Jeremy C Stein: Banks as patient debt investors
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the American Economic Association/American Finance Association Joint
Luncheon, Philadelphia, Pennsylvania, 3 January 2014.
* * *
I'm delighted to be speaking to this group; it's really an honor. Given the audience - and
because I may never again have so many economists in front of me at one time - I thought
that rather than giving a policy-oriented speech, I would test-drive a new research project.
The project is ongoing joint work with Samuel Hanson and Andrei Shleifer of Harvard and
with Robert Vishny of the University of Chicago. We haven't quite finished writing up the
paper, but we have most of the raw material and a pretty good idea of where we are trying to
go, so I figured I would give it a shot.1
Our aim is primarily positive, as opposed to normative: We're interested in better
understanding the economic role played by commercial banks, as well as the interplay
between the traditional commercial banking sector and the so-called shadow-banking sector,
which includes various non-bank intermediaries such as broker-dealers, money-market
funds, and hedge funds.
It would be an understatement to say that the literature on the role of banks is vast. Without
attempting to do it justice, let me just note three prominent classes of theories. The first
focuses on the liability side of banks' balance sheets - that is, their deposit-taking role. In this
view, what is most important about banks is that they create safe claims which, precisely
because of their safety and immunity from adverse-selection problems, are useful as a
transactions medium.2 In other words, banks are special because they are the institutions
that create private, or "inside," money. Although it does not necessarily follow as a logical
matter, this view has led some observers to advocate narrow-banking proposals, whereby
bank-created money is backed by very safe liquid assets, such as Treasury bills.3
A second class of theories emphasizes the asset side of banks' balance sheets and their role
as delegated monitors in the lending process.4 Here banks are seen as a mechanism for
dealing with the information and incentive problems that would otherwise make it difficult for
credit to be extended to opaque borrowers such as small businesses. Because this work is
silent on the precise structure of the liability side, it does not draw much of a distinction
between banks and other, nonbank lending intermediaries, such as finance companies.
Finally, a third class of theories explicitly addresses the question of what ties together the
asset and liability sides of banks' balance sheets - that is, why do the same institutions that
create private money choose to back their safe claims by investing in loans and other
relatively illiquid assets?5 What is the nature of the synergy between the two activities?
Our work fits into this third category, with two twists relative to previous research. First, we
stress the fact that on the asset side, banks hold not only loans, but like their
shadowbanking counterparts, they also hold securities, often in very substantial amounts. Moreover,
these securities holdings have a particular pattern. Banks tend to stay away from the safest
and most liquid securities, such as Treasury securities, and instead concentrate their
holdings in securities that are less liquid and whose market prices are more volatile, including
agency mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs),
asset-backed securities and corporate bonds. We argue that this pattern is an important clue
to the business of banking more generally.
Second, while we follow previous work in assuming that the safety of bank liabilities is an
important part of what makes them special, we depart from much of the rest of the literature
by downplaying the vulnerability of bank deposits to runs. Indeed, we emphasize precisely
the opposite aspect of deposit finance: Relative to other forms of private-money creation that
occur in the shadow-banking sector - notably, short-term collateralized claims such as
broker-dealer repurchase agreements (repos) - bank deposits are noteworthy because, in
the modern institutional environment, they are highly sticky and not prone to run at the first
sign of trouble.
In its simplest terms, our story is as follows: There are different private technologies for
creating safe money-like claims. The "banking" technology involves meaningful amounts of
capital as well as deposit insurance and thus leads to deposits that are both safe and
relatively stable. The "shadow banking" technology uses less capital and manufactures
safety by, instead, giving repo investors collateral and the right to seize the collateral on a
moment's notice. So shadow banking money is much more run prone than bank money.
Given its relatively stable nature, the banking model is better suited to investing in assets that
are illiquid and subject to interim price volatility - that is, to fire-sale risk. These assets can be
loans that involve significant amounts of monitoring, or they can be securities that require
less monitoring. What is essential is the synergy between issuing stable types of money
claims and investing in assets that have some degree of exposure to fire-sale risk. That
synergy, in our view, is at the heart of the business of traditional banking.
