additions to the literature. One, we present a model economy with a leveraged and regulated financial sector. Two, we find optimal Taylor rules for our economy that are consistent with a strong pro-inflationary reaction during financial crisis while maintaining a standard output-inflation mandate. We have three interpretations of our results. One, because the Federal Reserve has partial control over bank regulation it can exercise regulatory lenience. Two, the Fed’s stronger output orientation means that it will potentially respond more quickly when faced with constrained banks. Three, our results support procyclical capital regulation.

The Cost Effectiveness of the Private-Sector Resolution of Failed Bank Asset
by Haluk Unal and Rosalind L. Bennett 
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Abstract: In this paper, we examine how the cost of resolving bank failures differs between an FDIC liquidation and a private-sector resolution where the assets remain in the banking system.

Our findings show that private-sector resolutions do not deliver the expected cost-savings prior to the passage of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. We obtain this result when we control for the selection bias that arises from the resolution process. In contrast, during the post- FDICIA period, we observe that private-sector resolutions yield significant cost savings over FDIC liquidations. We also find that the direct costs are lower for private-sector resolutions over the sample period. We derive these results from a sample that spans all failures between 1986 and 2007.

Your House or Your Credit Card, Which Would You Choose?
Personal Delinquency Tradeoffs and Precautionary Liquidity Motives
by Ethan Cohen-Cole and Jonathan Morse
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Abstract: This paper presents evidence that precautionary liquidity concerns lead many individuals to pay credit card bills even at the cost of mortgage delinquencies and foreclosures.

While the popular press and some recent literature have suggested that this choice may emerge from steep declines in housing prices, we find evidence that individual-level liquidity concerns are more important in this decision. That is, choosing credit cards over housing suggests a precautionary liquidity preference. By linking the mortgage delinquency decisions to individual-level credit conditions, we are able to assess the compound impact of reductions in housing prices and retrenchment in the credit markets. Indeed, we find the availability of cash-equivalent credit to be a key component of the delinquency decision. We find that a one standard deviation reduction in available credit elicits a change in the predicted probability of mortgage delinquency that is similar in both direction and nearly double in magnitude to a one standard deviation reduction in housing price changes (the values are -25% and -13% respectively). Our findings are consistent with consumer finance literature that finds individuals have a preference for preserving liquidity - even at significant cost.

Forgive and Forget: Who Gets Credit after Bankruptcy and Why?
by Ethan Cohen-Cole, Burcu Duygan-Bump and Judit Montoriol-Garriga
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Abstract: Conventional wisdom holds that individuals who have gone bankrupt face difficulties getting credit for at least some time. However, there is very little non-survey based empirical evidence on the availability of credit post-bankruptcy and its dependence on the credit cycle.

Using data from one of the largest credit bureaus in the US, this paper makes three contributions. First, we show that individuals who file for bankruptcy are indeed penalized with limited credit access post bankruptcy, but we find that this consequence is very short lived. Ninety percent of individuals have access to some sort of credit within the 18 months after filing for bankruptcy, and 75% are given unsecured credit. Second, we show that those individuals who have the easiest access to credit after bankruptcy tend to be the ones who have shown previously the least ability and least propensity to repay their debt. In fact, a significant fraction of individuals at the bottom of the credit quality spectrum seem to receive more credit after filing. We interpret the widespread post-bankruptcy credit access and the differential credit provision across borrower types as evidence that lenders target riskier borrowers. Employing a simple theoretical framework we show that this interpretation is consistent with a profit maximizing lender whose optimal strategy involves segmenting borrowers by observable credit quality and bankruptcy status. This interpretation is also in line with survey evidence that shows lenders repeatedly solicit debtors to borrow after bankruptcy, especially with offers of revolving credit. Finally, we show that our findings depend heavily on the aggregate credit environment: the ease of credit and limited bankruptcy credit cost observed in the initial period of our data (2003-2004) become much less significant when we repeat the analyses in 2007, as the recent credit downturn began.

Looking Behind the Aggregates: A Reply to “Facts and Myths about the Financial Crisis of 2008”
by Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, Judit Montoriol-Garriga
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Abstract: As Chari et al (2008) point out in a recent paper, aggregate trends are very hard to interpret.

They examine four common claims about the impact of financial sector phenomena on the economy and conclude that all four claims are myths. We argue that to evaluate these popular claims, one needs to look at the underlying composition of financial aggregates. Our findings show that most of the commonly argued facts are indeed supported by disaggregated data.

Designing Countercyclical and Risk Based Aggregate Deposit Insurance Premia
by Dilip B. Madan, Haluk Unal and Robert A. Jarrow
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Abstract: This paper proposes an aggregate deposit insurance premium design that is risk-based in the sense that the premium structure ensures the deposit insurance system has a target of survival over the longer term.

Such a premium system naturally exceeds the actuarily fair value and leads to a growth in the insurance fund over time. The proposed system builds in a swap in premia that reduces premia when fund size exceeds a threshold. In addition, we build in a swap contract that trades premia in good times for relief in bad times.