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«Research Division Federal Reserve Bank of St. Louis Working Paper Series Understanding the Accumulation of Bank and Thrift Reserves during the U.S. ...»

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Research Division

Federal Reserve Bank of St. Louis

Working Paper Series

Understanding the Accumulation of Bank and Thrift Reserves

during the U.S. Financial Crisis

Su-Hsin Chang

Silvio Contessi

and

Johanna L. Francis

Working Paper 2013-029C

http://research.stlouisfed.org/wp/2013/2013-029 .pdf

October 2013

Revised February 2014

FEDERAL RESERVE BANK OF ST. LOUIS

Research Division

P.O. Box 442

St. Louis, MO 63166

______________________________________________________________________________________

The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors.

Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to Federal Reserve Bank of St. Louis Working Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors.

Understanding the Accumulation of Bank and Thrift Reserves During the U.S. Financial Crisis∗ Su-Hsin Chang Silvio Contessi Johanna L. Francis Washington University Federal Reserve Bank Fordham University and in St. Louis of St. Louis University of California, Santa Cruz This version: February 10, 2014 Abstract The level of aggregate excess reserves held by U.S. depository institutions increased significantly at the peak of the 2007-09 financial crisis. Although the amount of aggregate reserves is determined almost entirely by the policy initiatives of the central bank that act on the asset side of its balance sheet, the motivations of individual banks in accumulating reserves differ and respond to the impact of changes in the economic environment on individual institutions. We undertake a systematic analysis of this massive accumulation of excess reserves using bank-level data for more than 7,000 commercial banks and almost 1,000 savings institutions during the U.S. financial crisis.

We propose a testable stochastic model of reserves determination when interest is paid on reserves, which we estimate using bank-level data and censored regression methods. We find evidence primarily of a precautionary motive for reserves accumulation with some notable heterogeneity in the response of reserves accumulation to external and internal factors of the largest banks compared with smaller banks. We combine propensity score matching and a difference-in-differences approach to determine whether the beneficiaries of the Capital Purchase Program of the Troubled Asset Relief Program accumulated less cash, including reserves, than non-beneficiaries. Contrary to anecdotal evidence, we find that banks that participated in the program accumulated less cash, including reserves, than nonparticipants in the initial quarters after the capital injection.

JEL Classification: E44, E51, G21 Keywords: Commercial Banks, Financial Crisis, Excess Reserves, TARP ∗ Su-Hsin Chang: Washington University in St.Louis, Division of Public Health Sciences, Washington University School of Medicine, 660 South Euclid Avenue, Campus Box 8100, St. Louis, MO 63110, changsh@wudosis.wustl.edu. Silvio Contessi: Federal Reserve Bank of St.Louis, Research Division, P.O.

Box 442, St.Louis, MO 63166-0442, silvio.contessi@stls.frb.org; telephone: 314-444-7410; fax: 314-444Johanna Francis (corresponding author): Fordham University, Department of Economics, E-507 Dealy Hall, 441 East Fordham Road, Bronx, NY, 10458, ajofrancis@fordham.edu and University of California, Santa Cruz, Department of Economics, Santa Cruz, CA 95064. The views expressed are those of the authors and do not represent official positions of the Federal Reserve Bank of St.Louis, the Board of Governors, or the Federal Reserve System.

1. Introduction The aggregate level of deposits held by U.S. depository institutions (DIs) at the Federal Reserve Banks increased massively at the peak of the financial crisis between the end of August 2008 and the end of December 2008, in conjunction with the unprecedented expansion of the Fed’s balance sheet (Fig. 1).1 This huge change in deposits at the Fed, most of which are excess reserves (ER), prompted some commentators to argue that precautionary hoarding of cash and reserves was impeding loan growth and potentially slowing the recovery from the 2007-09 recession. The fear was that the accumulation of reserves would dampen the effect of Fed operations to revive the economy and at the same time potentially generate inflation. Keister and McAndrews (2009) and Martin et al. (2013) explain clearly that the level of aggregate reserves is determined by the policy initiatives of the Federal Reserve and may only marginally affect aggregate lending. Although this is true at an aggregate level, ER holdings are not distributed evenly across banks; individual banks can alter the composition of their balance sheets, changing lending to firms and consumers while hoarding ER and cash.

The biggest question raised by the massive accumulation of reserves is why individual profit-maximizing banks held large ER and cash during the financial crisis. Our answer is intuitive: because they were concerned about balance sheet risk and accessing short-term liquidity.





Our study consists of two parts. In the first part, we undertake a systematic analysis of this massive accumulation of ER using microeconomic data for more than 7,000 commercial banks and almost 1,000 saving institutions to identify motives for accumulation and determine whether these motives differ across DIs by size and type. In the second part, we study the effect of the Capital Purchase Program (CPP) on reserve and cash accumulation.

In the first part of our analysis, we provide some insight into the heterogeneous effects of the 2007-09 financial crisis and, to some extent, of the fiscal and monetary policy actions in the commercial banking sector. We estimate a log-linearized version of a simple model of stochastic reserves accumulation using bank-level data and censored regression methods.2 1 DIs (commercial banks, savings institutions, credit unions, and foreign banking entities) may hold their required reserves as either vault cash or deposits at their regional Federal Reserve Bank. Deposits at the Federal Reserve are the sum of reserve balances with Federal Reserve Banks and required clearing balances; on August 27, 2008, total deposits at Federal Reserve Banks were $20.394 billion; on December 29, 2010, they were $1,020.937 billion.