We have developed a simple theoretical model that captures the main ingredients of this
story and makes some further testable predictions. It's probably ill-advised over lunch, but I
will take a crack at sketching this model for you here. However, let me start with three
stylized facts to motivate the theory.
Stylized facts
The first fact, and the one that I suspect will surprise you the least, is the strong homogeneity
of the liability side of banks' balance sheets: Banks are almost always and everywhere
largely deposit financed. For example, in the cross section, and using year-end 2012 data, a
bank at the 10th percentile of the distribution had a ratio of deposits to assets of
73.6 percent, while a bank at the 90th percentile had a ratio of 88.9 percent.6 A similar
homogeneity is apparent in the time series: Over the past 115 years, deposits have averaged
80 percent of bank assets, with a standard deviation of only 8 percent. These patterns are in
sharp contrast to those for nonfinancial firms, for which capital structure tends to be much
less determinate, both within an industry and over time. They suggest that for banks - unlike
non-financials, and counter to the spirit of Modigliani and Miller (1958) - an important part of
their economic value creation happens on the liability side of the balance sheet, via
deposittaking.
The second fact, which is perhaps just a bit more surprising, is that the asset side of banks'
balance sheets - and, in particular, their mix of loans versus securities - is considerably
more heterogeneous. In the 2012 cross section, a bank at the 10th percentile of the
distribution had a ratio of securities to assets of 6.9 percent, while, for a bank at the
90th percentile, the ratio was almost six times higher, at 40.7 percent.7 One interpretation of
this heterogeneity is as follows: While lending is obviously very important for a majority of
banks, it need not be the case that a bank's scale is pinned down by the nature of its lending
opportunities. Rather, at least in some cases, it seems that a bank's size is determined by its
deposit franchise, and that, taking these deposits as given, its problem then becomes one of
how best to invest them. Again, this liability-centric perspective is very different from how we
are used to thinking about nonfinancial firms, whose scale is almost always presumed to be
driven by its opportunities on the asset side of the balance sheet.
The third stylized fact, illustrated in figure 1, is the one that I found most eye-opening:
While banks might be quite heterogeneous in their mix of loans and securities, within the
category of securities, they appear to have well-defined preferences. As can be seen in
the figure, banks hold very little in the way of Treasury securities and securities issued
directly by the government-sponsored agencies: These two categories accounted for just
7.7 percent and 5.8 percent of total securities holdings, respectively, on a value-weighted
basis in 2012. The large bulk of their holdings is in MBS guaranteed by the agencies and
other types of mortgage-linked securities - such as CMOs and commercial
mortgagebacked securities (CMBS) - which collectively accounted for 57.7 percent of securities
holdings in 2012. Also important is the "Other" category, which includes corporate and
municipal bonds, as well as asset-backed securities, and which accounted for
29.3 percent of holdings in 2012.
This composition of banks' securities portfolio is not what you would expect if they were
simply holding securities as a highly liquid buffer against, say, unexpected deposit outflows
or commitment drawdowns. It also appears - superficially, at least - at odds with the
narrowbanking premise that one can profitably exploit a deposit franchise simply by taking deposits
and parking them in Treasury bills. Rather, it looks as if banks are purposefully taking on
some mix of duration, credit, and prepayment exposure in order to earn a spread relative to
Treasury bills. And indeed, over the period from 1984 to 2012, the average spread on banks'
securities portfolio relative to bills was 1.73 percent.
By contrast, over this same period, we estimate that if banks had raised deposits and
invested them exclusively in three-month Treasury bills, they would have earned an average
net return of only 0.06 percent of deposits. This figure is based on three components. First,
the spread between the rate earned on bills and that paid on deposits averaged 0.87 percent
over the sample period. Second, there was additional noninterest income on deposits (for
example, overdraft fees) of 0.49 percent of deposits. Third, however, deposit-taking involves
considerable bricks-and-mortar costs. Using Call Report data on banks' total costs, and a
hedonic regression approach to infer the portion of cost that is due to deposit-taking, we
estimate this piece to have averaged 1.30 percent of deposits over the sample period. Thus,
the net profitability of narrow banking is given by 0.87 percent plus 0.49 percent minus
1.30 percent, which equals 0.06 percent.
