Bank Financing Strategies in the Face of Different Risk Pricing Across Claims

1. Bank Financing Strategies in the Face of Different Risk Pricing Across Claims Banking Regulation Conference 4 August 2014 Univ. of Iowa, Tippie College of Business

2. Organization • Deposit funding seems cheaper • US and NZ evidence • So why don’t banks finance themselves entirely with deposits? • Graph (model) • Variation across banks (why) • Implications of graph • More flexibility (lower access cost) is valuable • More flexibility reduces need to carry slack • Evidence on FLEX and bank value and slack policy Univ. of Iowa, Tippie College of Business

3. Abnormal returns to downgrade news for US banks Abnormal Return = Actual Return – [rf + (rm – rf)] Univ. of Iowa, Tippie College of Business

4. Deposit funding at US banks after a downgrade? Banks increase their use of insured deposits post-downgrade. They also reduce their lending (assets). Univ. of Iowa, Tippie College of Business

5. How to evaluate NZ banks? • Not as many as there are US banks. • Essentially impossible to conduct “event study” of downgrades of NZ banks (sample size problem) • What other way can we “test” for cheaper deposit funding in NZ? • Look for changes in bank behavior when risk becomes more expensive, but using plentiful data on the price of risk. Univ. of Iowa, Tippie College of Business

6. Credit risk spreads • Credit risk spread is the difference between returns on BBB-rated debt and the return on risk-free assets. • When the credit risk spread gets bigger, the price of risk rises. • Expect more deposit funding by banks when this happens Univ. of Iowa, Tippie College of Business

7. When credit risk spreads get bigger (increasing the price of risk), NZ banks use more deposit funding. NZ banks act as if the price of risk is lower on deposits than on non-deposit liabilities. Univ. of Iowa, Tippie College of Business

8. Deposit financing “seems” cheaper than non-deposit liability financing. Casual empiricism (intuition) also suggests that any rate paid on deposit financing can be more sticky than the rate paid on non-deposit liabilities. So why don’t banks solely use insured deposits? It’s not costless to access deposits Univ. of Iowa, Tippie College of Business

9. What sorts of costs do banks face when raising deposits? • Access costs! • Finite supply • Search costs (outside local market) • Branching costs • Advertising • Rising in quantity • Varying across banks (market power, reputation…) Univ. of Iowa, Tippie College of Business

10. What does this look like? Univ. of Iowa, Tippie College of Business

11. But, for a higher access cost bank… Univ. of Iowa, Tippie College of Business

12. So, a bank with lower access costs can more cheaply raise funds. This should be valuable! How to measure lower access costs (financial flexibility)? Univ. of Iowa, Tippie College of Business

13. Measuring FLEX • Graph on slide 7 indicates that bank use of deposit financing is increasing in spread. • Graphs on slides 10 and 11 indicate that accessing deposits is more expensive per unit for some banks. • Banks with lower access costs will switch more into deposit financing as spread increases, than banks with higher access costs. Univ. of Iowa, Tippie College of Business

14. Linear Relationship between deposit use and spread Univ. of Iowa, Tippie College of Business

15. Variation in FLEX(consistent with expectations) • σFLEX across banks = 0.026 (mean = 0.019) • Bigger, more profitable banks have larger FLEX • Lower access costs when depositors are more willing to put their money in your bank (perhaps more name recognition / greater charter value) • Riskier banks have lower FLEX • Higher access costs when depositors are less willing to put their money in your bank Univ. of Iowa, Tippie College of Business

16. Is FLEX valuable? Yes, but is it solely because of funding arbitrage opportunities? Or, does the lower cost of access that enables funding arbitrage also deliver additional benefits? Univ. of Iowa, Tippie College of Business

17. Additional benefits of FLEX • Without FLEX, firms (banks) would eschew some investments, particularly those that involved external financing at high access cost • Passing up valuable investment opportunities is not optimal • So firms (banks) carry excess cash/slack to enable investment in these opportunities • But slack is costly (agency problems, taxes) • Slack would be less necessary if a firm (bank) has lower access costs • Higher FLEX enables less slack and this is also valuable (due to reduced agency and/or tax costs) Univ. of Iowa, Tippie College of Business

18. In the US • There is a negative relation between bank FLEX and (cash [slack]/TA) ratio • When a bank has more flex, they carry less slack and therefore experience lower agency and/or tax costs associated with slack • What about NZ? • Don’t have the data (need individual bank data over a sufficient time series to estimate FLEX) to test Univ. of Iowa, Tippie College of Business

19. Other possible avenues for research (which may have policy implications) • Might FLEX alter the optimal maturity structure of a bank’s financing? • Given the stickiness of deposit rates relative to market rates, a steepening yield curve makes market rates rise faster than deposit rates. • Banks with greater FLEX can more easily take advantage of this stickiness (shift into deposits more easily when they become relatively cheaper) • Banks with greater FLEX may optimally shorten the maturity structure of their non-deposit liabilities (short term debt tends to be cheaper), and particularly focus on callable bonds [finance the call with deposit funding] Univ. of Iowa, Tippie College of Business

20. Thank you Questions? Univ. of Iowa, Tippie College of Business