Banks as Patient Fixed Income Investors

Hanson, Samuel G., Andrei Schleifer, Jeremy C. Stein, and Robert W. Vishny, “Banks as Patient Fixed Income Investors,” American Finance Association 75th Annual Meeting, Boston (2015).

Purpose:  To introduce a model explaining why asset holdings differ between traditional banks and so-called “shadow banks.”

Findings:

  • Traditional banks have more market share in assets that are illiquid and that are fundamentally safe but have high intertemporal volatility.
    • business loans, MBSs, etc.
  • So-called shadow banks hold assets that are either highly liquid or that have low volatility.
    • equities, Tresauries, etc.

Motivation:

  • Commercial banks’ liability mix is highly homogeneous (mostly customer deposits), both in the cross section and in the time series.
  • Bank assets are far more heterogeneous.
  • Banks’ scale seems to be driven by their ability to attract deposits (liabilities), rather than by their investment opportunities (assets).
  • Banks’ asset portfolio does not appear to be a liquidity buffer; rather, banks hold few Treasury securities and instead hold assets earning a (riskier) spread over Treasuries.
  • Bank risk-taking is not likely to be the result of moral hazard due to deposit insurance.

Model:

  • There are N risky assets
    • Assets are perfectly correlated, differing by their payoff in the bad state of the world.
  • The model has three actors: households, banks, and shadow banks.
    • Households are risk neutral, and invest in bank claims but do not own assets.
    • Banks invest in assets and issue claims on these assets to households. Intermediation is necessary to create safe claims, as no asset is risk-free.
  • The model has three time periods:
    • At time t=0, banks invest in risky assets and issue claims to households.
    • At time t=1, bad news arrives with probability 1-p. Shadow banks must sell assets for less than fundamental value, but traditional banks are not forced to sell.
    • At time t=1, payoffs to asset holdings and household claims are realized. If bad news arrived at time t=2, then the bad state occurs with probability 1-q.
  • Traditional bank intermediation
    • Traditional banks hold assets to maturity, and create safe assets by only issuing claims equal to their asset portfolio payoff in the bad state. The rest of their asset portfolio is financed using costly equity.
  • Shadow bank intermediation
    • A shadow bank is a dual institution–a highly-leveraged institution (HL) and a money-market fund (MMF).
    • The HL purchases risky assets and enters a short-term repo agreement with the MMF.
    • The MMF creates safe assets through its ability to seize the HL’s assets and sell them at fire-sale prices if bad news occurs.

Results:

  • In an interior equilibrium where both types of banks hold an asset type, the marginal benefit of stable funding (the avoidance of fire-sale losses) equals the marginal cost of stable funding (limits on the amount of claims that can be created—money creation).
  • Corner solutions are also possible, where an asset type is held exclusively by one type of institution.
  • Traditional bank asset ownership increases in asset illiquidity and in expected bad-state payoff.
    • High asset illiquidity and bad-state asset payoff diminishes the money-creating advantage of shadow banks.
    • Equities are not suitable for traditional bank ownership (bad-state payoffs are too low) but are suitable for shadow bank ownership (liquidity is high).
  • An increase in the premium households pay for safe assets lowers traditional bank ownership for all (risky) assets.
  • A decrease in the probability of bad news lowers traditional bank ownership for all assets.

Empirical Evidence

  • Banks with stickier liabilities hold more illiquid assets.
    • “Sticky” liabilities mean that depositors are less likely to withdraw them upon bad news.
  • Banks hold very little of either Treasury securities or equities.