Overall, our synthesis of these stylized facts is that banks are in the business of taking
deposits and investing these deposits in fixed-income assets that have certain well-defined
risk and liquidity attributes but which can be either loans or securities. The
informationintensive nature of traditional lending - in the delegated monitoring sense - while clearly
important in many cases, may not be the defining feature of banking. Rather, the defining
feature may be that, whether banks invest in information-intensive loans or relatively
transparent securities, they invest in fixed-income assets that have some degree of price
volatility and illiquidity and so offer a higher return than very liquid and safe Treasury
securities. In this sense, small business loans and CMOs are on one side of the fence, and
Treasury securities are on the other.
Before proceeding, I should note a natural first reaction to these observations. You might
say, "Of course banks prefer holding riskier securities to riskless ones, even if they create no
monitoring value in either case. They are just taking advantage of the put option created by
deposit insurance. In other words, the evidence on the patterns of banks' securities holdings
just reflects a moral hazard problem and nothing more."
Without intending to dismiss the importance of moral hazard generally, I don't think it can
fully account for the data in figure 1. One way to make this point is to redraw the figure,
restricting the sample only to those banks with the highest levels of capital at any point in
time - those above the median of the distribution by the ratio of equity to assets - as is done
in figure 2. As can be seen, the basic patterns are very similar to those in figure 1. Given that
these highly capitalized banks are less likely to impose losses on the Deposit Insurance
Fund, I think there is something deeper here than can be explained by a simple appeal to
deposit-insurance-induced moral hazard.
So what, then, is the story? As I alluded to earlier, it begins with the observation that a
deposit franchise has two important dimensions. First, it offers a bank a low-cost source of
financing, given the premium that investors are willing to pay (that is, the lower yield they are
willing to accept) for safe money-like claims. And, second, it offers funding stability, since
with an adequate capital buffer and deposit insurance, it is rational for depositors to be
"sleepy" and disregard moderate changes in the mark-to-market value of long-term
fixedincome assets. Thus, a stable deposit franchise gives a bank the ability to ride out transitory
valuation changes of the sort that might come from noise-trader shocks or fire sales, without
being forced to liquidate assets at temporarily depressed prices.8 As a result, traditional
banks with stable funding have an advantage relative to their shadow banking counterparts
in holding those assets where transitory repricing risk is high for a given level of underlying
fundamental cash flow risk.
Here's one way to put the broad theme of our work: We have learned from this year's Nobel
laureates, Eugene Fama and Robert Shiller, that discount rate variation - that is, transitory
movements in asset prices not driven by changes in future expected cash flows - is central
to understanding asset pricing. Our basic message is that this same discount rate variation
may also be central to thinking about financial intermediation and, in particular, the
connection between the asset and liability sides of intermediary balance sheets. In a world
with transitory pricing shocks, a stable funding structure can be an important source of
comparative advantage for holding certain types of assets.
The model
We have developed a simple model to try to make these ideas precise and to flesh out
further empirical implications. I won't try to walk you through it in all of its detail, but I will try
to give you a flavor for the basic structure and the main results.9
The model has three dates - 0, 1, and 2 - with a timeline illustrated in figure 3. There is a
collection of different long-lived fixed-income assets indexed by i. The payoffs on these
i R
assets are all perfectly correlated. In particular, each asset pays off at time 2 if the
aggregate state of the world is such that there has been no default, and it pays off a lower
amount, zi, if there has been a default. At time 1, there is an interim news event. With
probability p, the news is good, which means that all assets will definitely not default at time
2. And with probability (1 - p), the news is bad, which means that there is a subsequent
probability of default on all assets of (1 - q) at time 2. Thus, in the bad-news state at time 1,
fundamental i qR +
the value of asset is Fi = (1 - q)zi. However, if there is bad news at time 1,
the market value of asset i will be depressed by a temporary fire-sale effect and will be given
by kiFi =Fi. The value of ki is endogenous and asset specific in our model and depends on the
i
equilibrium quantity of asset that is liquidated at time 1; I will return to this feature
momentarily.