2 ER holdings at the micro level are confidential information. To recover a bank-level estimate of ER, we subtract estimated required reserves from reported cash, including total reserve holdings at the Federal Reserve. Therefore, our measure of ER also includes cash in addition to excess balances at the Federal Reserve. We discuss the bias this might We find evidence of three motives for reserve and cash accumulation: First, there appears to be a strong precautionary motive due to weak balance sheets; second, evidence of concerns about accessing short-term liquidity in the market, particularly for large banks3 ; and third, evidence that banks are sensitive to changes in the opportunity cost of holding low-interest-bearing assets, suggesting that opportunities for low-risk lending were inadequate.

We uncover significant heterogeneity in the responsiveness of reserves accumulation.

We find that (i) cash and ER holdings for large banks are much more responsive to the penalty rate than those of small banks, (ii) a different relationship exists between capital ratios and cash and reserves accumulation for large versus small banks, and (iii) large banks are much more sensitive to distressed loans as a percentage of deposits than small banks. We also find that thrifts behave like small banks in terms of the relationship between capital adequacy and reserves accumulation but like large banks in relation to the penalty rate and sensitivity to distressed loans.

These results likely reflect several important changes in the banking environment during this period. First, the federal funds and the repurchase markets experienced significant volume declines during our sample period. These markets are a significant source of short-term funding for banks. Notably, the declines in trading activity were more pronounced for large bank trading than for small banks. Second, increases in the Chicago Board Options Exchange (CBOE) Volatility index (VIX) during this period are suggestive of changes in risk perceptions. Third, there was significant regulatory uncertainty related to new consumer protection laws, changes to capital requirements, and concerns about future litigation.

In the second part of our analysis, we study the relationship between the CPP of the Troubled Asset Relief Program (TARP) and cash and reserves accumulation by banks.4 The ideal way to study the effect of capital injections on the banking system would be to have a counterfactual. Although we cannot observe what would have happened to the balance sheets of banks that received CPP funds had they not received them, we can observe banks that were ex ante similar to the CPP beneficiaries but did not receive capital injections. Operationally, we use propensity score matching (PSM) to construct a control group of non-CPP institutions that we compare with the CPP beneficiaries.

We then estimate the difference-in-differences between pairs of indicators for the two create in our estimates in Section 5.1 3 Ashcraft, McAndrews, and Skeie (2011) find similar evidence which we discuss in Section 5.2.

4 We use “CPP” and “TARP” interchangeably, although the CPP was the part of the TARP related to the banking

sector.

groups of banks to remove unobservable differences between them. Although we are able to match a large number of banks that received CPP funds, an important caveat of our study is that, because almost all large banks (as ranked by assets) received CPP funds, finding an opportune control is unfeasible; therefore, we remove the largest 20 banks from our study.

We find that the remaining sample of the beneficiaries of CPP funds accumulated less cash and reserves than non-beneficiaries. Popular opinion at the time of the crisis was that the CPP failed to improve lending because it increased reserves accumulation.

On the contrary, Contessi and Francis (2011) found that banks receiving CPP funds provided more loans than their counterparts, but since issues of endogeneity and selection were not dealt with formally, these were tentative statements. The banks that did not receive CPP funds may not have received them for various reasons—for example, because they were sufficiently capitalized and therefore had no need for the funds or, alternatively, because they were in such poor financial health they were ineligible for the program. In this paper, we construct an appropriate control group to address problems of endogeneity and selection for our results. To the best of our knowledge, this is the first study to adopt PSM in the non-experimental setting of applied banking. Similarly, Black and Hazelwood (2013) study bank risk-taking after receipt of CPP funds, using an event-study methodology that also carefully controls for differences between CPP and non-CPP recipients.

Our work contributes to the literature on reserves accumulation during crisis episodes.

As such it fits into the large and diverse literature addressing the reasons for reserves accumulation by U.S. banks during the 1930s and the substantial buildup in ER in the Japanese banking system during the 1990s. Our work also contributes to the more recent debate on the impact of the financial crisis on the banking system and the conduct of monetary policy in a regime that includes an interest on reserves (IOR) policy;

we discuss these issues in section 2.

In their influential analysis of the monetary history of the Depression era, focusing on the increase in ER holdings, Friedman and Schwartz (1963) argued that banks desired a higher level of reserves for precautionary purposes after the panic of the early 1930s. Horwich (1963), on the other hand, provided early empirical evidence suggesting banks held ER because of the lack of profitable alternatives to holding cash as a result of low interest rates. The widespread view in the post-WWII literature was that ER were considered purely surplus during the Great Depression, a view surprisingly shared by members of the Federal Open Market Committee (FOMC). According to this view, ER served no economic purpose, as commercial banks passively accumulated them due to lack of good loan opportunities (a view sometimes referred to as the “inertia effect” hypothesis (see, e.g., Frost, 1971). As a consequence of the large ER holdings, the Federal Reserve was essentially powerless to expand the money supply —the banking system was caught in a liquidity trap, a condition we also find evidence for in the 2007nancial crisis. Bernanke (1983) and Bernanke and Gertler (1990) emphasize the role of high risks and low returns on alternatives during the Depression era, supporting the view that ER holdings may reflect an environment with few investment alternatives of comparable risk. These results connect to a large literature examining the role of uncertainty on bank cash flows and the varying impact of uncertainty between periods of crisis and non-crisis (see, e.g., Orr and Mellon, 1961; Poole, 1968; Cooper, 1971;

Frost, 1971; Ratti, 1979; Hanes, 2006).

A series of recent studies discusses the importance of the constraints exerted by excess liquidity and their role in signaling a bank’s own liquidity. Calomiris et al.



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