Household preferences are as follows: Households are risk neutral over fluctuations in their
consumption. However, they derive additional utility - which can be thought of as
transactions services - from holding completely safe claims, since these claims can be used
in a money-like fashion. The upshot of these assumptions is that households require a fixed
rate of return on any risky claims, no matter how risky, but a lower rate of return on claims
that can be made completely safe. These latter safe claims can be interpreted as privately
created money.
Given these household preferences, the name of the game for financial intermediaries is to
create as much in the way of safe money-like claims from each asset category i as possible.
And given the structure of the model, there are two distinct technologies for creating safe
claims.
The first technology we label "traditional banking." A traditional bank is relatively conservative
in issuing safe claims. In particular, for each dollar it holds of asset i, it issues zi of deposits
and finances the rest with equity. Since asset i always pays off at least zi, even in the
worstcase scenario, a depositor in a traditional bank can sleep through whatever news comes in at
time 1 and still be assured of having a safe claim. In other words, a bank backs its deposits
with enough capital so as to make these deposits safe over a two-period horizon and hence
endogenously sticky; there is no reason for bank depositors ever to run at time 1.
Alternatively, one can think of the bank as having acquired deposit insurance - which allows
depositors to sleep through time 1 - and the deposit insurer as having imposed a capital
requirement of (1- zi) on the bank so as to reduce its expected losses to zero.
The second technology for creating safe claims we label "shadow banking." Shadow banks
are more aggressive: They rely less on capital, and more on the exit option at time 1, to
create safety for their investors. Specifically, a shadow bank issues kiFi of short-term
collateralized claims for each dollar of asset i it holds, where > The way these claims
kiFi zi.
are kept safe is that if there is bad news at time 1, the investors seize the collateral and
dump it at the fire-sale price, realizing kiFi. In other words, unlike bank investors, shadow
bank investors cannot afford to sleep through time 1; their ability to pull the plug at this
interim date is essential to keeping their claim safe.
For any given asset i, the key question is, which type of intermediary - traditional bank or
shadow bank - will end up holding the asset in equilibrium, and in what relative proportions?
The answer to this question turns on the following tradeoff. On the one hand, since banks
finance themselves with more equity and less cheap "money" than shadow banks, their
overall cost of financing is higher, which puts them at a disadvantage. On the other hand,
their more conservative capital structure means that banks' deposits never run on them.
Hence, unlike shadow banks, they are never forced to liquidate assets at temporarily low
prices when there is bad news at time 1; they can simply ride out this bad news and hold on
to their investments until prices recover at time 2. In other words, as compared with shadow
banks, traditional banks pay more to have a stabler funding structure, which is especially
helpful for investing in those assets for which fire-sale discounts are high.
To close the model, we need to endogenize the fire-sale discount factor, ki. We assume that
this fire-sale discount depends in part on the amount of liquidations at time 1, which is in turn
related to the extent of ownership of asset i by the shadow banking sector - the more the
shadow banking sector owns, the more gets dumped at time 1, and hence the lower is the
fire-sale price. This assumption implies that the fire-sale discount plays an important
equilibrating role in the model, and that we can have interior equilibria in which the ownership
i
of a given asset is divided across the traditional banking and shadow banking sectors; as
ownership migrates to shadow banks, the fire-sale discount widens, which tends to reduce
the relative advantage of shadow banks.
Specifically, we adopt the following reduced form: ki = k(μi, fi), where μi is the fraction of asset
i held by the shadow banking sector and fi is an index of asset illiquidity, with higher values of
fi corresponding to less-liquid assets. We assume that dki/dμi < 0, meaning that a greater
shadow banking share results in a lower fire-sale price, and that < 0, meaning that
d2ki/dμidfi
this adverse price-pressure effect is amplified in more-illiquid assets.
With all of this machinery in place, I can now state our main results, which characterize how
banks' equilibrium market shares depend on the two primitive asset-level parameters, and
fi
zi. First, we have that dμi/dfi < 0, which means that banks have a bigger share relative to
shadow banks in more-illiquid assets, all else being equal. Second, we have that dμi/dzi < 0,
which means that banks have a bigger share in assets that have less long-run solvency risk,
all else being equal.
Taken together, these two results suggest that banks have a comparative advantage in
holding assets that can experience significant temporary price dislocations but, at the same
time, have only modest fundamental risk. Agency MBS might be a leading example of such
an asset, since they are insured against default risk but are less liquid than Treasury
securities and, for a given duration, have more price volatility, as the MBS-Treasury spread
varies significantly.
The model also explains why, even absent any institutional or regulatory constraints, banks
would endogenously choose to avoid equities - they simply have too much fundamental risk.
Because their value can fall very far over an extended period of time - that is, because their
zi is close to zero - equities cannot be efficiently used as backing to create safe two-period
claims. So they are not good collateral for bank money. By contrast, to the extent that they
are highly liquid, they do make suitable collateral for very short-term repo financing. In other
words, equities can be used to back some amount of shadow bank money.
It should be noted that the model admits either interior outcomes or corner solutions,
depending on the asset-specific values of zi and fi. So it is consistent with the possibility that
some assets (say, highly illiquid loans) will be held only by banks, some (say, Treasury
securities) will be owned predominantly but not exclusively by shadow banks, and some
(say, agency MBS, CMBS, and CMOs) will be owned in significant quantities by each type of
intermediary, with an equilibrium fire-sale discount that just balances the tradeoff between
the two organizational forms. In this view of the world, loans are seen as being on a
continuum with less-liquid securities, and they are held by banks because of their relative
illiquidity and susceptibility to fire-sale discounts, not solely because of a need for monitoring.
Further evidence
One way to draw out some further implications of the model is to focus on the key
comparative static, < 0 - namely, that banks have a bigger market share in
dμi/dfi
moreilliquid assets. Now, of course in the real world, there are many different kinds of financial
intermediaries, not just two as in our simple model. But a rough generalization of our theory
would be to say that across intermediary types, we should expect those with relatively
morestable liabilities to hold more-illiquid assets.
To implement a test of this proposition, we use flow of funds data on eight classes of
financial intermediaries: banks, broker-dealers, money market funds, real estate investment
trusts, government-sponsored enterprises, property and casualty insurers, life insurers, and
finance companies.10 The flow of funds data include breakdowns of the different assets and
liabilities of each of these intermediaries. Our test then requires us to measure the "illiquidity"
of each category of asset and the "stickiness" of each category of liability, which we do using
homemade indexes that vary from 0 to 1. Although there is inevitably some subjectivity
involved in constructing these indexes, we try to minimize this subjectivity by relying as
heavily as possible on the parameters in Basel III's Net Stable Funding Ratio and Liquidity
Coverage Ratio.11 With these indexes in hand, we can then aggregate up to create values for
the asset illiquidity and liability stickiness of an entire intermediary sector.12
Figure 4 plots the results of this exercise using data as of year-end 2012. As can be seen,
there is a very tight cross-intermediary correlation between liability stickiness and asset
illiquidity. At one end of the spectrum are money market funds and broker-dealers
- prototypical shadow-bank-type institutions - with very low values of both, and at the other
end are banks and life insurance companies. While there are only eight data points, the close
fit of the regression line is consistent with the broad thrust of our story.
To further highlight the importance of stable bank liabilities, figure 5 takes an approach
similar to that of figure 4 but plots asset illiquidity versus the contractual maturity of liabilities,
rather than their effective stickiness. Now the banking sector appears as a huge outlier, since
the contractual maturity of banks' liabilities is extremely short - indeed, shorter than that of
broker-dealers - even while they hold highly illiquid assets. This observation underscores a
key point: If one wants to understand the divergent asset-side behavior of banks and shadow
banks, one has to look not to the literal contractual maturity of their liabilities, but rather to the
differing incentives that their overall financial and institutional arrangements create for
shortterm claims to be stable in the face of bad news.
Other implications
Our framework may also be helpful in understanding a couple of other aspects of the
business of banking. The first is banks' accounting treatment of their "available for sale"
securities, according to which ongoing mark-to-market gains and losses don't appear in net
income.13 This treatment implicitly presumes that these gains and losses are temporary and
that banks can ride them out by not having to sell the security in question before it matures.
While I would not want to go so far as to claim that our model justifies this accounting
practice, it at least provides a starting point for thinking about it.14 By contrast, the practice
10
The data are from the Federal Reserve Board's Statistical Release Z.1, "Flow of Funds Accounts of the United
States" (in June 2013, the release was renamed "Financial Accounts of the United States"),
www.federalreserve.gov/releases/z1.
11
See Basel Committee on Banking Supervision (2010, 2013).
12
As an example, using this approach, we assigned values of the illiquidity index of 0 for Treasury securities,
0.15 for agency MBS, 0.5 for corporate equities, and 1.0 for unsecured commercial and industrial loans and
commercial real estate loans. Similarly, we assigned values of the stickiness index of 0 for nondeposit
shortterm funding, 0.7 for wholesale bank deposits, 0.8 for retail time and savings deposits, and 0.9 for transactions
deposits.
13
These "temporary impairments" flow through another liability account called "accumulated other
comprehensive income" and affect earnings under generally accepted accounting principles only if the gains
or losses are realized by selling a security.
14
See Cochrane (2011) for a similar argument.
would be incomprehensible in a world in which changes in asset prices reflected changes in
expected future cash flows.
Second, our approach may help shed some light on the bricks-and-mortar costs associated
with bank deposit-taking. As I mentioned earlier, we estimate these costs to be quite high,
averaging on the order of 1.30 percent of deposits over the period from 1984 to 2012. And of
course, these costs ultimately represent an endogenous decision - banks could always
choose to offer their customers fewer and less attractive branch locations, fewer
opportunities for interacting with a human teller, and so forth. One view is that these
amenities are simply a separable flow of services to depositors, conceptually analogous to
interest income. However, an interesting alternative is that they represent a deliberate effort
to build loyalty - that is, to create a form of switching costs. To the extent that other elements
of their business model are also devoted to creating and exploiting deposit stickiness, it may
make more sense for banks to make complementary investments of this sort in enhancing
customer loyalty. By contrast, a money market fund complex - which also takes deposits, but
which invests exclusively in short-term assets - has less reason to spend as heavily on a
branch network.
Conclusion
Let me summarize. The creation of private money - that is, safe claims that are useful for
transactions purposes - is obviously central to what banks do. But safe claims can be
manufactured from risky collateral in different ways, and banks are not the only type of
intermediary that engages in this activity. What makes banks unique is that they use a
particular combination of financial and institutional arrangements - including capital, deposit
insurance, and access to a lender of last resort - as well as substantial investments in bricks
and mortar, to create liabilities that are not only safe and money-like, but also relatively
stable and thus unlikely to run at the first sign of trouble. This is in contrast to shadow banks,
who create money-like claims more cheaply, by relying on an early exit option, and who are
therefore more vulnerable to runs and the accompanying fire-sale risk.
I have argued that there is a synergy between banks' stable funding model and their
investing in assets that have modest fundamental risk but whose prices can fall significantly
below fundamental values in a bad state of the world. This synergy helps explain both why
deposit-taking banks might have a comparative advantage at making information-intensive
loans and, at the same time, why they tend to hold the specific types of securities that they
do.
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